Investment Thesis & Valuation
Thesis
The following key factors are being relied upon for this investment:
1. Management acuity: without Darryl I lack the confidence that there will be rigorous business discipline in operating and investing decisions. Provided he remains a director he can guide and supervise the new CEO starting in April. After a few years it will be come less of an issue as the company management culture should have absorbed his experience. The founder on the board also provides an important industry experience skill set which needs to be maintained if he leaves to ensure technical engineering matters are understood by the leadership.
2. Established Niche Leader: Adrad is the leader in Heat Transfer Solutions in Australia, maintaining this with innovation, business and operational efficiency is critical. Opportunities in Asia are important but more important is dominating it’s base market to provide leverage overseas. A change in the relationship with Kenworth Australia is a specific risk.
3. Profitable and Cash: There is no good reason for the business to go into losses other than it’s in major trouble, no large growth opportunity worth chasing by making losses and burning cash to reach. WC will impact FCF as it has to date (see graph), but should become less of a factor going forward and when taken out FCF should be strong.
4. Operating Leverage: With modest sales growth expectations and opportunities, a significant amount of value (EBITDA) growth is going to come from margin improvement and cost management. Operational changes underway and planned are expected to deliver these over the coming years, my bear case excludes these improvements and has a value under the current price as a result, so they are critical.
Other factors of note: Orange rather than red flags if they go negative
· Ownership: The founding director owns 61% of the company and other directors and KMP don’t own any. I like the skin in the game of the founder but don’t know him at all (but longevity of the business is a big plus) and would like to see other directors and KMP have stakes in the company that are economically important to them.
· Earning Stability: The OE business has long lead and tail work timelines and once established as a supplier, very sticky revenue. This is a bit like a SAAS business in it’s recuring nature and stability. Changes in technology to shorten the development cycle will challenge this stability.
· Alu Fin: setbacks and delays in this opportunity would lead to questions of what will grow sales and how strong their leadership is.
· Margin: I expect a slow but continued improvement in margins from the switch to Thailand and the reduction in duplicated costs. FY24 isn’t likely to show much but if guidance for FY25 doesn’t suggest noticeable improvements then deeper questions on the progress of efficiency improvements need to be answered.
· Working Capital: AR and AP will require attention but are expected to grow with sales. Inventory should either shrink or grow at a much lower rate than sales to reflect improved management and turns as guided.
· Acquisitions: Small add on’s within the specialist area are fine, but large acquisitions or those that expand operations out of Adrad’s niche will need a full review of the investment Thesis.
· Free Float: The lack of liquidity on market is both an opportunity and threat for small investors, but the bigger issue is how they “fix” it… 20% of the shares came out of escrow in February, so how this is handled will also give some indication on how shareholders are treated.
· Electrification: Not an imminent threat or opportunity for EV’s, Hydrogen opportunity is low odds, EO market supporting data centres and electric infrastructure is the tangible current opportunity. A space to watch to see how technology, markets and legislation develops.
· Warranty: H1 FY24 high warranty expense relates to issues that have supposedly been corrected. Ongoing high warranty expense would signal operational issues that will impact margins and may spill into brand damaging sales impact.
Valuation
Using a terminal year of FY28 for DCF and PE based calculations my base case valuation is $1.53 (IRR 17.5% at current price of $0.90). Growth is in line with FY24 guidance at 7% but modest given the expansion options across the market. Margins are expected to improve and so I increase these to 55% by FY28 but see this improving or Opex growth being below my 5% estimate given their focus on EBITDA% improvements. Assume EBITDA% reaches 20% and NPAT% reaches 11% by FY28.
Working capital will soak up cash as sales grow, but improved inventory management and ranging I expect should keep this to around 2% or well below sales growth. With a discount of 11% and PE assumption of 12.5 the value ranges from $1.60 to $1.45 on the bases case.
