Jenny Ruth: Plenty of upside to Scott Technology

Investing in Scott Technology will probably always be a roller-coaster ride and right now investors are experiencing one of the dips.

Profits are down, the dividend has been cut and the share price has also headed south, down to $2.65 yesterday after spiking to $3.85 last October, just ahead of its announcement that annual net profit fell 34 per cent.

By its very nature, the company's core business, making production lines for appliance manufacturers, is lumpy as it secures new contracts. The timing of such signings cannot be predicted.

It is also heavily subject to the vagaries of the dollar since most of its sales are overseas, although its domestic sales are growing - they accounted for just 15.2 per cent of sales in 2003 but 28 per cent last year.

Yet operationally, the company has never looked stronger. Take that 34 per cent drop in profit for the year ended August last year. The reported figure was $3.7 million, down from $5.6 million.

Managing director Kevin Kilpatrick told the annual shareholders' meeting in December that if the same average currency exchange rates had applied in the latest year as in 2003, pre-tax profit would have been up $4.8 million at $10.3 million, up from $8.4 million in 2003. Rather than the $35.8 million in sales it reported, they would have been $40.6 million.

On top of that, earnings in the latest year were depressed because Scott is expensing the costs of its joint venture with meat company PPCS, which is developing automated meat-processing equipment.

This is a conservative approach because the company could easily justify capitalising these costs.

Scott Technology's latest comment on the project, which is expected be commercialised during the current half-year, is that it has been successfully tested and is delivering the expected improved yields and health and safety advantages.

Rob Mercer, of Forsyth Barr, estimates the research and development costs last year at about $1 million.

Expensing R&D costs is totally in character: the company's ultra-conservatism is also evidenced by the fact that it has no long-term debt on its balance sheet. While I'd normally say that was an inefficient use of capital, it does give the company considerable strength when market conditions are adverse.

Similar phenomena appear to have been at work in the latest first half. Again, the headline number looked like bad news, with net profit dropping 40.8 per cent to $1.7 million.

Scott commented that the timing of contracts increased its work in progress and working capital requirements in the first half, but this should reverse later this year.

The last time the company was in the down part of the cycle in 2001, when annual net profit slumped to just $900,000, Kilpatrick shouldered some blame, saying the company could have recognised and reacted to the situation more than it did.

He declined to be interviewed for this story, but seeing he's somewhat of a perfectionist, my guess is he would find some nits to pick this time round, too, to lay some blame on the company.

Several times last year, he commented that "doing that which is easy provides little challenge and usually produces little reward" and "success in our business doesn't just happen. It requires vision, passion, commitment and a team effort."

Scott isn't just lying down and accepting the impact of the high currency. In its first-half report, it said it was reviewing operations to see how it could cut costs further and improve its margins. That is likely to include sourcing more components overseas and further investment in the latest technology.

Scott began this year with orders at record levels and has secured more since, including one from Haier, the world's fifth-largest appliance manufacturer, to build a production system in China, and another from a Turkish company to build a production system to be installed in Russia.

Scott has produced machinery for all the world's major brands, including Whirlpool, Electrolux, Siemens, Frigidaire and General Electric.

The potential of its robotic meat processors is obvious. While the initial trials have been on sheep carcasses, it is easily adaptable to other meats such as beef and pork, and the market should be as global as the appliances business already is.

One of the lessons Kilpatrick took from the 2001 downturn was that the company had to diversify. Back then, the bulk of its appliance contracts were in the United States. He told the annual meeting that inquiries were now coming from Mexico, Thailand, India, Egypt, Jordan, Syria, Bahrain, Poland and Slovenia. That's on top of work already secured in Australia, China and Turkey.

The robotic meat-processing venture, which started in 2002, is another avenue of diversification and its export potential has already been demonstrated by the fact that Scott has secured funding from Meat & Livestock Australia.

Forsyth Barr's Mercer says the beauty of the PPCS joint-venture is that the meat company is driving it.

"It has a high probability of being reasonably successful because it's a customer-driven initiative rather than a manufacturer saying, 'Hey, I've got a great idea'."

Initial sales will be in New Zealand and Australia, which should give the company more of a cushion against the currency.

Scott has a third arm, too, bought in early 2002 and also operating under the Scott Automation banner. Based in Auckland, it specialises in automating package-handling.

Last year, it branched out into automated warehousing equipment.

That third arm used to include a winery equipment business but that was sold to its senior management last year.

"The company wishes to remain focused upon its core high-tech manufacturing business," Kilpatrick explained to the annual meeting.

Mercer agrees that "this company is continuing to do all the right things in the way it's going about growing its business".

While he is cautious about the short-term outlook and recommends that investors "accumulate" rather than "buy" the stock, he rates the company highly.

"The core business is actually still delivering growth and the long-term story is still robust."

Mercer also points to Scott's longevity - although it only listed in 1997 when it was spun out of Donaghys, its origins go back to 1913, when father and son John and Andrew Scott formed an engineering business.

"It's got a proven capability over many years," says Mercer.

"The business is sound, well-managed, conservative and yet it has this wonderful growth potential."

Who, what, where

Scott Technology head office: Scott House, 123 Crawford St, Dunedin.
Profile: The company makes production lines for appliance manufacturers worldwide, materials handling equipment and robotic meat processors.
Results: Net profit for the six months to February fell 40.8 per cent to $1.1 million, although sales rose 29.5 per cent to $21.9 million.
Management: Managing director since 1968, Kevin Kilpatrick; financial director, Chris Hopkins.
Market capitalisation: $66.2 million.
Major shareholders: The Marsh family with 17.8 per cent and Urquhart with 8.8 per cent.