Sarine Technologies — Capital equipment sales gradually recovering

Sarine’s FY17 EPS came in at US$1.64 and was considerably below the previous year (US$5.14), with Q417 EPS of just US$0.17 (Q416: US$1.42). Group revenue remained 31.6% below Q416, translating to an FY17 sales decline of 19.1% y-o-y. Sales of capital equipment were negatively affected by abnormally high surplus inventories of polished diamonds in H217 and illicit competition in India. Both factors were already highlighted in Q317 and continued through mid-December 2017. That said, there was also a visible sequential improvement in business sentiment and capital equipment sales, which resulted in Sarine’s revenue increasing in Q417 by 14.6% vs Q317. Muted Q417 sales of rough diamonds by key producers (De Beers, Alrosa), as well as flat rough prices, may indicate a normalisation at the midstream level. Moreover, shortages of certain categories of polished diamonds are becoming visible. In addition, it is worth noting that FY16 was a particularly strong year in terms of capital equipment sales amid low polished diamonds inventory at the midstream level by end-2015, coupled with a favourable price relationship between rough and polished diamonds that drove midstream profitability. Sarine’s installed base of Galaxy family systems reached 345 at end-2017, with 11 systems delivered in Q417 (including six Galaxy and five Meteor systems). This compares with 24 systems in Q416 and an average of c 11-12 systems delivered during the fourth quarter in the period 2013-2015.

Recurring income remained solid at nearly 50% of group revenues in FY17, compared with c 40% in FY16, although the higher share was to some extent a function of lower equipment sales compared to the previous year. The company has reached its milestone of 10 million stones scanned in a single year and now aims at doubling the number in FY18, and trebling the associated revenues on the back of higher average prices. This should be assisted by the increased adoption of an attractively priced, comprehensive service package for retailers consisting of Sarine Profile, AI-based 4C grading reports (the company opened its new lab in February this year), Sarine’s light performance grading and the recently introduced Sarine Diamond Journey. So far, Sarine Profile’s contribution remained at 2% of group sales (behind the previous expectations highlighted in the FY16 report of 5%). The company was recently able to attract two Chinese chain retailers (JAFF and JASS, launching Sarine Profile after the Chinese New Year) and also anticipates increased adoption through 10 new programmes that are currently being initiated or expanded.

Group gross margin in Q417 reached 65.4%, which is below Q416 (71.7%) due to lower volumes and also slightly behind Q317 (65.7%) as a result of less favourable product mix. Sarine’s G&A costs increased 24% y-o-y (due to ongoing IP litigation), but were 14% lower than in Q317 on the back of lower third-party professional fees, as court-related IP protection activities came to a standstill during Diwali, and amid a reversal of accrued incentive-based compensation. R&D expenses continue to decline after the peak in H117, with US$2.0m booked in Q417 (17% below the US$2.4m recorded in Q317), as most of the expenses related to Clarity and Colour grading technology and Advisor 7.0 planning software were already incurred. Despite pre-tax profit being around two-thirds lower, the income tax charge was c 9% higher y-o-y in the quarter, as it included a US$1.0m write-down of certain deferred and other tax assets.

Sarine retained a solid net cash position of US$29.1m (up from US$27.8m at end-September 2017) and recommended a final dividend distribution of US$1.50 (payable on 10 May). Including the interim dividend already paid, the aggregate distribution would reach US$12.3m (vs FY17 operating cash flow of US$10.8m) or US$3.50 per share (compared to US$4.50 paid out of 2016 earnings).

Sarine trades at a trailing 12-month P/E of 47.4x. Based on Bloomberg consensus for 2018 and 2019, the shares are trading at a P/E of 17.9x and 13.8x, respectively, with expected y-o-y EPS growth of c 160% (on an adjusted basis) and 30%, respectively. We note that the market consensus includes only two broker estimates, with one not yet adjusted following the Q3 results.

Sarine’s valuation and upside is mainly dependent on its expansion in the downstream segment, which should further support earnings growth and improvements in profitability and returns. Some premium can be expected given Sarine’s industry position and leadership in technology. ROE has scope to improve towards 2014 levels (34%) as the company believes it has passed the peak of its current investment cycle and that 2017 represents a transition year, where expenditures peak while revenues from investments should become meaningful from 2018.

Given the lack of direct listed peers, we have combined a set of companies active in the laboratory and site-based materials analysis and testing business. Although we acknowledge that these companies operate in different markets than Sarine, we identified some similarities to Sarine’s activities. Sarine is trading at a discount to this peer group on both P/E and EV/EBITDA ratios of c 15-30%.

Bruker Corporation is a manufacturer of advanced analytical instruments used within the academic and government, pharma/biotech, clinical diagnostic and industrial markets. Part of Bruker’s business covers analytical solutions enabling the development, production and refinement of metals at highest quality standards. Bruker also offers solutions for gold analysis, gold assay and gold karat determination.

Bureau Veritas is a global leader in testing, inspection and certification, whose commodity division provides a wide range of inspection and laboratory testing services. In the exploration and mining segment, the company has the global infrastructure and expertise to service exploration, mine assaying and metallurgical testing projects. Industry applications represent around one-quarter of group revenue.

Spectris is a supplier of specialised measuring instruments and controls for technically demanding industrial applications. Around 60% of group sales is derived from materials analysis, as well as test and measurement services (both laboratory and offline). Key end-markets for materials analysis include metals/minerals/mining, pharma/fine chemicals, academic research and semiconductors.

Intertek is a leading total quality assurance provider, offering, among others, services in the area of materials testing of metals to assess the suitability, integrity and safety of products, components and assets. Intertek’s technicians provide laboratory and site-based materials testing of metals. The company uses state-of-the-art 3D digital measurement software that comprehensively delineates physical objects and is accurate to one ten-thousandth of an inch.

In the peer comparison table (Exhibit 2) we also show two Indian companies, primarily engaged in midstream manufacturing. We note that Gitanjali Gems’ multiples are depressed as a consequence of a fraud scandal associated with the company’s owner. Moreover, given Sarine’s focus on expanding into the downstream market, it is instructive to look at players in this area with strong brands and balance sheets. However, it should be noted that these companies cannot be treated as close peers, given that Sarine’s current exposure to the retail business is just c 2% of group sales. Chow Tai Fook (the largest jewellery retailer in China and Hong Kong) and Tiffany & Co both trade at significant premiums to Sarine on both forward P/E and EV/EBITDA ratios. The premiums are likely a reflection of their very strong brands and market positions in jewellery retailing.