Shortly after Judges Scientific makes its biggest-ever acquisition, Richard sets out to discover whether the pasture is greener over at SDI, a smaller listed business that does much the same thing: buys and builds companies that make scientific instruments.
If I were to use one measure to compare highly acquisitive businesses it would be Return on Total Invested Capital (ROTIC).
One profitability ratio to rule them all
This is profit (Earnings Before Interest, Tax, and the amortisation of acquired intangible assets) as a percentage of total invested capital.
Total invested capital includes acquired intangible assets at their original cost, i.e. before any amortisation, which may be much higher than their book value.
We include acquired intangibles at a cost in the company’s capital to see if it has been a good acquirer. ROTIC tells us whether the company is earning decent returns on the capital required to operate the business currently plus the capital invested in acquisitions over the years.
Two authorities persuaded me that ROTIC is the best measure for judging acquisitions.
The first is Warren Buffett, who probably needs no introduction. If you are wondering how to account for something, it is often a good idea to use Google’s Advanced Search to search berkshirehathaway.com, the site of Buffett’s investment company, for an answer in his expansive annual letters to shareholders.
I found this definition of ROTIC in the 1983 letter:
“In evaluating the wisdom of business acquisitions, amortization charges should be ignored also. They should be deducted neither from earnings nor from the cost of the business. This means forever viewing purchased Goodwill at its full cost, before any amortization.”
When Buffett was writing, firms were not required to categorise different kinds of acquired intangible assets so goodwill was the only one they reported.
Brad Ormsby, Judges Scientific’s chief financial officer, explained to me that all acquired intangible assets, brands, for example, and intellectual property, should be treated the same way.
Conceptually, this is tricky enough to require a whole article to explain. Fortunately, I have already written that article, because today I want to use ROTIC to compare two similar acquisitive companies.
They are Judges Scientific and SDI. They both buy and build businesses that manufacture scientific instruments.
JDG v SDI
As a shareholder in Judges Scientific, I routinely calculate its ROTIC, even though the company publishes its own version of the statistic. That is because I calculate it in a slightly different way, and I need a consistent methodology to allow comparison between companies.
I also deduct corporation tax at the standard rate from profit. To compare SDI to JDG, I have had to give it the same treatment, so the numbers will differ from my earlier article, in which I provided a worked example pre-tax.
Finally, my data for SDI starts in 2015, around the time it initiated its buy and build strategy. Judges Scientific has been at it for ten years longer, so I have more data:
| 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | |
| JDG | 26% | 29% | 27% | 20% | 13% | 15% | 9% | 12% | 16% | 19% | 14% | 16% |
| SDI | 8% | 11% | 11% | 14% | 13% | 13% | 18% | |||||
| Source: JDG and SDI annual reports, SharePad | ||||||||||||
| Notes. JDG data is year to December, SDI data is year to April | ||||||||||||
On the basis of ROTIC, you could hardly fit a cigarette paper between them. Over the last five years, Judges Scientific has achieved an average ROTIC of 15% after tax and SDI has achieved 14%.
Investors will, of course, judge the companies by other criteria as well, SDI has grown rapidly through the pandemic for example, while Judges has treaded water.
But as a proxy for their growth potential, ROTIC is probably the best. The higher the returns Judges Scientific and SDI earn on money they have invested in acquisitions and operations, the more they can plough back into more acquisitions and growing existing operations.
Postscript: Has Judges bitten off more than it can chew?
With a turnover of £91 million in the year to December 2021, Judges Scientific is considerably bigger than SDI, which had a turnover of £35 million in the year to April 2021, although Judges is nowhere near as big as some of the archetypical buy and build operations.
Companies like Diploma (£787 million turnover in 2021) and Halma (£1.3 billion), which operate in different buy and build markets, seem to have inexhaustible acquisition engines.
Size can be a problem. One of the things shareholders worry about as buy and build companies grow is that the size of the acquisitions required to significantly impact revenue and profit also grows.
