recession-proof, globally-scalable microcap

SDI has grown local currency revenues by a compound annual growth rates between 7.5% to 8.0% pa over the past 6 years that I have followed the company.

Conceptually, I have always liked the business, particularly the resilience of the company's market place in terms of the exponential rising of dental care expenditure in both the developed and developing world, and also the opportunity for SDI to pursue a capital-free scale-up as the company establishes increasingly referenceable and credible market awareness of its products.

The stock was never cheap enough for me to buy according to my investment process, and besides in the years from 2005 to 2008, the company had too much debt for my investment filters (I look for Net Interest Bearning Debt-to-EBITDA to be less that 1.0). The reason SDI had been hamstrung with high levels of debt was because of the working capital drag that needed to be funded in order to support the global sales push. In order to fill the ever-widening sales distribution pipeline, Working Capital-to-Sales Ratio was stubbornly high in the mid-40% range for many years.

I became more interested in acquiring the stock in 2007, when I detected an inflexion point in the working capital intensity of the business. In that year, WC-Sales fell to below (a still very high) 40% for the first time. Trouble was, the stock was trading at multiples above my investment triggers, and anyway debt was too high, at almost double EBITDA (interest cover fell just 2.0x in DH2007).

In the following financial periods my interest in the stock increased as I saw a clear and favourable trend emerging in the inventory component working capital, which led me to conclude that this would lead to improving future cash flows and improved balance sheet health:
Inventory-to-Sales (December half balance dates):
2004 = 30.1%
2005 = 23.2%
2006 = 21.4%
2007 = 20.0%
2008 = 19.1%
2009 = 18.9%
2010 = 17.7%

While net debt levels had begun to stabilise from around 2006, it was only in 2008 that they began to fall, as follows:
DH04 = $13.8m
DH05 = $13.9m
DH06 = $13.8m
DH07 = $13.7m
JH08 = $13.9m
DH08 = $11.1m
JH09 = $9.0m
DH09 = $7.0m
JH10 = $5.8m

By 2009 the company's balance sheet was all but completely repaired, with solvency metrics within my accpetable limits (EBITDA/Net Interest for JH09 = 8.6x and for DH09 = 13.5x; and NIBD fell below EBITDA for the first time in DH09).

But the stock only became cheap enough for me to buy in April/May this year, at an EV/EBITDA multiple of less than 3.5x and a free cash flow yield (my preferred valuation methodology) of 18%.

At the onset of the Global Financial Crisis, SDI management committed to a plan to reduce net debt by at least $1m pa. Well, kudos to them; they've clearly exceeded their objective handsomely.

Which brings us to today.
The company has come a long way and has survived some major capital market disruptions and volatile exchange rates (90% of SDI's products are sold offshore) that would claimed the scalp of many companies of this size.

I believe the company is in the best position it has been since its lisitng, with the balance sheet in fine fettle (EBITDA/NI = 15x in JH10, and I forecast the company to be debt-free in 18 months time). Despite the headwinds of a strenghtening Australian dollar in the past 2 years, SDI has still been able to demonstrate good earnings momentum:
NPAT, FY08 = $1.13m
FY09 = $3.12m
FY10 = 3.47m
I model a forecast of $3.8m of NPAT is FY11 and $4.5m in FY12.

Despite the stock's 25% share price move today, I still see SDI as attractively valued, with the following FY11 valuation metrics:
EV/EBITDA = 3.9x
P/E = 7.2x
Free Cash Flow yield = 17%

In my view SDI is one of the most undervalued, durable businesses I follow, and I expect to remain a shareholder for many years to come.

Prudent Investing

Cameron

PS. Founder of SDI, the MD Jefferey Cheetham, who owns 45% of the company, is paid a salary of a "mere" $300,000 pa, making him one of the least offensively remunerated CEO's of a listed company that I know.