Tuesday, January 10, 2012

VICOM - Part 3A (Understanding the ITC industry)

In 2003, VICOM purchased SETSCO (Scientific Engineering and Technical Services Company) for a sum of $15.7m. Currently, SETSCO accounts for 45% of VICOM's net profit, but information about it has not been very forthcoming, leaving many in doubt about what SETSCO really does. While some might feel that SETSCO is a completely different type of business from vehicle inspection, in fact the whole of VICOM business can be classified as being in the ITC industry.
Vehicle inspection is actually a niche area under the ITC (Inspection, Testing and Certification) industry which offers its services to a very wide variety of products ranging from food to buildings, from marine to aerospace.

The main purpose of this post is to let readers understand the functionality and fundamental of the ITC industry. This will be more of an informative post and most of the information is gathered from the following sources:

Deutsche Bank's Investor Day report of SGS
NZB's FY10 report of SGS
Bureau Veritas Investor Relation Presentation
TUV SUD Annual Report 2010
AL Tech

Before I start, I will like to warn reader to exercise some discretion in discerning between facts and opinions as 2 of the sources are analyst's report while 2 of them are company's annual report. Stuffs like market structure and past information counts as fact while things like valuation are more of an opinion. I have also highlighted important points in bold.

About the business

From Deutsche Bank Report

Inspection Services: SGS inspects and verifies the quantity, weight and quality of traded goods. Inspection takes place prior to shipment at the manufacturer’s or supplier’s premises.
Testing Services: These services test product quality and performance against various health, safety and regulatory standards. It is done by SGS in state-of-the-art laboratories close to the customer’s premises.
Certification Services: SGS certifies whether products, systems or services meet the requirements of standards set by governments, standardization bodies (e.g. ISO 9000) or by SGS customers. SGS also develops and certifies its own standards.”

Market Structure

Fig 1 Market Structure from Bureau Veritas

From NZB Report

Competitive landscape
“The global testing, inspection and certification remains a highly fragmented market, with less than 20% of market value estimated to be outsourced to independent companies such as SGS. SGS, Bureau Veritas, Dekra, TUV, DNV and Intertek account as the six largest players in the industry though their combined share do not exceed 15%. SGS share does not exceed 5%.”

From Deutsche Bank Report

“We estimate the global testing, inspection, and certification (TIC) industry serves a c.EUR60bn market. Out of this market c.30-35% is served by specialized and independent agencies such as SGS, Bureau Veritas and Intertek while the rest is not yet outsourced.

The industry covers all sectors (primary, secondary and tertiary), companies of various scales of operation (from small to large), and all regions. A large portfolio of services is offered, ranging from very basic (commodities quantity control) to tailored and sophisticated services(tests in laboratories, critical products / building conformity assessment). The market is still highly fragmented with only a few global players operating in multiple sectors (SGS, BV and Intertek) while the rest of the market (DNV, Dekra, TüV Süd and others) comprises mid-size organizations that often focus only on one region or on a limited number of sectors and areas of expertise. However, the industry is in a consolidation phase with large players like SGS focused on adding to their capabilities and increasing their local presence.”

Business’s Fundamental and Barrier to Entry

From TUV SUD Annual Report

“The key growth driver – not only in the CERTIFICATION strategic business segment, but also within the entire TÜV SÜD Group – is our service offering relating to the market readiness of manufacturers’ products, from development to marketing through to recycling. Here, we expect above-average growth rates in photovoltaic and in the inspection of textiles and leather goods. Overall, double-digit revenue growth is expected in ASIA PACIFIC.”

“In the ASIA PACIFIC region, revenue growth is primarily generated in the CERTIFICATION strategic business segment. However, the INDUSTRY and MOBILITY strategic business segments will increase their contribution to revenue in this region in the medium term. We see high potential for growth in the ASIA PACIFIC region, particularly in the area of environmental and energy technology.”

“In the CERTIFICATION strategic business segment, our business development in the ASIA PACIFIC region continued to be impacted by risks arising in Singapore due to higher administrative burdens, new certifications, and competition from the public sector. Furthermore, we are facing new risks in the region due to falling student numbers at the PSB Academy, tougher legislation in the field of education, and the new EduTrust certification scheme.”

From NZB Report

VTIC industry has experienced CAGR of between 5-6% over the past 20 years, nearly 10% on average in the past 10. The industry has tended to decouple from traditional macro indicators such as GDP or World Trade volume growth, though a minor cyclical dimension is still conserved (some 35% of sector growth). Resilience of VTIC activities is on the account of the structural drivers behind sector growth combined with the upstream expansion of testing services in the product value chain, resulting in a lower dependence from final demand.”

“The industry is characterized by high barriers to entry, due to the need of an international network, extensive know-how and expertise as well as the need of accreditation from government bodies.”

