Basler (
BSLX.Germany)
Price: €11.27
I want to look at another hidden champion in this post. I previously examined Corticeira Amorim in
this post, and
this post. Hidden champions are companies that are usually market leaders in a niche industry or technology. Hidden champions by their very nature are businesses with moats, often due to a few factors, technological advantages, cultural advantages, and worldwide distribution. It's no accident that hidden champions are the top of their field. Most hidden champions are private companies, only about 9% are publicly listed. Considering the small relative float, and the superior execution level these companies exhibit it's rare to find them selling cheaply. What got me interested is that with the European crisis many hidden champions have seen their prices fall along with the broader market, and I think we might be in a rare period when some of these companies can be picked up at reasonable prices. So now onto the current hidden champion Basler.
Basler is an optics company located in Northern Germany near Hamburg. The company makes a variety of different cameras for industrial applications. The cameras Basler sells are focused on three main markets, the industrial segment, traffic segment, and medical segment, the key is that these aren't consumer cameras.
The cameras are interesting, they come in all shapes and sizes but the company specializes in small fast ethernet cameras. The cameras only need to be connected to an ethernet cable, the cable can be up to 100m in length. The ethernet powers the camera (Power over Ethernet technology) and also sends the video back to a computer. The cameras are tiny and have some impressive stats. I picked one from the Area Scan category as an example, the camera is 42mm x 29mm x 29mm (1.65in x 1.14in x 1.14in), it can capture color video at a resolution of 1294 x 964 pixels at 30fps and send the video back over Gigabit ethernet. If you're having trouble picturing the size the lens is about the same size as a beer bottle cap. Basler makes both the camera hardware and software to accompany it.
I briefly mentioned possible applications above. To dive a bit deeper Basler breaks out camera application into three categories:
Industrial - Cameras in this category can be put on a production line and used as sensors. For example a camera might check a food assembly line for foreign objects in a package. If the camera is applied to the print industry it could be used for quality control, or sorting.
Medical - A camera in this category can be used in surgery or highly demanding medical devices. The company mentions microscopy as one use. I had a knee scoped a few years ago and now I'm wondering if a Basler camera was used. Complete random aside, if you're considering a scope I'd highly recommend it, I'm back to running, skiing and biking without any issues or pain.
Traffic - Basler cameras can be applied to traffic in three different applications, traffic control, traffic enforcement and tolling. Traffic control is a monitoring application, used by a local transportation department and often shared to local news websites as "traffic cams". Enforcement is the dreaded red light cameras, and tolling is something like EZ-Pass an automated toll system where a device resides in the car and there's no need to stop and pay a toll the driver just passes straight through.
At this point it might be appropriate to ask how Basler is a hidden champion. The company is considered a leader in the vision technology field. They were the first to incorporate Gigabit ethernet into their cameras and they're helping to define the USB 3.0 video camera standard. The company has over 50 models of cameras and are considered the highest quality in the field by clients. In addition the company has more than 20 years of experience in their current niche. I would say these things qualify Basler as a hidden champion, a leader in a niche category, a high quality producer, and a culture that has experiencing operating at this level for years.
Recent Performance
The company had a record year in 2010 where they surpassed the 2007 high water mark for sales. According to the annual report they expect single digit growth in the industrial market and double digit growth in the medical and traffic markets. The company expects to grow at a steady 5% rate for the foreseeable future. In the first nine months of 2011 revenues are running ahead of 2010 with expected revenue in the €54m range. If the recent margins remain stable the company should have EBIT come in at €8m with net income slightly higher due to tax benefits.
In the half year results Basler reports that their sales breakdown into the following geographic areas:
43% Asia
35% Europe
22% North America
It should be noted that Basler has sales offices in the top optics locations worldwide. They also have sales offices in areas where customers are concentrated.
Examining the financials
When I looked at Basler's current results I was favorably impressed, the company has a nice return on invested capital, and great margins. I wanted to get a historical perspective to see if the company had always operated at this level, or if it's recent. I put together this spreadsheet with some relevant information from the past five years.