Summary
A stable, profit making, cash generating business with a long history that is expanding operations under experienced and credible management taking advantage of new market opportunities. Not a 10 bagger but a possible 3-5 bagger at current prices in the next 5 years on an un-demanding rate of growth adding to operating leverage from scale and operational efficiencies.
Expect 3+ year investment time frame to realise value. Comparables to IPO years and current year operational transitions are going to provide a muddy financial view for investors that may be discounted by the market until a few consecutive halves show consistency.
Disc: I own RL
With the thought of NextDC still fresh on my mind
Not sure if "heat transfer" products would solve the cooling issue from DCs but one hopes that this could be a potential application.
Apart from that a few other "tidbits" I found since having this on my watchlist for 6 months but no time to write about it yet
Apologies for being too brief.and cryptic But worth spending your time understanding this company.
Hopefully I've piqued some interest, but don't mind if you give this straw a pass.
Not held but still thinking.
Guess it is up to me to read the prospectus...
Other Equipment
Aftermarket
Despite the glowing story of Adrad's sector and the small market cap, maybe these tables explain why some of the financial metrics are still remaining in single digits.
Even more divided on this than before I think. Probably need to do more reading before deciding.
Company Overview
Adrad is an aftermarket suppler of heat transfer solutions for heavy automotive/transport and power generation via a wholesale distribution of standard parts or bespoke manufacture. Growth, improved margin and capital efficiency is expected from further movement of production to Thailand, range focus and opportunities in Asia.
Corporate History
· Founded in 1985 by Gary and Karen Washington with a focus on delivering reliable and efficient heat transfer solutions to the aftermarket segment that meet the needs of its customers across a broad range of industries including automotive, transport, mining, construction, agriculture and energy. Adrad has an established network of branches, workshops and manufacturing facilities across 8 main sites and 16 warehouses in Australia, New Zealand and Thailand. Adrad is headquartered in Beverley, South Australia and has approximately 500 employees
· Adrad IPO’s on the ASX on 30 September 2022 at $1.50 raising $22m from investors. $15m was for the sale of new shares and $7m the sale of SaleCo (The shareholders and directors of SaleCo are Mr Glenn Davis, Mr Gary Washington and Mr Donald McGurk and the Company Secretary of SaleCo is Ms Kaitlin Smith). Use of Funds:
- 5.3m - PP&E in Thailand & Australia (OE)
- 1.0m – Expand Thai manufacturing facility
- 2.0m – PP&E (Aftermarket)
- 4.3m – Working Capital
- 3.6m – Offer Costs
- 5.8m – Existing shareholder sales
· Harrop Engineering Australia Pty Ltd ACN 134 196 080 (Harrop engineering) is a related party of the Company. Harrop Engineering’s sole shareholder is the Existing Shareholder, and Mr and Mrs Washington are also directors of Harrop Engineering. Harrop Engineering was previously a wholly owned subsidiary of the Company. It was transferred to the Existing Shareholder as part of the restructure which occurred in October 2021, and is no longer part of the Group. The Company and Harrop Engineering are parties to a longstanding supply arrangement under which the Company supplies certain heat exchange products to Harrop Engineering. the price for products supplied to Harrop Engineering is calculated at cost plus a markup which equates to a relevant gross margin of approximately 24.8% for the Company there is no fixed term. FY21 sales were $1,071k (<1% of total sales).
· Related Party: The rent payable under the Harlaxton Leases and Arlyngton Lease increases by 4% per annum, subject to periodic market review.
Business Operations
· Adrad operates across two main segments:
- Distribution (Aftermarket) – Australian manufacturer, importer and distributor of radiators and other heat exchange products for the Australian automotive and industrial aftermarket.
- Heat Transfer Solutions (Original Equipment) – Designer and manufacturer of OEM industrial radiator and cooling systems from its facilities based in Australia and Thailand.
· Distribution (Aftermarket): automative and industrial heat exchange products of which around 2/3 are third party sourced and 25% sold via the Natrad franchise network of 46 stores (at IPO). Non-franchise pricing is flexible to react to landed cost and raw material cost changes to maintain margins. The supplier base is diverse with over 60 wholesale and parts suppliers, the top 10 accounting for approximately 46% in FY21. 16 distribution warehouses across Australian and New Zealand service the network.
