Troubled Times Ahead For Scales?

Long term readers will know that I’m a big fan of Scales (NZX:SCL). I like the management, the share price (up until today), the balance of land ownership with a business extracting value from that land, and the fact that the product is never going to go out of fashion (food).

However it is a farming business, and it’s therefore subject to the ebbs and flows of the industry. Weather, disease and other factors are annual risks that can cause fluctuations in the share price.

While I had factored recent logistical issues (which caused a drop in sales) into my share price calculations for this stock, there have recently been some new developments that I had not considered / foreseen, which I believe will effect the share price going forward.

Specifically, the industry is expecting to have trouble importing workers to harvest the crop and prune the trees (I know they complain about this every year, but this time I think it’s different because of Covid19).

A little bit of research suggests that tree pruning should occur now, and picking at Mr Apple (the subsidiary owned by Scales) will need to start in February.

This will be a problem because the crop will not be harvested, and costs will increase as Scales will have to pay more to entice New Zealanders to harvest them.

Upon reading this, a thoughtful person might make a connection with the job losses due to covid19 and assume that NZ has enough free labour to do these jobs, especially when they pay $25-$27ph. Unfortunately history shows that New Zealanders simply aren’t willing to fill these jobs as the unemployment benefit is more attractive and people are unwilling to move for the work.

It is my hope that the foreign people who worked in the ailing NZ tourism and hospitality sectors would be willing to work as pickers while their industries recover. I suspect that the uptake on this won’t be sufficient to fill the required number of jobs, but I assume that it will be enough to get by without Scales having to raise capital. I say this because the company delivered a normal dividend in June, which suggests either a lack of foresight from management (unlikely), a miscalculation of the effect of Covid19 (possible but improbable) or that they planned to struggle though, treating it as a BAU problem (as it’s difficult to get seasonal workers each year).

What Are SCL Shares Worth?

Well, it is a difficult question to answer. I’m going to have to make some assumptions.

According to an article from Stuff, Jacinda may relax border restrictions for skilled workers, but Nick Bibby (Business Manager of agricultural worker supply company Thornhill) says this will be too late. He infers that Jacinda is holding them to ransom (a “bribe” as he puts it) in exchange for being reelected, if as he says, pickers can be considered “skilled labor”. Implicitly, the current government does not intend to fix this particular labour problem, and I assume that it will be too late for any other government post election. There will certainly be some labour for this work, but costs will be higher. Frustrating as it is (because there’s no need to have this problem), there could most certainly be a problem harvesting apples for Scales.

I think the assumption that I will make is that they won’t have to raise capital and therefore there will be no shareholder dilution. I’m also going to assume that the economy is not going to be hot going into the next year, and that there will be a subdued share market. Because of this, I will assume that the opportunity cost of buying shares in SCL is high. In fact, to put a value on this, I will assume that SCL will return nothing in the coming year. Consequently they will need to return 8% minimum for a year in the share price to have any value. As I’ve previously valued SCL at about $5, this would place them at about $4.60.

However, if I was to value them on the same terms of growth that I had previously valued them, they would be worth less than this.

The valuation is pretty subjective based on your required ROI, labour cost (and supply) expectations, but either way I think it’s clear that there is potential downside for this stock in the coming year.

If the market takes a short term view (which I expect that it likely will, at least at some momentary point) then the potential downside could be significant. In that scenario there could be a major buying opportunity within the coming 6 months or so.

Personally I’ll be holding my current position and looking to top up if there’s a major crash in the price that goes below what I think they’re worth at that time (which will depend on my other opportunities and the state of the company’s financials and guidance).


The Good News In The Recent Bad News From SCL

Scales (NZX:SCL) recently announced a “Business Update” informing shareholders that the horticulture division has under-performed during COVID19, and that the final year guidance will be at the bottom of the previously announced range of $30m – $37m NPAT. The market reacted negatively to this, but I see it a different way.

To summarize the horticulture part of the announcement, the apple harvest was comparable to the 2018 record and 95% has been packed. Export packout rates are predicted to be 80%. In summary, this is similar to former years, which is good news.

