Roctest LTD RTT CN
March 04, 2010 - 8:57am EST by
2010 2011
Price: 1.90 EPS $0.20 $0.28
Shares Out. (in M): 6 P/E 9.5x 6.8x
Market Cap (in $M): 11 P/FCF 6.3x 5.0x
Net Debt (in $M): 1 EBIT 2 2
TEV ($): 12 TEV/EBIT 7.4x 6.0x

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RTT (US symbol RCTEF) is an obscure, small, thinly traded, and somewhat complicated Canadian microcap company, not followed by any brokerage firms, according to Bloomberg.  Even for someone like me, who has a high tolerance for that kind of stock, it normally wouldn't be worth the bother, but RTT has a combination of low valuation (EV 4.5 times LTM EBITDA) and some impressive proprietary fiberoptic technology that is beginning to bring in substantial growth in high margin revenue.

Based in Montreal, RTT is in two fairly distinct business segments, "Civil Engineering" and "Industrial," based on the type of products and their markets, although there is some technology overlap between them.  I'll start with Industrial, even though it is only about 30% of RTT's approximately C$26 million sales at the moment, because it is a much better, inherently higher margin business, and already provides most of the company's profits.

Industrial:  What RTT calls Industrial should perhaps be called Medical because that application is the biggest part of it.  This involves the world's most miniaturized fiberoptic pressure and temperature sensors, and they are used as components of the thinnest catheters and implants, such as an intra-aortic ballon pump, made by major medical device companies.  This is a patent protected, highly proprietary technology, with a wide moat and margins to match.

When it comes to catheters and other medical devices, thinner is better, since that allows access to narrower passages in the body.  RTT's FISO subsidiary, based in Quebec City, last year introduced a fiberoptic pressure sensor that measures 125 microns in diameter, which is smaller than 0.005 inches.  It has other pressure and temperature sensors that are somewhat larger, but still slimmer than nearly anything else available from competition.  In addition, fiberoptic sensors are unaffected by RF or magnetic waves, letting them be used to monitor vital signs in a patient in an MRI machine, for example.

It takes a long time, often five years, between when a medical device company starts its work on a potential new product and when its finished device has gotten FDA approval.  Then more time must elapse before the new disposable product has been is used in enough procedures to generate a good "razor blade" income for RTT.  There is no product on the market yet that is using the 125 micron sensor mentioned above--that won't happen for another several years.  Only later in 2010 will the first product that uses RTT's previous advance, the 260 micron diameter fiberoptic pressure sensor, come to market.

Once they do get rolling though, new medical devices should have a major positive effect on RTT.  For example, 55% of its Industrial segment's sales for the nine months ending  September 2009 (year end results should be out March 24th) came from supplying the sensor to just one disposable catheter product, and intra-aortic balloon pumping product for cardiac assist treatment.  With several major and start-up medical device clients working on new products that will make use of FISO's sensors, and with the newer miniaturized sensors allowing the creation of more advanced devices with bigger market opportunities, it seems reasonable that in a few years as these new products get introduced RTT may have several times that level of sales. Also, FISO's current primary customer is still far from saturation of its market, with volume still having room to double over the next 3 to 5 years.  Given the highly sophisticated technology involved, and the fact that the sensors are the key components of devices that themselves have very large margins, one would expect continual high margins.

For the 9 months ending September 2009  the Industrial segment had EBITDA margins of 17% on C$5.8M of sales, which were up 26% from the previous year.  With the Industrial section currently at a C$7.5M sales run rate, with high gross margins and a technological lead in a field with strong growth potential, one could argue that the current EV of C$11.6M for the entire company is a reasonable valuation for just that division, implying one is getting the other 70% of RTT's revenues, the Civil Engineering division, for free.

Civil Engineering:  This division, running at a C$17.5M run rate in 2009, has lower margins and less certain growth potential than the other business, but it isn't without some attraction.  It makes sensors and monitoring systems to check the condition of large infrastructure assets, such as bridges, tunnels, dams, buildings, and pipelines.  These sensors and systems measure stress, cracking, rusting, corrosion, motion, and other characteristics that could lead to catastrophic failure.  About half the business involves systems that are installed in new construction, and half is retrofitted to existing structures.

The underlying technology used in most of RTT's sensors in this sector is vibrating wire, which has been around for many decades and is not proprietary to any company, resulting in more competition and lower margins.  On the positive side, RTT has pioneered the use of fiberoptic sensors which are better for many applications, such as a recently announced contract for a leak detection system on a 150 km pipeline.  Fiberoptic sensors now represent about 25% of RTT's Civil Engineering business, and is the fastest growth and highest margin part of that business.  Where fiberoptics shine is in anything needing monitoring over a long distance, such as a long tunnel which is showing signs of movement, a long bridge, high rise buildings and large ships, all applications that RTT has gotten business.

RTT's Civil Engineering fiberoptic operations come primarily from its Smartec division.  Its competitive strength includes a deep understanding of the requirements and limitations of each of the five distinct fiberoptic technologies that one can use, and an increasing number of patents on its sensors.

Unlike RTT's Industrial segment, where the big market is major medical device companies that sell mostly in the US and Europe, RTT's Civil Engineering business is conducted all over the world., with most of its sales in developing countries where the big infrastructure investments are taking place.  For example, in North America there might be one new dam put up every few years, while in Southeast Asia alone they build over 100 per year.  Growth in bridges, buildings, and other monitoring candidates is likewise much faster in the developing world.  RTT's products are at work in 100 countries, and it has sales representation through agents or dealers in 75 countries. 

