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Sarine Technologies — Focus on cost savings and marketing efforts

Sarine Technologies — Focus on cost savings and marketing efforts

As the midstream market continues to struggle, Sarine reported a net loss of US$1.4m in Q119 amid weaker scanning activity and lower margins on equipment sales. In this environment, the company is focusing on prudent cost management and further promotion of retail-oriented products (which remains a minor part of the business at just under 3% of Q119 group sales). Management has recently seen some initial signs of potential recovery in the number of scanned stones. The company retained a solid gross cash position of US$32.7m (vs US$28.9m at end-2018).

Milosz Papst

Written by

Milosz Papst

Head of Content, Investment Trusts

Sarine Technologies

Focus on cost savings and marketing efforts

Industrials

SGX research scheme

15 May 2019

Price

S$0.32

Market cap

S$112m

US$/S$1.37

Share price graph

Share details

Code

SARINE.SP

Listing

SGX

Shares in issue

350.6m

Last reported net cash at end-March 2019 (net of lease liabilities)

US$25.5m

Business description

Sarine is the leading provider of equipment and services for the diamond manufacturing industry. These help to automate planning and maximise yield. It has also developed products that allow it to enter the much larger and more profitable wholesale and retail segments of the industry.

Bull

■

Leading market position, strong customer base and proprietary technology.

■

Expanding into new and larger addressable downstream market.

■

Strong net cash position.

Bear

■

Challenging environment for midstream manufacturers.

■

Copyright infringement.

■

Risk associated with lab-grown diamonds

Analyst

Milosz Papst

+44 (0) 20 3077 5700

As the midstream market continues to struggle, Sarine reported a net loss of US$1.4m in Q119 amid weaker scanning activity and lower margins on equipment sales. In this environment, the company is focusing on prudent cost management and further promotion of retail-oriented products (which remains a minor part of the business at just under 3% of Q119 group sales). Management has recently seen some initial signs of potential recovery in the number of scanned stones. The company retained a solid gross cash position of US$32.7m (vs US$28.9m at end-2018).

Significant decline in Q119 recurring revenue

Sarine reported a 34.4% y-o-y decline in revenues to US$10.9m in Q119, with recurring revenues from inclusion mapping services down c 20% y-o-y. Although the company was able to deliver 33 new systems, these exclusively represented models for scanning smaller stones, which are sold at a lower margin. As a result of these factors, Sarine’s gross margin declined to 56.2% in Q119 from 68.2% in Q118 and the company booked an EBIT loss of US$0.8m (vs US$3.6m profit in Q118). Diluted loss per share came in at 0.40c (Q118: 0.88c of profit).

Operating costs kept under control

Sarine’s overall operating expenses declined in Q119 by 11% y-o-y to c US$7.0m. We understand that the reduction is predominantly a function of the management’s emphasis on keeping the cost side constrained. These measures have offset the higher costs associated with the reorganisation and expansion of the sales team in AsiaPac. Having said that, Sarine’s marketing plan for 2019 aimed at promoting its rough diamond planning and manufacturing technology and retail-oriented products remains intact. Sarine’s G&A expenses went up sequentially to US$1.6m from US$1.4m in Q418 as they started to reflect the trial phase of its patent litigation.

Valuation: Shares offering a c 6% dividend yield

Sarine’s shares are traded at FY18 adjusted P/E and EV/EBITDA multiples of 10.8x and 4.1x, respectively. These ratios represent a 57% and 72% discount to the laboratory and site-based materials analysis and testing business, respectively. The company’s current temporary dividend policy at one US cent every six months translates into a dividend yield at 6.25% on an annualised basis. The policy has been communicated during the FY18 results release as a response to higher sales and marketing expenses expected in 2019 and weak industry performance.

Historical financials

Year
end

Revenue
(US$m)

PBT

(US$m)

EPS

(c)

DPS
(c)

P/E

(x)

Yield
(%)

12/15

48.5

5.3

1.03

3.00

22.7

12.8

12/16

72.5

22.0

5.14

4.50

4.5

19.2

12/17

58.6

9.4

1.64

3.50

14.2

15.0

12/18

58.5

10.1

2.17

3.00

10.8

12.8

Source: Sarine Technologies accounts

Sarine Technologies coverage is provided through the SGX research scheme.

