Pickings have been slim over the last few weeks; you can probably tell by the lack of new ideas I’ve come across and posted on here. So in the absence of any money-making idea, here is an interesting little company that I think teaches a valuable lesson.
Selling Capital Goods
There is a specific type of company that needs to be treated carefully by investors and that is one that sells capital goods to other businesses. I’ll explain what I mean by this. Capital goods are big purchases by business that are expected to last for a number of years. I recently came across an example in the US which sells digital projecting equipment to cinemas. During the last few years cinemas have been spending a fortune on upgrading from analogue to digital projectors and the company has benefited with huge sales. But the company trades on a P/E ratio of less than 10 despite 20% growth per annum. Is this undervalued? Well no. The cinema market is now over 90% digitalised, so those sales have already started to decline. Cinemas don’t need to buy a new projecter every year, and sales are very lumpy.
Pretty impressive growth, and it looks like it justifies its adjusted P/E ratio of 19.6
But dig a little deeper and you learn that this company is mostly in a young market, Chinese producers are only just upgrading from analogue printers to digital printers for ceramics. In another, smaller area, graphics, XAR is operating in a more mature market, and take a look at its revenues over the last 8 years.
When investing, the first thing that is always on my mind is, ‘what if?’. What if sales decline? What if competition increases? What if a new invention renders their product obsolete?
In XAR’s case, there is nothing that is supporting sales being high long term, and as soon as the market matures, those sales will decline as can be seen in its graphics segment. Now sales in the next couple of years may rocket, and the share price could climb higher, but in 10 years time do I have any indication of where the company will be? No I don’t, the market will be mature and competition likely more fierce.
That gives me no confidence in ascribing a value to this company, it could be over-valued, it could be under-valued, but I know enough to tell me the downside here is not protected.