Scott Technology managing director Chris Hopkins

By Jenny Ruth

Tuesday 24th October 2006

Scott Technology, which manufactures production lines for appliances manufacturers and is developing robotic meat processing, reported a $242,000 net profit for the year ended August. While that was down 23.2% on the previous year's result, it was a big turnaround from the first-half $1.4 million net loss. The company also declared a three cents a share dividend, its first payout since the first half of 2005. Directors said they are confident of delivering a much improved performance in the current year.

Sharechat: What were the major factors in the profit turn-around in the second half?

Scott Technology managing director Chris Hopkins: It was a recovery. I wouldn't say the full-year result was a good one, but given where we were at the half year, the recovery was good. We had some problem projects in the previous 18 months and we've wrapped up some of the problem projects and made good progress on the jobs we have at hand.

SC: How much of the turn-around was currency related?

CH: It's the volatility that causes us the most problems - not being able to plan and manage for the dramatic changes we do have. It's quite difficult to quantify. There are a whole lot of factors that go into that. We had a very full order book in the previous year. Some of the problem was getting that work contracted out in a local economy that was running hot, the ability to find the resources and then the cost of doing that had quite a negative impact on our previous year's result. Having less volume and less of that work, we've had less issues to deal with (in the latest half year) which makes it a lot more manageable. It certainly helps (to have a lower New Zealand dollar) and we want the dollar lower than it currently is. We're not a commodity dealer so it's difficult to pin it back.

SC: At what date was the Package Handling Systems sale settled?

CH: It was effective May 31 so there was nine months in the result.

SC: Was that business always a loss-maker or were there particular factors affecting it in the latest year?

CH: There were particular factors affecting it this year. It had contributed in previous years. Last year was a difficult market for us. There was a bit of a drop off in business. The reason for selling it was we wanted to concentrate on appliances and meat processing. It was part of our diversification strategy when we bought it in 2002 but looking ahead it didn't fit, it wasn't a close fit with where we were heading in the business. When you're going through a process of selling a business, there are other costs that come out and a little bit of that is reflected in the nine months. It's probably not a fair reflection of the bottom line performance of that division. You do end up with a lot of other costs that crop up in a business when you're selling it.

SC: Was the profit from the sale of that business all property-related?

CH: We sold the whole business, including land and buildings, as a package - and also some of the trademarks we had as part of that business. We had spent quite a lot of money on the property in terms of building a special-purpose building for our needs. We had invested quite heavily in making the facility a property that befitted Scotts and our image. We didn't make any large property gains.

SC: Is the meat robotics project still a cost to the company?

CH: Some projects are recovering costs - we're getting enough revenue to cover costs. We've still got a little bit of tail end bottom line costs to the company.

SC: So it's still slightly negative?

CH: Yes.

SC: You're talking about commercialisation of that project - what sort of time frame is likely before it starts contributing profits?

CH: We've had a machine running at one PPCS plant in the last season and just recently installed another system in a meat processor in Australia as part of an R&D project we undertook with Meat & Livestock Australia and Tech NZ (part of the Ministry of Research, Science and Technology). There are a lot of parties involved. It's been good for us. We did the first few projects solely as a joint venture between PPCS and Scotts. That was done in the early days to prove the technology and to prove we could do it. It's gathered a bit of interest from the Australian industry as well. As that interest has grown, we've sought more government R&D money to help us cover the R&D costs. We're still pretty much in that phase at this stage. We have a vision of creating a solely automated boning room but there are individual building blocks. Some of them are ones ready for commercialisation. There will be some early commercialisation of parts of the system. There are a lot of issues to be resolved in the meat processing sector. Not only do they have to deal with commodity prices and droughts, the vagaries of the weather and even trying to get labour. The health and safety issue is a big one and is probably becoming more of an issue. All those factors mean there are some opportunities there. For the total size of the market you would have to look at the markets in Australia and New Zealand and where they're heading in terms of livestock numbers and numbers processed. It's very difficult to forecast or put any sort of estimate on that. It's an industry that typically doesn't like to spend a lot of money on capital plant. Their margins are very low and competition is tight. There are opportunities in other areas of the world but at this stage we're concentrating on the New Zealand and Australian markets to develop and prove the technology.

SC: Will the tipover point into it contributing to profit happen in the current year?

CH:That would be our current expectation. That's partly driven by the fact that we have the funding on board to help us meet the R&D costs. The intention is to minimise the impact on the company's bottom line in developing this technology.

SC: You comment in the results release that you're trying to combat the NZ dollar cycles by increasing technical innovation and expertise. Can you give me an example of what that means?

CH: That's what we try and do on all our projects. We're spending a lot of time trying to get a lot smarter in our purchasing, using the high value of the New Zealand dollar to our advantage in both purchasing and offshore contracting. The real key to it is getting smarter in engineering design. With everything, there's a hard way and an easy way. We're trying to find the easy way to do something. Even expanding the market to a certain extent helps with the cycles. Our projects aren't just in US dollars but in Euros and other currencies as well (now). If we can lead the competition, we can obtain better prices for what we're selling as well. The meat industry is an element as well. If we can lead the industry then ideally we can command a premium for our expertise and technical know-how. That sort of philosophy applies to the appliances sector as well.