The first thing that stood out to me was that ROIC and ROE are really only above average recently. Additionally there seems to be a break right around 2009 where something changed dramatically. So I went digging and the answer was found in the 2009 annual report. It seems that Basler was rocked by the financial crisis reporting a sizable loss in 2009. The crisis and dire conditions caused the board and management to re-evaluate the business. Consequently they sold off a lower earning core division and streamlined operations (presumably by firing employees). The result of this was that the company lowered their break even point from €51m to €36.5m.
The changes management took in 2009 seem to have been prudent and the right course of action looking back two years later. Sales picked up in the camera business and due to the increased operating leverage earnings received a nice boost and subsequently ROIC and ROE rose as well.
One thing an enterprising reader of my spreadsheet might notice is that I included Basler's leases in my calculations. The company leases all of their facilities, and a substantial portion of their assets are leasehold improvements. I don't like the structure of something like this because the company doesn't own what they've developed. I'm sure it could be argued that all they're leasing is a building space and in theory they could move their equipment and setup somewhere else if they needed to. The problem I have with this is that the company is at the mercy of their lessors. The lessor knows considerable improvements have been made and it gives them leverage to raise the lease price cutting into Basler's results. I'm not privy to the decision making behind this, but it seems that Basler has operated this way as far back as I can find results. The notes mention that Basler has the option of buying out the buildings at the end of the lease. The rate on the lease is 6.34%, I have no idea if this is a competitive rate in Germany, it's slightly higher than their outstanding notes but lower than their bank rate.
One last point I want to mention is on the tax front. If you notice the company actually gets a boost to net income in 2010 from a tax refund even though they were profitable. This seemed like a potential red flag but I found buried in the notes that Basler has €17m in a tax loss carry forward that they're working down. I don't know exactly how these work in Germany but I'd estimate they have a year or two of this left.
What can go wrong?
After reading so much about this company I started to feel like I was wearing rose colored glasses. I'm a sucker for their technology it's really cool stuff, and a lot of financial metrics looked great. I needed to step back and evaluate, so I took a look at a few things, the first was earnings quality. Earnings quality is excellent, with a very low amount of accruals, and net income confirmed with solid cash generation.
I also looked at cash flow, the company is a consistent cash flow generator. They do have to re-invest a substantial amount back into development but they have continually thrown off free cash flow. The free cash has been used to pay back bank debt and pay dividends among other things.
Other red flags or points of queasy-ness did emerge for me. The biggest is that a few people in management have made loans to the company at market rates. I'm not sure why this is necessary but it leaves me uneasy. On the flip side the same people also own significant shareholdings. I just can't imagine a situation where management offers to loan the company from their own personal fortune. I should note these loans do seem to be paid back, but it's a constant revolving door. As one loan is repaid another one is extended.
Of course the biggest thing that can go wrong is for Basler's sales to drop off. Basler doesn't have a margin of safety in the traditional sense that I like. Most companies I take a look at have a large slug of assets protecting my downside. Yet at the same time Basler is a great company with a nice moat that no net-net could ever dream of. In a sense the margin of safety is the moat, the competitive position Basler holds in their market. The risk here is that if sales do drop the shares can fall hard, back in 2009 when they reported a loss the market cap was €19m half of what it is today.
Catalysts
I'm not sure if the following items are catalysts but I think they're good things that can only help the company.
The first is Basler authorized a 10% buyback, so they'll buyback up to 350,000 shares on the open market. This could be a great way to support increased trading volume in the company. The justification for the buyback is fascinating. The board said the shares are at a very low level and they want to buy them when cheap and hold on so at some future point when they're more richly valued they can use them in an acquisition. The bad news in this is that the buyback won't be canceling any shares. I'd prefer a buyback to shrink the piece of the pie I own.
The second item is that the company has formally instituted a dividend policy as of last year. They declared that there is a fixed dividend component of €.20 a share and a variable component both together totaling 30% of net income. The dividend paid for last year which should be similar to the amount this year gives the shares a modest 2.5% dividend yield.