Large acquisitions are generally more risky, though. They cost more because big acquirers with deep pockets like private equity firms are also interested in them.
If the acquired firm is big in comparison to the acquirer, it will have a disproportionate effect on the acquirer’s revenue and profit, which might be a good or a bad thing.
One of the comforting things about Judges’ strategy so far is it has typically moved ahead in a piecemeal fashion, one relatively small acquisition after another.
That all changed on Monday when Judges announced the acquisition of Geotek for £45 million plus up to £35 million should Geotek earn more than £6.4 million in adjusted profit in 2022.
Before Monday, I think I am right in saying its biggest acquisition was Scientifica in 2013. Scientifica cost £12 million plus a £1 million performance-related earnout. Judges was a smaller company then though. Scientifica cost about a third of its revenue, compared to Geotek, which will cost at least half.
Most of Judges’ deals, twenty to date, were much smaller.
In 2021, Geotek only earned £1.5 million profit, but Judges says it was badly impacted by the pandemic and £6.3 million average profit over the last three years is more representative.
Using the £6.3 million average, we can see that Judges has paid about 7 times the adjusted profit for the shares with the earnout not triggered. It is by no means an extreme price to pay but is more than the 4 to 6 times multiple Judges habitually pays.
The announcement indicates other risks or opportunities.
Geotek develops and sells instruments to analyse geological cores for university researchers, mining and gas operators. It also rents out equipment and personnel to do the analysis.
This means Geotek earns much of its income from services, whereas Judges’ other businesses mostly sell equipment. There may be fewer synergies between Geotek and the rest of the business and some of its services earn big revenues from a small number of customers, which can vary significantly from year to year. On the other hand, Geotek brings Judges new capabilities.
Geotek also supplies oil and gas exploration companies, businesses that are in vogue and out of vogue at the same time. Shareholders can be encouraged by talk of energy independence in the wake of spiralling energy prices, while our ultimate objective is to switch to clean energy sources.
As a result of the takeover, Judges’ ROTIC will probably fall. Crudely, If we add the £45 million minimum purchase price to the denominator, total invested capital in 2021, and £5 million, the £6.3 million average profit less corporation tax, to Judges’ post-tax profit as though Judges had owned Geotek for a typical year, ROTIC is 14%.
A decline to 14% from 16% is no calamity, and, other things being equal, as Geotek grows, returns will increase.
But long-term shareholders will remember the high cost of Scientifica and losses booked by the subsidiary contributed, along with a weak performance from another relatively large acquisition two years later, to Judge’s lowest ever ROTIC of 9% in 2016 and pronounced weakness in the share price in the middle of the decade.
As one investor I follow articulated, a big deal that brings in potentially lumpy and cyclical revenues could test the faith of shareholders.
Mgt here have earned the trust of shareholders over many years…this deal will draw upon that trust imho pic.twitter.com/vTkYx2SReY
— Rhomboid1🇺🇦 (@rhomboid1MF) May 23, 2022
On the other hand, it could seal the reputation of Judges’ veteran dealmaker, chief executive David Cicurel.
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Richard Beddard
Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard
Hi Richard,
Thanks for that, very useful as always.
My question is this: can we realistically use price to earnings to compare the small companies JDG normally buys with that of Geotek?
If JDG buys a small operation then presumably the selling owners have been paying themselves a minimum salary (e.g. £9-12k) thereby not reducing EBIT much, and then taking most of their income as dividends (to reduce NI charges) which would not decrease EBIT at all.
Easy to see how a very small company bought on a stated p/e of 4 could have a p/e of 8 if realistic salaries were allowed for.
Happy to be contradicted as my understanding in this area is very limited.
Best wishes,
Tom Norman
Hi Tom, thanks for your comment. It’s a good point, not one I had considered, and probably another reason we should not expect the company to achieve the same multiples for bigger businesses. Judges may have done well to keep the multiple down to 7x (if it is right about the three year average profit being more representative).
However, the ‘low’ price may be justified because Geotek is a more risky proposition than usual, which makes it very difficult for us to appraise!