· Heat Transfer Solutions (OE): address On Highway (Trucks) and Off Highway (Construction, Mining & Rail) mobile segment and stationary segment of Industrial (below 1MW in engine power) and Power/Energy Generation (above 1MW – remote power generation stations). Using lean and flexible manufacturing principles from one off projects to full just in time capabilities in Australian and Thailand as well as R&D capabilities to validate thermal performance. OE supply or project work may be from a few months to a few years but after sales service and repairs can extend 5-20 years. There a few formal fixed-term contracts and Adrad employs Business Development and Sales teams to both prospect for business and manage customers.
Strategy and Direction
· Investment Decisions: Adrad is transitioning from a Privately owned and run company with loose investment decision criteria to one focused on return on funds invested under new management. “Sweeting Assets” to reduce working capital and target a 15-20% return on funds invested and a focus on PBT & EBITDA outcomes rather than just sales growth should see operating leverage improve but sales growth will be modest.
· Power generation: Data centres provide an opportunity for OE colling systems for generators and some traction exists in Australia but the Asia market will require the development of a lower cost product and take time to penetrate.
· Aluminium: radiators and cooling systems are moving from Copper/Brass based to aluminium due to weight and cost but aluminium expands and contracts significantly more with heat so requires specialist design to fit and for connecting parts which Adrad is leading on developing. Not worth patent protecting, but trade secrets and processes provide competitive protection of sorts.
· Thailand: Adrad has had basic operations in Thailand for around 10 years, but is now in the process of transferring all manufacturing there, leaving design and engineering in Australia. The manufacturing footprint in Thailand is growing and the equipment is being upgraded or transferred from Australia. There is currently a period of duplication of inventory and costs while this transfer takes place but once finished there should be significant efficiencies that improve EBITDA and operating leverage.
Market and Competition
· Distribution (Aftermarket): Adrad is concentrating on heat exchange products and being the go-to supplier of these products rather than a generalist supplier. IPO talked to expanding the product range but this has been abandoned for lack of competitive edge and the lack of cash and operating efficiency in pursuing this in a crowded market.
· Distribution is a crowded market with large dominant players in Trade and Retail. Adrad’s edge lies in specialising in cooling and as a channel for it’s OE manufactured parts at the high end.
· Heat Transfer Solutions (OE): Adrad is the largest and only significant supplier of large scale OE equipment in the Australian market. Specialising for designing and building for the Australian conditions (of which there are many).
· Kenworth: Adrad has been the specialist supplier of radiators to Kenworth Australia for 45 years via the brand Air Radiators.
· Alu Fin: A specialist aluminium cooling system for large (mega) underground mining trucks, Adrad is developing this specialist equipment for CAT in Australia which take time due to design and manufacture complexities but once established provides a long opportunity which can be expanded to other manufacturers of this equipment.
People & Ownership
Leadership Team:
· CEO: Darryl Abotomey (ex-Bapcor CEO of 10 years) who joined as a Director in April 2023 and from August 2023 has been acting in this role pending a replacement (Kevin Boyle who will start in April 2024 from 6 years as CEO at Blue Lake Milling a private company, but he has 20 years of manufacturing management and operations experience). The previous CEO was Donald Cormack and ex-E&Y partner was in the role for 15 years.
· CFO: Rod Hyslop joined in November 2022, good ASX listed experience, some manufacturing and GM, mostly Energy and started in industry then audit with AA.
· Chair: Glenn Davis, legal background with M&A, appointed in January 2022 for the ASX listing (Director of Beach Energy since 2007) – governance rather than operating skill set.
Director Ownership:
- · Gary Washington (Founder/ED): 49.3m shares (61%)
- · Donald McGurk: 0 shares
- · Glenn Davis: 0 shares
- · Darryl Abotomey: 0 shares
Disc: I own RL