ShareSoc Company Seminar - February 2020

It's been almost a year since I last made it to a ShareSoc company event and I don't know where the time has gone. We don't get a large number of years to play with as it is so it's rather alarming to see one disappearing so quickly. Nevertheless it was great to return and meet some new companies. Going into the seminar I only knew SDI in any depth but coming out of it I now have a few more plausible investment opportunities to consider. Hopefully these brief notes will serve to explain my interest and general belief that meeting management is very positive when approached rationally.

DX Group (DX.)

Five years ago DX Group floated on the stock market and for the first 18 months business seemed, more or less, to be stable. Then, in November 2015, the doors were blown off by an awful warning and both profits and the share price are yet to recover from this calamity. After a couple of years the largest shareholder Gatemore had had enough and, with the company on the brink of collapse, they drove through a wholesale board refresh while supporting a critical fundraising effort. At this juncture Lloyd Dunn became CEO with Ron Series lined up as Chairman along with Russell Black and Paul Goodson as NEDs (roles that they retain today). The key aspect to these appointments is that all of the directors had decades of experience in the transportation sector and had worked together previously (notably in the turnaround and sale of Tuffnells Parcel Express).

So shareholders lucked out with this Dream Team of a board and still it's taken over two years to sort out the mess. As Ron Series pointed out a large part of the problem was that DX floated on the back of an integration strategy and that flat-out didn't work. Instead the board have driven the recovery by devolving authority downwards, to the area level, while making operational improvements, funding an investment programme and working to create a stable balance sheet. Now local managers make decisions and deal with local customers in whatever way meets their needs. That said Ron Series was very clear that they hadn't just cut costs - instead they want to handle freight at the right price (previously much was loss making) and focus on areas of potential strength. This sounds like a sensible (if entirely obvious) strategy and yet DX Group hadn't worked like this for years. An example of this discipline is the loss of Her Majesty's Passport Office (HMPO) contract after they tendered on commercially realistic terms. This accounted for 6-7% of sales but there's little profit in nonviable revenues and so why bother?

Looking at the group it has two halves which contribute roughly equal revenues. The crown jewel is DX Exchange. This was set up to transport time-sensitive documents for legal clients and it's been a huge cash-cow for the group. Unfortunately the previous integration strategy messed up the network and customers walked (alongside migrating to digital document exchange). For a while the decline looked terminal but the board have reduced the shrinkage to ~5% per annum and hope to offset this through cross-selling. There's also DX Express for secure, tracked, express deliveries (for items such as glasses and bank cards). This should be an area of growth as some deliveries have to be physical and good customer service will stimulate repeat business. On the other side there is DX Freight which specialises in awkward freight that can't be automatically handled. There's a big market here but this is still loss making for the group (another legacy of terrible prior management). In order to achieve break even, and profitably, the focus is now on becoming more efficient and charging appropriately for different classes of items. In the long run ~8% EBITDA margins are possible on freight business and it has high barriers to entry - which is why the board haven't just disposed of this division.

By this point of the presentation I was feeling pretty good about DX Group. The new board have performed very well over the last two years and they've been steady buyers of shares along the way. So when they say that they should return to pre-tax profit in FY20 I'm inclined to believe them. What I don't know is whether the shares are good value or not at the current price. This is never going to be a high-growth, highly-scaleable business but it can become a solid, cash-generative operation. This isn't going to happen overnight though as capex of £10m is already planned for the next two years (following a spend of £3.5m in 2019). In this budget £2.5m will go on IT systems and bringing expertise in-house for their secret-sauce core tracking system. The other £7.5m is going on new depots, increased mechanisation and equipment. It's a big chunk of money but the board see this as a way to turn DX Freight into a modern, competitive delivery business. I'm not convinced enough to want to invest right now but if the transformation stays on track I'll be happy to reconsider in a year or two.

