DE-RATED SGS WARRANTS A SECOND LOOK

Since we last teased on SGS, it seems to have lost the plot against the Stoxx 600 and AlphaValue’s TIC (Testing, Inspection, Certification) sub-sector. A portion of this deficit can be attributed to the deviance that Eurofins Scientific brings from being exposed to pharmaceuticals and clinical diagnostics testing. Vs. its key peer Bureau Veritas, this can be boiled down to relatively lower organic growth expectations in the medium-term, a lag and lower transparency on its sustainability solutions portfolio, and the tendency to pay out a higher portion of earnings. The latter being a double-edged sword, as it is also a part of SGS’s appeal. However, given that SGS is a market leader in most aspects within its sector, could the current de-rating set up the next wave of returns for SGS’s investor base? We believe so.

Undoubted market and sector prospects

(Outsourced – Services provided by third-party players such as SGS, Bureau Veritas etc.  Insourced – Services performed by the companies as part of their operations)

Globally, the TIC market was estimated to be worth c. €250bn in 2021 and between now and 2030, it is expected to grow at a CAGR of 5.3% to c. €400bn. Within the current market only 45% is outsourced, and though this share may waver depending on the geographical and regulatory constraints governing a particular segment, there has been a gradual and undeniable move towards outsourcing. Additionally, the top 3 players occupy c. 15% of the outsourced market and the top 5, about 20%. This implies that organised players have two platforms to grow. First, through an increased share of outsourcing and, second, by gaining market share within the bigger outsourced pie. The good news is that the underlying markets for TIC are experiencing relentless growth.

Megatrends will drive growth

The growth of the TIC sector will be shaped by four key megatrends, namely, Sustainability, Health & Fitness, Globalisation, and Connectivity. These megatrends are further divided into more secular trends. For example, consider Sustainability. It alone can open many new growth avenues for the TIC market. Not only will there be a need for dedicated sustainability solutions (e.g., carbon footprint consulting, industrial safety, responsible supply chains, traceability etc.), it is already integrated into areas such as energy, natural resources, transportation and many others. SGS has already launched SGS Sustainability Solutions Framework and, in 2021, derived about 47% of its revenues linked to this framework. By 2023, SGS aims to exceed 50% in revenues through this framework. Similarly, equally lucrative cases can be made for the other megatrends.

Barriers to entry and bolt-on acquisitions will capture it

The TIC sector has high barriers to entry. First, the multitude of certifications and accreditations required and their variation across geographies and sectors. This area also needs to be regularly updated and tracked to provide the best level of service. Second, companies must have a global as well as a local presence to serve their customer needs and this reinforces the first point as these rules also vary across customers. Third, the ability to offer as many services as possible from a range of services that could be provided within a particular sector. Relatedly, this brings us to the importance of a highly-skilled workforce who are well versed with the savoir-faire to fulfil customer needs while ensuring compliance with all the rules and regulations. Last is the onset and proliferation of new fields, which demand governance processes and procedures to be established; TIC companies are an important stakeholder in that regard.

The other characteristic that we have seen across the sector is a preference for small, bolt-on acquisitions to plug gaps in existing portfolios, and this intertwines to the third point mentioned above. Also, since about 55% of the market is insourced, these small acquisitions are a safer bet to expand market outsourcing while at the same time tackling the fragmentation that exists across sectors. SGS is following a similar strategy.

De-rated SGS remains the leader

Near-term de-rating triggers set aside, when one looks at SGS through the numbers that matter, a strong track record of outperformance emerges. With its strong balance sheet, SGS has sector-leading operating margins and ROCE. Having streamlined its divisional structure in 2021, SGS is aiming to unlock incremental margin benefits. We certainly give it the benefit of the doubt. Additionally, the group has clear leadership in c. 30% of its portfolio offerings, with another 15% at least equal to the competition. However, the positive for us is that, within the remainder of the portfolio that is challenging for market leadership, there are very few underperforming (Cost of Capital) pockets. Looking at the portfolio from a growth perspective, about two-thirds of the portfolio can grow at mid-single digits or higher. So, we are confident is SGS’s ability to maintain its leadership.

Concerning the near-term headwinds, the entire sector faces the likelihood of decelerating growth should a recession materialise across the major economies. Pertaining to SGS, in H1-2022 its organic growth at 5.8% was lower than Bureau Veritas’ 6.5%. With similar FY22 aspirations for both companies, we expect SGS to pull its socks up by the year-end. On sustainability reporting, we are of the opinion that more information around this area will play a part in closing the gap with Bureau Veritas. Hence, these headwinds are readily addressable.

Operating Margins – SGS in green, steady and above
ROCE – SGS in green, steady and above

Ride the next wave

At the current share price, SGS trades at a forward P/E of 25.4x, a discount to its 10y P/E of 28.4x. Even if one excludes the pandemic-influenced high P/E years of 2020 and 2021, the average P/E over the past 8 years works out at 26.9x. Combine this with a dividend yield of 3.5%, a dividend which should also increase and potential takers can earn a decent return. With the share price already up by about 10% since the lows seen in June, it is worth accumulating.