Q119 results highlights: Environment still tough

Sarine reported a net loss of US$1.4m in Q119 (versus a US$3.1m net profit in Q118), with group sales decreasing by 34.4% y-o-y to US$10.9m. This is in line with the statement included in the company’s profit warning issued on 18 April, where management highlighted the continued difficult situation in the Indian diamond midstream sector. The factors weighing on the industry have been extensively discussed in our prior update notes and include: 1) working capital issues resulting from tightening of bank funding, with Indian banks recently calling for return of part of the existing loans towards the end of the Indian fiscal year ending March, reducing credit lines to manufacturers by c 20–30% according to Sarine; 2) weak Indian rupee versus the US dollar exacerbating the working capital shortfall; 3) competitive threat from lab-grown diamonds; and 4) the US-China trade dispute affecting Chinese consumer demand.

The above has translated into lower recurring revenues from inclusion mapping services (down 20% y-o-y, still representing more than 55% of group sales), even though these remained quite resilient in 2018 despite external headwinds. The reduction was driven by lower manufacturing activity in the midstream, which was accompanied by lower volume of rough diamonds entering the pipeline. During the first two cycles of DeBeers sights this year, rough diamond sales declined by 26% and 19%, respectively, while the third cycle saw a more normalised sales level at US$575m (provisional figure), up c 10% y-o-y (although from a low comparative base last year). The drop in Alrosa’s sales was even stronger at 33% in the first four months of 2019. More recently, Sarine experienced a rebound in scanning activity and reached a record level on several days in excess of 50,000 scans. This may constitute potential initial signs of recovery, although we believe it is too early to draw a final conclusion.

Sarine’s retail-oriented revenue represented just under 3% of group revenues in Q119, compared to around 2% in prior periods. In April 2019, the company announced that New Art CIMA, a leading bridal jewellery retail chain, has decided to introduce Sarine Diamond Journey. This includes its latest feature, 3D-Origin, which is a 3D-printed model of the actual rough stone from which the polished diamond was derived. This follows the announcement in February 2019 of the adoption of Sarine Diamond Journey by Schachter & Namdar, a diamond supplier and DeBeers sight holder in Namibia. This product should be assisted by the increased emphasis put on diamond provenance and traceability. The company has highlighted that it aims to onboard further midstream suppliers to the process, which will allow for a more comprehensive rollout with retail customers.

In Q119, Sarine delivered 33 Galaxy-family systems (compared to 12 systems in Q118), including 29 Meteorite and four Meteor models (all delivered in India), bringing the total installed base to 443 units. However, it must be noted that both models are systems for scanning smaller stones and are characterised by a lower unit price and gross margin in comparison to the systems for larger stones. As a result, equipment sales by value were down and, together with lower scanning activity, led to a significant decline in Sarine’s gross margin to 56.2% in Q119 from 68.2% in Q118.

Amid the demanding market conditions, Sarine continued to focus on prudent cost management. In line with the trend in prior periods, R&D expenses continued to decline and at US$2.1m were 22.6% down y-o-y. This was largely the result of lower employee compensation and outsourcing expenses. At the same time, sales and marketing expenses fell 6.0% y-o-y to US$3.2m due to lower marketing and trade show expenses and the lack of incentive-based compensation accruals (partially offset by higher sales compensation expenses in the APAC region to drive Sarine’s retail-oriented products adoption). G&A costs declined 2.1% y-o-y to US$1.6m but were up sequentially as the company entered the trial phase of its patent litigation. Consequently, Sarine booked an EBIT loss of US$0.8m in Q119 (vs a US$3.6m profit in Q118). It is worth noting the Q119 operating profit figure was influenced by the adoption of IFRS 16.

