Zytronic plc (ZYT.L)

Decaying business but good investment?

As per usual the below is just my personal opinion NOT AN ADVICE. If anything, if you read this and think the reasoning is rubbish, please save me some money by telling me. Thanks!

Sometimes a great business is a bad investment usually when it’s so expensive that economically it can’t work for shareholders if we accept that intrinsic value of a business is the sum of all cashflows into infinity correctly discounted. For infinity read say 50 years… Consider Cisco in 2000:

The Rise and Fall of Cisco

The flipside of great business/bad investment is bad business/great investment. Does it exist? It’s likely the cigar-butt of Graham/Buffet fame. Here we may have another example - Zytronic Plc. Other people have covered it in more detail and provided good reasons to buy it - eg: Alex Stuart - Zytronic Plc. At this stage I think it’s largely irrelevant what the company does given the position it’s in.

Cigar-butts only work in aggregate not individually - Graham/Schloss had many securities in their portfolios to make the strategy work. On an individual basis it’s basically a speculation. As such I want to think about what could happen and what’s the likely outcome for the bet/investment. Here is where we are:

Pros:

• Selling way below book (£13m book but market cap £6m)

  • Lots of cash for now (£3.7m as of March ‘24) - but burning through it fairly quickly

  • Lots of possibly valuable property - perhaps to the tune of £10m if revalued to today’s prices

  • IP - patents - probably depreciating fairly quickly

• Still selling quite a bit with a decent pipeline - although this was revised down recently

• Decent management - seems they are not trying to hide things and deal with the problems. They are also paying themselves reasonable salaries. CEO owns about 1% of the stock.

Cons:

• Super-long lead times to sales. They were really clobbered by Covid and lost a lot of sales for four years now. If the lead times are 1-2 years it would take them at least the same time to go back to the previous sales perhaps more or never as the technology and competition might have moved on. If they regain profitability in the next one to two years it's unlikely they will run out of money (they burnt through almost 2mil last year) but beyond that survival is really questionable.

• Management is reviewing business with a facilitator - I appreciate they want outside perspective but the consultant is likely incentivised to recommend to continue operations - but perhaps the best case would be a sale or liquidation?

• Customer concentration - in the last call they mentioned the big ones are involved on multiple projects so perhaps not so bad but still a biggish risk?

In summary it used to be a nice cash generative business without much prospect for growth (with decent management) when it worked and here is what could happen:

1. If they regain profitability (say £1-2m PBT) it could be worth in the region of £20-30m which is a considerable upside on today’s £6m. I'm giving this a probability of less than 50% say 30% - turnarounds are hard but not impossible.

2. If they fail quickly - let's say they run out of money in two years or less and liquidate or sell - it's worth at least the £10 mil in property - I'd say the probability of that is low - maybe 10%. Sunk cost bias, endowment effect etc perhaps in play - management will want to continue operations due to loyalty. Also in a liquidation, the assets are likely to largely disappear to various groups like the employees, lawyers etc. Let’s say the value at that point is as is today. Would shareholders push them to sell? Maybe.

3. If they fail slowly - say over five years, sales don't improve, CEO leaves, they get into debt, mortgage the property and generally run it into the ground, let's say the probability is 60% of that happening. Inertia is a horrible thing and hope springs eternal - usually people will be happy to deceive themselves that just one quarter more and the results will improve etc, then they do a bit (by just reversal to the mean), then they crash again etc etc. Again, depends on the board and shareholders to push for a solution that doesn’t destroy shareholder value.

Then, if I bet/invest 100:

It’s a positive expected value bet even under these conditions. I'm ignoring the discount rate and assuming the above happens in say two years. Also, note that in the slow fail scenario I’m assuming final value of 30 - that’s because I think I can set a stop loss at that level.

Sidecar investment?

As per Zeckhauser (Munger says you should basically invest as Zeckhauser plays bridge) Zeckhauser - Investing in unknown and unknowable you can take advantage of confidence others have in an investment. There are number of activist investors who bought into the business. Could they pressure management into selling/liquidating?

The above is necessarily simplified ad-absurdum, there are number of ways this could play out, eg some clever restructuring, management change, partial sell, heavy risky bet on some internal product development that pays off but I think the above scenarios are broadly the way it could go.

Please let me know what what am I missing. Thanks!