Somewhat fortuitously, the past ten days have seen both my purchase of Somero Enterprises Inc. (LSE: SOM) and the publication of their final results. As hoped, the results were good and I am therefore sitting on a 6.5% profit, but there’s little chance of me selling any time soon. This is my first purchase in a good few months, and so I wanted to outline the rationale.
Somero Enterprises Inc.
Somero is a leading supplier of laser-guided equipment for use in the accurate laying of concrete, supplying parts and training to customers as well (so exciting. I love it already). Operating mainly in the US, they also have offices in the UK, India and China.
Looking at the ten-year chart Somero suffered, along with many, during the economic downturn. Since then, however, growth has resumed and the share price has benefited from positive momentum. I first looked at the company in August ’16, and with the benefit of hindsight should have made a purchase at the time. However, take a quick look at the valuation metrics of Somero today:
- P/E: 14
- P/B: 4.5
- P/S: 2.7
- P/CF: 11.5
- Yield: 3.2%
Based on these values I would argue Somero is reasonably valued. Not cheap, but certainly not expensive. One thing I like to do when determining the value of a growth company is to measure these metrics against the five-year revenue and net income growth rate of the company. For Somero, these are 29% and 98.7% respectively (net income measured in this case as 4-year growth). Speaking last week to @wheeliedealer on Twitter, I am reminded of the benefit of the PEG ratio (price/earnings to growth) in assessing growth companies. This ratio looks to measure the P/E ratio against the anticipated growth rate of the company to determine whether it is undervalued or not.
ADVFN uses the earnings-per-share of the previous two periods to determine the growth rate, which in this case comes out at a shade over 35% per year. Dividing the P/E by this figure gives us a PEG of 0.4 (with a value of 1 being considered fair value). In this instance, then, the PEG ratio suggests Somero to be undervalued. (Were we to use the five-year EPS growth rate, the PEG ratio would drop to 0.2)
We can see from the ten-year numbers how the company fared during the financial crisis. However, since then they have turned it around and resumed a healthy level of growth. They have no debt on the balance sheet, and approximately $21m in cash. More than enough to cover current liabilities of around $8.3m.
Somero have generated free cash flow for the past seven years, at a compound annual growth rate of 44%. It is not a capital intensive business. We’ll come back to this later.
Full Year Results
For those looking for income, Somero as mentioned currently yield 3.2% on today’s price. The raise in dividend amounts to a 61% increase on the 2015 results, but represents only a 40% payout ratio. Alongside this, I note the following:
“The Board plans to review the Company’s cash position alongside cash requirements for current business needs and future investment during the first half of 2017. The Board will then assess the level of excess cash that may be subject to distribution back to shareholders through a special dividend later in 2017.”
The company report strong performance in North America, from which they currently derive 71% of revenue. Growth in cement consumption during 2016 was up 10.9% on the prior year, and management appear confident this trend will continue into 2017. I note they make reference to the “new political establishment” which is widely considered to be placing emphasis on massive infrastructure investment during its four-year term. Somero appear to be suitably placed to take advantage of this.
Obviously when reading management praise their company, it is best taken with a slight pinch of salt. Sometimes the picture is not quite as rosy as the one painted. One way to judge whether management are honest and reliable is in assessing whether they achieve their objectives.
Management at Somero declared a five year plan to generate revenues of $90m annually by 2018, of which they have just completed their third year. With revenues this year of $79m there is a strong likelihood that they will at least achieve their target at some point within the next two years. This gives me some confidence that management are able to set realistic targets and act effectively in meeting them.
As ever, I use a discounted cash flow model to steer me in the direction of a possible intrinsic value for the company. The inputs I have used are as follows:
- An average free cash flow of $8.7m
- Free cash flow growth of 20%
- This growth to continue at a 20% average for five years
- Slowing to 3% thereafter (mirroring inflation)
- A 10% discount rate
This results in an intrinsic value of £3.94 at today’s exchange rate (SOM reports in Dollars) against a current valuation of £2.81.
Based on these inputs, then, Somero would currently appear to be undervalued. As always, the numbers used can drastically alter the intrinsic value. For example, if we believed Somero to be capable of continuing this growth for ten years instead of five, the intrinsic value would rise to £6.89. If we believed free cash flow could only grow at 10% a year it falls to £2.49. The process is entirely subjective.
I’m no expert at making macroeconomic forecasts (is anyone, really?) but there appears to be some confidence that the global economic situation is improving. The US Fed recently voted to raise interest rates again, signalling they believe this to be the case. Somero appear well placed to take advantage of increased infrastructure spending over the coming years. I am however cautious of the fact that the company is vulnerable to a slow-down in the economy, particularly in the US, resulting in a repeat of 2008-2009.
Given its current valuation, I think 14 times earnings is a more than reasonable price to pay for a company growing revenues, net income and free cash flow at a healthy and appealing rate. I am excited to see what Somero can achieve in the coming years.
Disclosure: SOM is a constituent of the portfolio.
If you’d like to discuss anything contained in this article, contact me on Twitter @britishinvestor.