SC: Apart from the depreciation charge, what are the reasons for the difference between operating cash flow and net profit?

CH: There are very large movements in our working capital. It's something in the order of $6.9 million. That's mainly work in progress. Because we manufacture large projects, we get progress payments. In the prior year, we had the project in Turkey funded through the Export Guarantee Scheme. With projects we undertook in previous years, most of the cash came at the end of the project so we had to fund it. When we ship it, we convert that working capital into cash. This year we converted a lot of that previous work in progress into cash. Then the current projects that we're working on have got more favourable payments that mean we get good progress payments through the project as we construct it. One thing I would point out is our work in progress, the value of projects under construction, at the moment looks very low, only $215,000. In some years in the past, we've actually reported negative work in progress. That's always changing and it changes pretty quickly in our business. A snapshot at any one time is a little bit dangerous. It's an area where you need to understand the nature of long-term construction projects and how they affect the balance sheet.

SC: Why is the company paying out three times its EPS in dividends, especially after paying out more in dividends than NPAT last year?

CH: We haven't paid a dividend ... we missed the last 12 months. Our dividend is going to be paid in December this year. Historically, you used to accrue a final dividend but now the accounting profession accounts for them when they're paid.

SC: So you're expecting much better earnings-per-share in the current first-half?

CH: That's one factor. We wanted to indicate to shareholders we're confident of being able to do that. In previous years we've paid out lower ratios but we've always tried to maintain a dividend. It's a bit difficult in our business when it gets so lumpy. We see it as a sign of good faith and confidence by the directors. It's also a small gesture to shareholders for staying with us through the last couple of years. At the end of the day our equity is quite high. We've got a good strong cash position. There are a whole lot of factors that go into the decision to pay a dividend. Historically, a lot of our shareholders came from Donaghys and that always had a good dividend history, a steady dividend stream. With the lumpy nature of our earnings, a steady dividend is more desirable. We try to take some of the peaks and lows off.

SC:With hindsight, did the company take on too much work when the NZD was high?

CH: Yes, with hindsight, that's perhaps the case. We did get stretched in our resources. We ended up having to do a lot of work in a difficult local environment. With the value of the dollar, in hindsight we might have done things slightly differently. It's very difficult when you're taking on large lumpy projects and a large order comes along to not do it. You're always trying to plan out the future, where you're going to be in 12 months time. There's a lot of crystal ball gazing. There was a desire for the company to expand and enter new markets and we did enter new markets, particularly Turkey and Russia. We picked up new customers that we've completed a few projects for - Bosch-Siemens (in Germany) as well. Although we did take on a lot of work and it was difficult to get profits out of that work, it has given us a good position going forward.

SC: You had problems with on particular contract (was it the Turkish one?) Can you explain what went wrong there?

CH: That was the one that caused us quite a bit of anguish. We've been trying to manage the business over the last 18 to 24 months on this project. It became evident on that one. It was a combination of all those factors I've talked about before: taking on too much work, the desire to get a new customer, the value of the dollar at the time we did the sales, the difficult local sub-contracting environment. All those sort of things. It showed up in one particular project.

SC: But you say there are benefits resulting?

CH: We've established showpieces. At the end of the day, we sell confidence that we can do the job. These are large projects and they're quite often not well-defined at the beginning. When we sell it, it's not even designed. We sell a design and build of a piece of machinery that's not been designed and built anywhere else. Each of our projects becomes a showpiece and adds to that confidence. From that point of view, each job we complete is an investment in the future as well.

SC: Is the company still outsourcing? Is it doing much outsourcing offshore?

CH: We are still outsourcing. We're trying to bring some of the key areas back in house that we had some difficulty with in outsourcing, particularly technical areas we felt were quite difficult to manage and get the results when we outsourced. We're trying to pick the areas that can be managed and outsourced successfully.

SC: Is having no debt a good position for the company? If so, why?

CH: It comes back to that earlier question about the movement in operating cash flow. In our business, with these large projects we can quickly have large swings in our working capital requirements. It's an increasing trend for our customers to get performance bonds and guarantees when they pay us money. We start designing and building machinery that's never been built before and we ask our customers to give us money to do that. They want guarantees in case the work isn't done. If you've got a lot of debt, you don't have a lot of headroom to issue those performance bonds. If you have a lot of debt, it becomes a constraint. If we can't issue a performance bond, the customer won't deal with us. (No debt) means we have the ability to undertake those large projects.

SC: Is it better to have an accountant running the company rather than an engineer?

CH: Whoever runs the company isn't running it on their own. We've got 170-odd engineers in the business, 98% of our staff. We're an engineering company run by engineers. I just happen to be a figurehead for the group of engineers that run the company. Kevin (Kilpatrick, the previous managing director) is still in that role of engineering director and that's the focus on the same thing he does extremely well. There's a bit of a transitional period for us. In the last couple of years, I was appointed general manager to focus on the commercial aspects of the business. Kevin was focusing on the engineering side. The latest move was a continuation of that. It was sped up by Kevin announcing he wanted to retire in 18 months time. It's good that we have a managed transition.

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