From Deutsche Bank Report

“General overview
SGS’s customer base is relatively fragmented, i.e. the group’s top 100 clients together account for less than 15% of group sales. The contract scope is wide, ranging from basic quantity checks to very sophisticated tailor-made services involving laboratory testing.

Revenue patterns are quite predictable since a big portion is generated from recurring contracts. Customer loyalty is high as it can be expensive and time consuming to change from one provider to another. Furthermore, many services are specialized and only delivered by certain certification companies. Acquiring and processing the first certification cycle is costlier than subsequent recurring testing and certification processes.”

“Growth drivers
We believe globalization results in increased global trade flows, which are a major driver of growth for SGS, generating among other things the desire to trace the origin of goods.
Furthermore, we believe that protectionism, rather than freight forwarding companies, should be a growth driver for the sector. We believe that standards and testing are “great weapons” to be utilized by countries to avoid imports.”

Fig 2 Resilience to downturn from Bureau Veritas


Fig 3 Deutsche Bank report on SGS's valuation

Fig 4 NZB Bank's report on VTIC peer group valuation

Cash Flow Generation

Fig 5 Cash Flow from Net Income from Bureau Veritas's Report

Fig 6 Deutsche Bank's FCF analysis of SGS

Here's for a better understanding of 2 of the many segments in ITC industry

Civil Engineering

Fig 7 AL Tech's brochure

Industry Service


“TÜV SÜD Industry Services provides services for the safe, reliable operation and optimization of industrial plant, buildings and infrastructure facilities. The division supports its customers with tasks including the planning, construction, operation, dismantling and disposal not only of plant and facilities, but also of refineries and power plants. The division focuses, in particular, on developing solutions in the fields of energy efficiency and renewable energy.”

From Deutsche Bank

“SGS’s services in this segment increase safety and quality and reduce technical and commercial risks faced by various industries. SGS assures asset integrity (asset needs to fit purpose) from design to decommissioning, across all industries, globally. SGS has a large portfolio of service offerings addressing safety, quality, compliance, reliability, and maintainability issues for the overall production cycle in any industry including design, procurement fabrication, construction commissioning, operation, maintenance and modification.

SGS’s Industrial Services business primarily serves the oil & gas, power, construction and transportation industries. The different client segments that SGS caters to are plant operators/owners, EPC contractors, consulting companies, construction companies, suppliers of technical components, government authorities, investors, insurers, and trading companies.”

My Summary

While all these reports are mostly about the largest company in ITC industry with global operations, it does shed light on the industry itself. Competition inside the ITC industry is pretty strong as even the leader (SGS) can only garner a 5% share and the trend poinst toward more consolidation and acquisition. Companies compete through having more accreditions and services available as well as having a brand recognition. Such intense competition has also been recognised in VICOM's annual report and chairman's statement.

Despite the competition, high barrier of entry exists as one has to meet the high accredition standard of the country as well as brand name recognition. However, once one is able to secure a steady base of customer, recurring income is expected as these services may need to be performed on a regular basis (for e.g. safety inspection of plant). Cost of switching inspector is also not cheap as labels and certificates need to be changed while the whole range of products need to undergo a re-inspection.

Growth in the industry is not exactly dependent on economical growth as policies and regulations will still need to be obeyed. Despite the fact that most of the largest companies core operation are centered in Europe, the 2 largest SGS and Bureau Veritas has proven to be rather resilient. But, a portion, possibly one-third of its growths, might still depend on economic growth as services like inspection of oil rig and new construction are part of the revenue. The industry being one that offer its inspection and testing services to a whole range of products help to diversify its income source and reduces the risk from a global downturn. In fact SGS even has a 2014 plan in which they seek to double their income with a compounded annual growth rate of 13.7% and to achieve an operating margin of 20%.

The main source of growth in this industry will still be a tighter regulation, public and consumer's demand for better quality control and adoption of health and environmental standard. Events like Japan's Nuclear Plant incident and Avian Flu can have a positive effect on the industry.

FCF is also pretty high as capex will be spent only on acquiring of new technology and accredition. A huge proportion of costs come from employee which requires the company's management to be able to understand staffing requirement in relation to potential growth in revenue.

With high barrier of entry, a proven resilient business model and recurring income, these companies are often valued at a PE of 20. Despite being situated in Europe, currently SGS (Swiss) has a PE of 21, Bureau Veritas (France) PE of 21.2, Intertek Group (London) PE of 26.5. This does not mean that VICOM deserves a PE of 20 but that such valuation shows the confidence of investors in these stocks even though the Euro debt crisis is still developing.

Part 3B will be on SETSCO's standing in the Singapore's ITC industry and the competition that it faces.


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