Diaceutics (DXRX)

A brand-new addition to the public markets the company that we see now is the culmination of 15 years steady development with ~30% sales growth for the last 5 years. Diaceutics principally helps pharmaceutical companies get the most out of patient testing. This is important as we move away from a one size fits all therapy approach and towards precise individual treatment. In simple terms genetic differences can make drugs more or less effective, in a big way, and mapping/testing these variations is the way forward. However creating this mapping requires a vast amount of real-world laboratory and patient data - far beyond the limited data-sets produced by clinical trails. So Diaceutics have around 1/3 of their employees involved in extracting, cleaning and protecting this data. These "boots on the ground" allow the company to aggregate vast amounts of data that can then be analysed and sold to clients within their (soon to launch) diagnostic commercialisation platform. Once up and running labs will be able to submit patient data directly to Diaceutics while pharma clients will be able to securely interrogate data (and it has to be secure as this is very privileged data).

However this platform, currently named Nexus, isn't live just yet. About $30m has been spent on it so far with much of this capex used to recruit labs for automatic data collection, put a robust SASS infrastructure in place and design the interfaces to their data lake. Currently they are 47% of the way through the IT build with completion anticipated in Q4 of this year (although there will be continued investment and commercialisation spend after the platform is available). Apparently there's enough cash at hand (just under £12m) to complete this project and it could be transformational. In addition Peter Keeling, Founder and CEO, believes that there are no significant direct competitors to Diaceutics. Other firms collect lab data, of course, and other firms analyse it but no one seems to do everything. This point is perhaps backed up by the fact that client retention sits at ~80% which suggests that they value the services on offer (so Diaceutics should have pricing power too).

The other side to the company is that they don't just collect data - they also work with labs to make sure that pharma tests are run correctly and to introduce new tests. Getting this right is important for both patients and drug companies. With the former early identification of their personal bio-markers, and which drugs may be effective, is vital in improving 5-year survival rates. As for the latter Peter showed a slide around how leaky the testing pipeline is in practice with the outcome being that less than half of the patients who would benefit from certain types of drugs actually receive them. This means half of the potential sales for pharma (and these drugs can be very expensive/profitable) with actual patients missing out on effective therapy. So Diaceutics work with, and are paid by, manufacturers to help introduce new tests and eliminate hurdles in a lab setting. This is a growing opportunity and right now Diaceutics are working on 53 brands, for 31 clients, with the current target market being 150 test dependent therapy brands that each bring in ~$1.5m per brand when mature. The latter point is significant as early-stage brands don't want to spend too heavily and so revenue per brand is much lower in the early days.

It's fair to say that this is not another blue-sky pharma stock. The company has been profitable and cash generative since inception and it remains majority employee owned (with Peter himself controlling 25% of the issued share capital). By being based in Northern Ireland, and hiring data scientist talent from local universities, I think that the business is able to remain grounded and well regarded by staff members. This is important as corporate culture plays such a large part in organisational success. I also appreciate the fact that the IPO was done for very sensible reasons. This cash is being used to buy more data (£5.5m allocated), invest in the Nexus portal and expand the Asian team (from 1 to 11 people). This headcount increase is important as pharma is a global business and Diaceutics needs to be present on a global basis (currently they have 110 employees in 19 countries). All of this adds to my impression that Diaceutics is a cautiously run operation with great ambition. If they can ride the wave of tests which recognise that many illnesses have a genetic component then they should profit handsomely.

SDI Group (SDI)

I'm not going to cover SDI in depth because so many of us are already investors in the group. For background this recent update by Jack Brumby covers all of the bases as does this research note from Finncap. Suffice to say that I saw Mike Creedon, CEO, present way back in 2015 and he has done everything that he said that he would at the time. For this simple reason I have great confidence in his integrity and there's ample proof that he can manage an acquisition strategy. This is key since 11 companies have been acquired in the last 5 years with each of these falling into either the Digital Imaging or Sensors & Control reporting segments (SDI don't report on the individual brands as this is commercially sensitive).

