27/2/20 Synertec FY20 Appendix 4D and Interim Financial Report

SOP released a disappointing half year report, with revenue falling from $12.8m to $7.3m and profit before tax falling from $121k to a loss of $968k. While revenue falling wasn't unexpected given the prior period had the benefit of large low margin construction work, higher margin engineering services revenue also fell from $3.1m to $1.7m. 

However the most disappointing aspect and ultimately thesis breaker for me was the huge negative working capital with a $2.9m operating cash outflow compared to  $1.2m inflow from the period before. Management commentary suggested some of this may be timing with one particular contract, but glancing at the balance sheet doesn't suggest a large receivables build-up but rather a general degradation across the receivables/payables and contract liabilities/assets balances. 

One of the main reasons I was attracted to SOP originally was it appeared they were under-earning on reported profits but a strong focus on working capital meant cash results were strong. This may change in the future and I will keep SOP on my watchlist but removing it from my scorecard for now.

Small provider of engineering consulting services to customers operating in complex, high risk or regulated industries. Reverse listing in August 2017 saw them come onto the market with little fanfare, but founders hold 43% of the business with one continuing on as Managing Director.

Since listing have continued to win large contracts across various industries, with comments at last year's AGM that the order book is the largest it has ever been across all target industries and into new geographies (10% of revenue earned overseas last year).

Reported profits have been masked by costs associated with the reverse takeover as well as a conservative revenue recognition policy that sees cash received before revenue is recognised, resulting in a large deferred revenue entry on the balance sheet. On a cash basis, company has seen their cash balance grow from $3.7m since listing to $6.2m at 1H19.

Despite being a consulting business, the company has some strong IP with their proprietary LNG custody transfer system which has been successfully rolled out to the Gorgon and Wheatstone LNG plants, both owned by Chevron. Management see a global market for the system, and have partnered with global engineering group Trelleborg to drive further sales.

It is important to note how SOP's deferred revenue balance masks the company's underlying profitability. Since FY17, SOP has received ~$45m in cumulative cash receipts vs ~$39m in cumulative revenue recognised. This has led to the growth of the company's deferred revenue balance from $51k in 1H17 to $5.1m in 1H19.

As an example of what this conservative accounting means is 1H19 EBIT was $64k, while 1H19 operating cash was $1.25m. While the deferred revenue balance is not entirely profits, if you net off the work in progress asset balance (opposite of deferred revenue) and adjust for tax, you come very close to the $2.5m growth in the company's cash balance since FY17.

This means the business has produced roughly $1m in "cash profits" each year since FY17, despite reporting very low operating profits. While the company is growing I expect the deferred revenue balance to grow with it, but management's focus on working capital should mean cash profits remain strong and capital returns become a possibility.

On another note, while the cash balance is reported as $4.7m at 1H19, there is an additional $1.5m term deposit held as Other Asset, meaning the company currently has over 60% of it's market cap in cash. The company is also very capital light as you would expect, with only $421k in PPE.

26/8/19

Annual Report FY19

SOP released their FY19 annual report which was a mixed result but the outlook for the business is undeniably positive.

Headline numbers were 111% revenue growth to $24.1m, EBITDA breakeven and operating cash flow of $800k. The strong revenue growth is positive, but it didn't have the corresponding effect on profits due to the increase coming entirely from the lower margin Fixed Price Solutions segment (effectively cost plus small margin on materials). Fixed Price Solutions increased from $8m to $21m, however the higher margin Engineering Services fell from $3.5m to $3m. This fall is my major concern with the result, however it was addressed in the management commentary.

The other factor depressing short term profits is the fact that SOP must continually invest ahead of the curve for growth. As with most professional services businesses, there is a lag between putting on (and paying) an employee before that employee maximises revenue generation. Employee expenses increased from $5.5m in FY18 to $7m in FY19 to service the sharp increase in revenue but also to prepare for the expected future growth.

One aspect of the report I need to dig deeper into is despite the wind-down of SOP's deferred revenue balance, profits didn't roughly equate to the cash that has come into the business. This could be explained by the effect mentioned above about a lag between costs and revenue however it is worth checking with management which I will do in the future.

Overall from a reported financials point of view SOP's result slightly missed my forecast of $1-1.5m with operating cash flow of $800k. While disappointing, the low market cap and cash balance continue to provide a great margin of safety while management execute the growth plans.

Beyond the reported financials, management provided the clearest breakdown of their growth plans and targets since they have listed. Management outlined a medium term target of $40m revenue at "above industry average" profit margins. On top of that, they made comments that the FY19 result was impacted by a "substantial amount of deliberate strategic investment by Synertec in the development of new products and know-how" which I take to mean executing some contracts at lower margins to develop the IP to execute further similar contracts at scale, or to deepen relationships with key clients.

On top of this, deep detail was provided on the two core IP's the company has developed that service large addressable markets; custody transfer systems for LNG plants and advanced integrated control systems for infrastructure projects.

Interestingly, management commented they are in "advanced discussions" with one of Australia's leading engineering services firm to develop a strategic alliance to jointly bid for infrastructure tenders with SOP's advanced integrated control systems IP.

This leaves SOP set up well for FY20 with management claiming that multiple projects are currently under tender with a strong potential pipeline. Management must now execute on their plans and hopefully win some more work at higher margins as they leverage their IP.