What's a good price?
Past readers of the blog might have noticed that I didn't include a section discussing why the company is cheap. Partially the reason is I'm not sure if they're exactly cheap. On a pure metrics basis of say EV/EBIT they seem cheap sporting a ratio of 4.32. But once you add back in those pesky leases the EV-adj/EBIT bounces up to 6.4x. Another measure of value the P/E ratio stands at 4.6x seems crazy cheap, but if you back out the tax advantage to earnings the stock is at 6.23x which is close to the DAX P/E and reasonable considering the illiquidity. So all things considered Basler is basically trading at a market multiple with the DAX.
With some of the metrics behind us I think it's fair to conclude that the stock is attractively priced, but probably not cheap. If I wanted to find a reason this is at €11.27 and not €18 I think it's found squarely in two things, the market cap and associated illiquidity and the fact that it's family owned. This is a €39m company we're talking about that only traded 5500 shares last year. Put another way only 16% of the company traded. This is way too small for many funds to invest in, and even if they wanted to invest the volume isn't there.
The second issue is that the company is 51% owned by the founding family. Often family controlled companies scare away institutional money. Strangely enough I find myself researching and investing in a lot of these family companies across Europe. My rational as an individual is that often a controlling family won't do anything that could put their fortune at risk. This often means a company might not run at the optimal level, yet it gives me comfort that my investment is safe. Of course all this presumes that management isn't looting the company from shareholders which doesn't seem to be the case. Salaries are modest and low compared to US standards. The one outstanding question are those loans the officers keep making, I'm not sure what to make of them.
Why I can't bring myself to buy
I wrote the bulk of this post over two days and as I started I kept thinking that this is a great company I'd love to own, my feelings slowly changed as I wrapped things up. Everything seemed great at first, a reasonable price, great returns and significant earnings momentum. Basler seemed to be a fat pitch a great company at a really good price. But for some reason after I finished researching and typing this post the thought of buying Basler shares just didn't sit well with me.
I thought this over a lot Sunday afternoon and I think I know why I'm unsettled. The first thing I started to think about was my downside risk, I discuss this above. The next thing I kept thinking about was what happens to me as an investor if the market never realizes that Basler is relatively cheap, where am I in five years? At first I thought no problem I could invest and let them compound my money for me at nice rates. In a few years I would own a piece of a company who's book value had increased at 15% or so for the holding period. The problem I realized is that while the company has a really nice ROE and ROIC the invested capital is mostly debt, leases and intangibles. The problem is even if I held for 5 years and ROE averaged 15% for those five years as an investor I wouldn't have anything tangible that increased.
The problem is the company needs to constantly re-invest in R&D to maintain their competitive advantage. This investment is recorded as intangibles on the balance sheet, the problem is this isn't something that can be easily realized or maybe realized at all. In a sense the earnings are a product of the intangibles, but the intangibles might not have much value themselves. The R&D is a necessary expense, they can't sell off their intangibles if times get tough, the intangibles are the business.
The other problem is the biggest asset is the company's leasehold improvements. I realize that there is value to these improvements yet at the same time it's not like the company could sell their facilities if they needed to. They could probably sell some equipment, but definitely not the land and buildings. And unfortunately for Basler land and buildings are re-usable and retain value whereas specialized technology for camera production does not. Looking forward in five or ten years the land and building will probably be the same value or more, the camera technology not as much. I'm willing to be ten year old camera manufacturing equipment is on eBay for pennies on the dollar.
So my final conclusion was that for me to realize a return with Basler I would be relying on two things outside of my control, multiple expansion and continued earnings momentum. If earnings stay strong and continue, and the margin expands an investor would do well in Basler. The problem is if neither of these things happen my fear is an investor will find themselves a few years down the road in the exact same spot as now, invested in a company with great metrics but nothing tangible to show for it.
I would love to be persuaded otherwise, leave a comment or send me an email!
Talk to Nate about Basler
Disclosure: No position in Basler, long Corticeira Amorim