In the presentation Mike ran briefly through all eight niche brands and it's fair to say that he sounded as confident as I've ever seen him. There's been great sales growth over last 5 years and they should hit 40% for the FY which is very impressive. Net debt has gone up because of Chell acquisition and at ~£5.7m this is roughly equal to EBITDA - pretty much the peak leverage that the board are happy to allow. Good cash generation should bring this figure down but if another big acquisition opportunity comes along it's likely that SDI will issue shares to pay for it. Usefully part of this will probably be made available through Primary Bid but an Open Offer is unlikely due to time pressure around closing a deal. Apparently there remain many targets out there but Mike is keen to retain some pretty strict criteria on purchase (~1x EV/Sales and 4-6x EV/EBIT). What is interesting is that new investments are often given a shot in the arm as SDI invests in the products and people alongside looking for integration savings. This, along with targeted bonuses, motivates staff and turnover is very low. In fact SDI have more issues with recruiting engineers as new graduates don't always want to work in the provinces!

In summary it's all looking very positive for the group. There were quite a few questions at the end of the presentation and usefully Mike stated that they have almost no dependency on China either in terms of sales or supply chain. So that's reassuring. Another question related to patent protection and it turns out that SDI don't spend anything on patents or otherwise protecting IP. The believe that this is fairly pointless and would rather spend time and money on innovation and bringing out new products to meet demand. This does make a lot of sense and comes back to the idea that a lot of the group's value is in its people and the tacit knowledge that they have in very specific areas. As such I was happy to hear that there is cross-talk between group companies, where there is expertise, and that staff seem to quite enjoy these opportunities to help each other out. It all adds up to a company that is greater than the sum of its parts. There probably won't be a trading update until May but I can see Mike bolting on a smaller acquisition in the next few months. Interesting times.

The Northern VCTs

I must confess that I knew little about the Northern VCTs prior to this presentation and I'm still not in a position to invest in them. However they have an Open Offer live at the moment. In total they're raising £40m and have got about £30m so far - which means they'll probably close by the end of the month. If you do follow one of these links you'll find out that Mercia Fund Management is the new manager following a friendly merger in December 2019. For continuity the old investment team have simply transferred into Mercia but now they can benefit from portfolio & funds support along with leveraging Mercia's experience in the EIS space.

A differentiating factor for these VCTs is that they have a regional focus on the basis that there is much less investment capital available outside of London. Since launching in 1995 they have constructed a solid regional reputation and built an enviable return track record. One reason for this is that the managers try to invest as late as possible rather than investing in every blue-sky idea; from here they provide scale-up capital of a larger size as the investment thesis is validated. To make this work the portfolio is very diversified with no sector bias; very necessary as small companies are volatile and risky. Hence there are roughly 200 companies in the portfolio with the very largest, Lineup Systems, being 5% of NAV and position size falling rapidly once outside the top ten holdings. As the VCT rules recently changed the portfolio is roughly half MBO and half venture capital with the latter being the destination for new investments. Generally they look to do 8-10 new investments per year in order to replace realisations and other portfolio events. I don't know how this different focus will impact on future returns but apparently lots of B2B businesses are popping up, as companies outsource aspects of their business, and there's a healthy demand for such services.

So I like the focus of these VCT funds and the fact that they're providing funding to small businesses on a nationwide basis. Examples of recent investments are Pure who supply healthy pet food which looks delicious (if out of my price range), Quotevine who specialise in real-time finance software and Duke + Dexter which is a high-end shoe brand offering funky designs. These all fit into the typical sector split that the managers are aiming for (technology, consumer, healthcare, services and digital) and should be fairly uncorrelated in terms of performance. What's also true is that these are real, profitable businesses that need capital to grow. In other words the opposite of the blue-sky, loss-making outfits latterly favoured by Neil Woodford. I know where I would put my money given the choice.

The author holds some of the shares discussed in this article.

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