The bad news is that horticulture sales to date have only been 70% of expected volume, though sales are continuing and prices are higher than last year – except for Asia, where 35% of sales haven’t happened and prices are cheaper. Basically, they didn’t sell as many as they thought they would have.

The good news is that the food ingredients side of the business has performed well (you might recall that I previously predicted that this is where all the growth would come from).

We could take a bit of a guess that horticulture revenue will be $186m, compared to last year’s $265m (70% less, as they have stated). Given that last year’s horticulture NPBT was 8.3% of horticulture revenue, the drop in NPAT from horticulture could be $11m (8.3% of $265m = $22m, minus 5.8% of $186m [$10.8] = $11m).

Clearly there is a wild assumption in the above maths, which is that the NPAT to revenue ratio will drop drop 8.3% to 5.8%. I arrived at this number because as costs will be the same, as revenue drops, the ratio of NPAT to revenue gets smaller. I arbitrarily took 30% off as a guess. You may agree or disagree with this figure, but it is enough to drop NPAT below $30m, forcing the food ingredients business to make up the difference, as stated in the recent announcement.

So, if NPAT last year was $36.4m, and we take my guess of the $11m impairment of the horticulture profit from this number, we see that the NPAT from the food ingredients business could have increased by $4.6m to bring us back up to the lower end of the guidance. Based on last years growth in NPBT of $3.7m, I don’t think this is an unreasonable guess.


So, why is this such good news? Well, I believe that the horticulture will bounce back next year because recession or not, people want food. Also it is my belief that the logistical issues of COVID19 will no longer exist next year. Therefore we can view NPAT as being an extra $4.6m this year and proof of a successful, growing endeavor into the food ingredients industry.

$4.6m growth represents 12.6% growth on last years NPAT working on the assumption of all other aspects of the business recovering. This makes the current share price quite favorable on a forward earnings basis (on a 2 year minimum investment term), and the markets reaction to the news creates a buying opportunity.


Scales (NZX:SCL) Quick Overview

I decided to take a quick look into Scales Corporation Limited (SCL) to see if there’s any value in the current share price.

SCL has continued their dividend and has stated that they are committed to maintaining that going forward. This can be construed as a vote of confidence, since they don’t seem to be paying that dividend out of debt.

Current Market Capitalization of SCL is $700.892m against a broadly flat underlying NPAT of $36.4m and $104.9m cash and equivalents in the bank.

The outlook for performance is flat, with the exception of the Food Ingredients aspect of the business which represents 32% of current NPAT. They are also well positioned for growth by acquisition, and are actively looking for opportunities – though this has been the case for a little while now, so I guess the right opportunity is yet to present itself. My general feeling about this company is that they aren’t wasteful and tend to make good decisions, so the lack of recent inorganic growth is unlikely to be due to anything untoward.

Revenue of $484.6m.
Revenue from Horticulture: $264.8m.
Revenue from Food Ingredients: $155m (up by nearly double since last year).
Revenue from Logistics: $87m.

Assuming they grow the Food Ingredients business by $20m – $100m this year and the rest of the business remains flat, that might translate to an NPAT of $40m – $45m (Lets say $40m with potential upside, as the logistics business may have suffered and there’s the possibility of a recession that could ebb demand).

If we take the ~$105m cash that you get when you buy at the MC of ~$700m, that leaves a MC of $595m. Divide by the NPAT and that gives a ratio of 16.3, with an outlook of 10% growth giving a forward looking ratio of under 15. Not bad for a stable company with the possibility to grow future earnings with smart acquisitions.

This share isn’t likely to make you rich quickly, but looks like a good option for a get rich slowly scheme or part of a portfolio of reliable dividends. It’s quite possible that in 5 years time, an investor would be looking at a 10% dividend after tax based on today’s purchase price. In short, the current share price has value in it to suit the right strategy, in this investors opinion.


Scales Corporation Limited (NZX:SCL)

Doesn’t benefit from fluctuations in the exchange rate causing weakening of the NZD against a stronger US dollar due to a policy of hedging up to 48 months.

More information about Scales Corporation Limited…