December 2006, I bought Multi-Chem

The disappointing performance of Surface Mount Technology highlighted the cyclical nature of manufacturing industry, especially for those without clear competitive advantage in a competitive market. Thus I normally do not take interest in companies in the manufacturing sector while shopping for bargains.

However, Multi-Chem caught my attention while I was stock screening based on profit margin and ROE. During stock shopping, I would quantitatively make a first cut selection of stocks, qualitatively assess its business and if these 2 test were passed, I would then make a more thorough quantitative forecast to determine its intrinsic value with my spread sheet program.

Multi-Chem had 3 business segments:

1. PCB Drilling and routing
2. Distribution of speciality chemicals and other PCB related products.
3. Distribution of IT security products

1 and 3 were the its main revenue contributor while 2 was getting less significant with time. I was particularly attracted to its business of distributing IT security products.

Multi-chem conducts distribution of IT security products via an almost entirely owned subsidiary called M.tech. Their business strategy was to carry only the leading IT security products (e.g. Nokia, Tipping point, Check Point) and regularly conducts courses, seminars with product vendors to raise IT security awareness. The end result was growth in sales quarter after quarter. M.tech also formed strategic partnerships with these vendors and Nokia even gave it exclusive distribution rights.

Though PCB drilling and routing was cyclical in nature, IT distribution business enabled it to smoothen out any possible dip in earnings should electronics demand go down in foreseeable future.

I worked in the IT security industry, I knew the recent interest in IT security amongst business would work in favour of M.Tech, (and hence Multi-chem).

However, things were not all rosy. From the segmental information given in the Annual report, I found out that revenue due to IT distribution rose more than 50% year on year, making it comparable to revenue from PCB drilling and routing. Yet, the profit IT distribution brings in accounted for only a quarter of that from PCB drilling and routing. The much lower profit margin from IT distribution business meant that this segment would had to grow to 4 times that of PCB drilling and routing in terms of sales to even out the company earnings. Even if IT distribution business could grow at 40% per year, it would take it at least 4 years to deliver the profits PCB drilling and routing brings in now.

Bearing any down turn in electronics demand and assuming continue good growth in IT security products distribution, I estimated Multi-chem's intrinsic value to be about 52 cents, with cost of capital at 10%.