I’ve posted several times analyzing companies that I think are good investments.  You’ve seen the format, bear case, bull case, valuation, blah, blah, blah.  I realized along the way, that I may be giving you the impression that this investing thing is easy!  The reality is, for every company that I find that I would consider investing in, there are literally dozens, if not hundreds of companies that I look at that I decide not to invest in.  So today, I’m going to highlight a company that I am not comfortable investing in and why.  This will probably be a regular feature at Bootstrap, so tell me what you think.  Then one of these days, I will finally post the attributes I look for in the “perfect investment”.

With no further delay, let’s look at our contender:

Company Overview:

Dynamic Materials Corp (BOOM) is a leader in the field of precision and explosive welding.  That’s right, they blow stuff up.  This company is a real man’s dream.  Explosive welding is a very specialized field in which dis-similar medals that cannot be joined by traditional means are welded together with the use of high explosives.  As you can imagine, this is a niche that is very hard to get into and has very high barriers to entry to licensing and permitting requirements.  Recently they acquired a German company which also performs explosive welding to broaden their geographic reach.

Common Sense Test:

Although the service they perform is fairly esoteric, it is fairly straight forward.  The business is understandable and the financials are straightforward and easy to understand – just the way I like them.

The Bear Case:

The majority of DMC’s revenue comes from the explosive metalworking component – about 90% of revenues.  The Oilfield Services and Precision Welding account for the remainder of the revenue.

The largest portion of the explosive metal working revenues is derived from oil processing and petrochemical processing.  In the current environment of falling oil prices and tough economic environment, demand for DMC’s services could be in decline due to temporary (or permanent) delays in capital expenditure by their customers.  This has weighed on the stock price and driven the price from a high in Dec 2007 of $60 to the current $29 per share.

Additionally, they have made a large acquisition that they may have problems integrating effectively.

The Bull Case:

DMC has some long term pluses in its favor:

• They operate in a unique niche, with very high barriers to entry.
• They have one of the coolest ticker symbols ever: BOOM – OK, that’s really not a good reason to invest in a company, but still, it is cool.
• Over time, oil demand will keep rising, driving strong end user demand for DMC’s services.

Valuation:

On paper the DMC’s valuation is pretty good.  They generated over $2 per share in free cash flow in the last four quarters.  A conservative discounted cash flow analysis gives me a price per share of around $36.  That gives us a comfortable margin of safety of 20%.

However, as we look through the financials of DMC, we see the following on the balance sheet:

Goodwill & Purchased Intangibles represent the value of the businesses they purchased above the value of the physical assets.  In this case the values are assigned to things like “core technology” and “customer relationships”.  Goodwill and Intangibles are written off against operating income over time (amortized) similar to depreciation for capital expenses.  Unlike capital expenses, there is nothing physically real about the majority of Goodwill and Intangibles.  At the end of the day, this represents the amount of money that the company paid over and above all of the physical stuff like plants, equipment, velvet paintings hanging in the office, etc.  For DMC, the combined $110m in intangible assets almost equals the stockholder’s equity of $116m.  Meaning, most of what you own as a shareholder, is the “excess” capital they paid to purchase a business.

Generally, I don’t like to see a lot of intangible assets on the balance sheet.  When business get difficult, companies generally evaluate their goodwill for “impairment” meaning that the assets aren’t generating the return expected.  If there is impairment, the goodwill or intangible are written down and a hit on earnings is recorded.  This can devastate a company’s stock price when it happens.  Given the recent economic climate, I have seen this happen often to companies carrying a lot of intangibles.

Additionally, companies generally underestimate how hard it is to integrate a new acquisition.  It can take years to fully get departments to talk to each other and really leverage back office “synergies” that are supposed to drive savings.

Conclusion:

Despite the relative attractive valuation and long term prospects of the company, I would pass on adding DMC to your portfolio.  I think the recent acquisition makes for relatively high risk and the amount of Goodwill and Intangibles just scares me.  I think DMC is a good company in a great niche, but for the time being, I don’t expect it to make an attractive investment.

This one will stay on my watch list.  One scenario that may play out is that DMC is forced to write down the value of some of their intangibles in the future.  If that happens, the stock price may get temporarily depressed which would make this stock a better risk/reward proposition.

Let me know what you think of my analysis of DMC!