Exhibit 1: Financial highlights

US$000s, unless otherwise stated

Q119

Q118

y-o-y

Revenues

10,922

16,661

-34.4%

Cost of sales

(4,789)

(5,295)

-9.6%

Gross profit

6,133

11,366

-46.0%

Gross margin

56.2%

68.2%

-1,207 bps

Research and development costs

(2,066)

(2,668)

-22.6%

Sales and marketing expenses

(3,248)

(3,455)

-6.0%

General and administrative expenses

(1,644)

(1,679)

-2.1%

Operating profit

(825)

3,564

N/M

EBIT margin

(7.6%)

21.4%

N/M

Net finance income (expense)

(161)

24

N/M

Income taxes

(424)

(480)

-11.7%

Post-tax profit

(1,410)

3,108

N/M

Diluted EPS (c)

(0.40)

0.88

N/M

Source: Sarine Technologies, Edison Investment Research

Despite the reported net loss, Sarine’s gross cash position remains firm at US$32.7m (up from US$28.9m at end-2018), which was assisted by the reduction in trade receivables translating into operating cash flow at US$4.3m in Q119 (vs US$6.6m in Q118). Following IFRS 16 adoption, Sarine recognised finance lease liabilities of US$7.2m on its balance sheet.

Valuation

Sarine’s valuation is mainly dependent on improvement in the midstream diamond manufacturing sector and the company’s expansion in the downstream segment, which should support earnings growth and improvements in profitability and returns. Sarine’s current LTM ROE stands at just 4.5% and the return towards 2014 levels of 34% seems unlikely in the immediate future, given the current unfavourable market environment.

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 (for a detailed description, please see our previous update note). Although we acknowledge these companies operate in different markets from Sarine, we have identified some similarities to Sarine’s activities.

Sarine trades on a 2018 P/E of 10.8x when adjusted for the US$0.5m write-down of deferred and other tax assets recognised in Q418. This translates into a 57% discount to the peer group. At present, there are no consensus estimates available for the company.

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 Sarine’s current exposure to the retail business is just under 3% 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, which is likely a reflection of their very strong brands and market positions in jewellery retailing.

Exhibit 2: Peer group comparison

Market cap

P/E (x)

EV/EBITDA (x)

(local ccy m)

2018

2019e

2020e

2018

2019e

2020e

Bruker Corporation

US$6,533

36.4

25.8

23.4

20.0

16.2

14.8

Bureau Veritas

€9,294

22.3

20.4

18.7

12.9

12.1

11.4

Spectris

US$2,938

15.9

14.5

13.6

11.4

10.7

10.0

Intertek

US$8,052

24.9

23.7

22.0

15.5

14.3

13.4

Peer group average

-

24.9

21.1

19.4

14.9

13.3

12.4

Sarine Technologies

S$112

10.8*

N/A

N/A

4.1

N/A

N/A

Premium/(discount)

-

(57%)

N/A

N/A

(72%)

N/A

N/A

Chow Tai Fook

HK$74,100

17.6

16.8

15.1

11.7

10.8

16.2

Tiffany & Co

US$11,860

18.2

19.6

18.2

11.8

11.3

18.5

Source: Company accounts, Refinitiv consensus as at 14 May 2019. Note: *Sarine’s FY18 P/E is adjusted for the US$0.5m write-down of deferred and other tax assets.

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This report has been commissioned by SGX Limited (“SGX”) and prepared and issued by Edison Investment Research Limited (“Edison”). This report has been prepared independently of SGX and does not represent the opinions of SGX. SGX makes no representation in relation to acquiring, disposing of or otherwise dealing in the securities referred to in this report. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

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Frankfurt +49 (0)69 78 8076 960

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

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Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document (nor will such persons be able to purchase shares in the placing).

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Research: TMT

Claranova — Growth strategy paying off

Claranova has reported another strong quarter, with organic constant currency revenue growth of 33% y-o-y in Q319, maintaining the same rate of growth as in H119. Geographic and product expansion are driving PlanetArt growth, while the recent acquisitions by Avanquest have reinvigorated the division. We have revised our revenue forecasts up to reflect stronger than expected growth, although this has a minimal impact at the EBITDA level.

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