A 'fairly cheap' long-term investment

After visiting the factory and meeting management, our companies analyst really rates this AIM company.

On a recent tour of Solid State (LSE:SOLI) Steatite manufacturing facility, our guide, Steatite's operations director, tells us about the exacting work the company does in just one of its business units, Computing. 

An array of computers and printers - ultimately destined for submarines, bomb disposal units, outside broadcasters, train conductors, and commercial customers - are laid out on orderly benches. They are being built, transformed, or tested using decades of know-how so they withstand shock, heat, pressure and electronic snooping. 

With evident glee, our guide tells how a bomb disposal computer, bearing little resemblance to the laptop it once was, is controlled by a custom keyboard, bearing little resemblance to an actual keyboard, and Playstation joysticks, because that is what the operators grew up with.

Know-how is important because testing is expensive, so when it makes a bespoke product Steatite wants to get it right the first time. 

Trusted adviser

Solid State describes itself as a trusted adviser to customers, which are generally electronics manufacturers sourcing components through Solid State's distribution division, Solid State Supplies, and subsystems from its manufacturing arm, Steatite. 

As well as rugged computers, Steatite also makes battery packs, radios and antennas. There is a wide range of applications and hundreds of customers for them, but typically they are used in harsh or secure environments where failure would not be welcome. The radios are used by special forces and the battery packs in submersibles owned by oil companies, for example.

A trusted adviser, Solid State says, remains at the forefront of electronics technology and adds value at every opportunity. These are laudable aims, and also a lot of work. The pay-off is loyal customers who value the company's electronics know-how and its accreditations to handle dangerous material like lithium and sensitive information like military communications. Customers should pay a good price for components sourced and configured for them and products that have been designed or customised to their specification. 

The company has grown by acquiring small electronics manufacturers and distributors and raising them up to its own levels of efficiency and service, as well as winning new supplier accounts on the distribution side, and developing new products on the manufacturing side. 

The year to March 2019 was another year of acquisitions and product development, although the acquisitions are getting bigger and more expensive, and the product development more judicious.

Serial acquirer buys again

In November 2018, less than four months before the financial year-end, Solid State Supplies, the distribution arm, bought Pacer, its largest acquisition to date. Pacer was no obvious bargain. Solid State paid £3.8 million in cash and assumed about £2 million in debt, in total around 12 times the operating profit earned by Pacer in its last year as an independent business. 

Apart from its size, Pacer is fairly typical of the companies Solid State has bought in the past, perhaps something of an underachiever. Pacer earns higher gross margins than Solid State Supplies but lower operating margins, which means it has proportionally higher overheads. 

Solid State has moved the company's stock to its own Redditch warehouse to reduce costs, but its objective is not to cut its way to higher profitability but grow Pacer into profitability. It is keeping a newly built facility in Weymouth that provides value-added services and has funded more high-priced stock that the company could not previously afford to buy in volume.

Pacer brings Solid State new opto-electronics products and exposure to a new specialist and regulated market (medical electronics). The increase in scale brings the distribution side of the business closer to an underserved middle-sized sweet spot in distribution, between niche “lifestyle” businesses and the massive catalogues.

Manufacturing margins

The manufacturing arm is more profitable, Solid State increased operating profit margins from 9% to 10% in 2019, having reorganised each of its three business units into respective centres of excellence in Redditch (Computing), Crewkerne (Power) and Leominster (Communications). Profit grew as the company focused on higher margin products, even though revenue fell slightly in 2019. The company says each business is targeting new opportunities, secure computers for government and battery packs for robotics applications.

Organic growth should follow. The last manufacturer it bought was Creasefield in June 2016. Creasefield, which was loss-making at the time, joined Solid State's battery division, which experienced a decline in revenue in 2019. The company says it is focusing on markets that require high levels of reliability in harsh environments, due to the commoditisation of less specialist markets.

The previous acquisition was Q-Par in May 2013. It is a manufacturer of antennas and joined Solid State's communications division. A sales push in the USA fizzled out in 2018 and, in response, the company is growing an “off the shelf” family of antenna products, which it hopes will bring in more consistent revenue at similar margins to the large bespoke jobs it had been bidding for without enough success.

Niche manufacturers promise higher returns than distribution businesses because they add more value, but it is probably more difficult to find new acquisitions to complement and integrate into the existing business. Perhaps that is why Solid State is considering acquiring a business that is sufficiently different it will form a new, third, division.

In distribution, scale may bring higher returns, although Solid State is looking to buy a much bigger distributor next time, probably with a European footprint. A deal on this scale, it says, would require it to raise money from investors by issuing more shares. Current sales to Europe are modest, but a sales office in Europe would facilitate growth. 

Solid State has rarely needed to raise money from shareholders before, though, and the scale of its ambition is slightly unnerving.

This is how I score Solid State...

Does Solid make good money?

After tax and debt adjusted Return on Total Capital Invested of 10%*, implies it has not overpaid for acquisitions in the past. Return on Operating Capital of 15% in 2019, slightly below the long-term average, suggests the ongoing business earns good money.

Score: 2

What could prevent it from growing profitably?

I wonder if the specialist bespoke nature of the company's manufacturing arm limits its growth potential. That may be why the company is mooting a third division.

Increasing trade friction may reduce demand for Solid State's UK-based manufacturing customers who export.

Score: 1

How will it overcome these challenges?

Solid State's know-how and long customer relationships make it a strong competitor. Economies of scale in the distribution business should make it more profitable.

To achieve scale in the "medium term", it is likely to have to raise money from investors. Perhaps it is in too much of a hurry?

Score: 1

Will we all benefit?

We should do. Chief executive Gary Marsh is very experienced, a substantial shareholder and part of a not particularly expensive board. 

The company briefs private investors as well as institutional investors, and its instincts are to win the trust of customers. 

Score: 2

Are the shares cheap?

Score: 1.7

Fairly. A share price of 468p values the enterprise at just under £40 million, about 16 times adjusted profit in 2019.

A total score of 7.7 means Solid State may well make a good long-term investment.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard.

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.