In addition, RTT has moved toward being a solution provider rather than just a sensor maker.  In cooperation with its various dealers and engineering firm partners, last summer RTT introduced a monitoring service, which converts the sale of a complete monitoring system from a capital purchase to monthly service fee, and solves the issue of the infrastructure owner not having the skills to interpret what the sensors are saying.

There is still plenty of growth potential in the developed world.  According to trade magazine Better Roads, of the approximately 290,000 interstate or state bridges in the US, about 21% or 62,000 are substandard and should be replaced or repaired.  Those on the list get more frequent visits by inspectors, but very few have a monitoring system installed that can warn of major changes between visits.  Because the cost of failure can be so catastrophic, dams in the developed world usually do have some sort of monitoring system in place, but many of them were built long enough ago that they will need refurbishment or replacement soon.

Customers of RTT's Civil Engineering division are mostly governmental bodies, which has mixed implications.  Developing country governments will be spending more on infrastructure, and should be able to afford to, ex a major crash in the world economy.  Developed country governments want to spend on infrastructure to stimulate their economies, but are losing their ability to finance their deficits, so may not be able to. 

RTT points out that its monitoring systems can be placed on infrastructure items and justify the government not replacing them as scheduled as long as the sensors report they are holding up well enough; the cost of the monitoring system to a new or existing asset is trivial compared to the expense and disruption of, say, replacing a bridge, so  can be sold as a cost saving item to newly budget conscious governments.

How this plays out over the next several years is unclear.  Fortunately for RTT, the highest margin part of the Civil Engineering segment is the fiberoptic systems that detect leaks in pipelines, LNG facilities, tankers, and similar assets.  The systems are relatively proprietary, have higher margins, are growing faster than the older vibrating wire based systems, and are often bought by businesses rather than governments due to the nature of the assets that these systems protect.

Sales and Earnings Outlook:  Numbers for the last quarter of 2009 will be out in three weeks.  I suspect the Industrial segment showed continued growth, but can't guess how the Civil Engineering did. 

Because I think that I think the clearest and most promising outlook is for RTT's Industrial segment, I'll focus on that.  Based upon the pipeline of medical device companies developing new products using the FISO division's advanced sensors, my guess would be that at the least we should see one such new product per year being introduced, with the first major new one coming in mid-2010.  The one catheter now on the market brings in close to C$4M per year to FISO.  If that stays flat, and each new product is only half as good in terms of market potential, then sales for that division would rise from something approaching C$8M in 2009 to C$9M in 2010, C$11M in 2011, $13M in 2012, etc.  If more than one of its customers new products hit the market in a given year, and/or if the revenue from them are similar to the C$4M RTT is getting from the first major one, then those estimates will prove very low.

RTT has estimated gross margins for its fiberoptic products to be in the 50-60% range.  Even at 50% (as a technological leader selling a critical component of a product that itself has huge margins, I would bet that 60% is more likely) that would add C$2.5M to the Industrial segments gross profit in 2012 versus the estimated C$4M in gross profit for 2009.  Since this is an OEM business, there would be little increase in selling expense at higher volume levels, nor would depreciation rise much since RTT can increase production without major capital investments.  Assuming modest increases in R&D and G&A, contribution for Industrial segment would rise to about C$2.8M in 2012 vs. about C$0.8M in 2009.  That would produce untaxed EPS of C$0.44 per share in 2012, assuming the Civil Engineering segment added nothing to earnings or was given away for free, and also assuming that all existing options get exercised, along with 100,000 per year of additional options granted.

If the current major product continues to grow from the C$4M/year level, and any new products that come to market using its technology are closer in sales to that one rather than all just C$2M/year that I was using above, then the division's earnings will be many times higher.

I don't mean to indicate that I am bearish on the outlook for the Civil Engineering segment.  Fiberoptic products in that segment, where the margins are high and the competition relatively light, make up 25% of that business and are growing nicely.  RTT is well represented in China, Southeast Asia, and South America, where there is a huge need for infrastructure investment, and there is money to afford RTT's monitoring systems on new projects and retrofitted to older ones.  RTT believes that a lot of its costs for that segment are relatively fixed, so if it gets the sales growth that it expects there will be a big improvement in profitability from the just above break even levels of 2008 and 2009. 

My problem is that with customers and projects all over the world, and infrastructure spending in each country subject to so many different influences, I just don't know how to predict what will happen with any great confidence.  That is OK, though.  As long as RTT's Industrial segment can over the next few years become the supplier of critical sensors for an increasing number of disposable medical devices that could not even exist without its proprietary miniaturization skills, that division alone will be worth many times the stock's current valuation.

Risks:  As with most microcaps, the buyer takes on significant risks:

About half of the sales of the Industrial segment represents one component product sold to one customer.  If any technical or safety issues were to cause the customer to stop selling that product, that would be a severe blow to RTT's profitability.  A few years down the line, if all goes well, RTT should have multiple such products in the market and that would be less of a risk.

RTT reports in Canadian dollars, and has its headquarters and other costs there, but only does on the order of 10% of its business in that country.  A strong C$ raises costs, reduces revenue, and causes translation losses.

The relatively fixed cost structure in the Civil Engineering business would cause operating leverage to kick in the wrong direction should sales be disappointing.  Should the developed world's economies have another major leg down, at some point the loss of export opportunities would hurt the government finances of the developing world, and cause a reduction in their infrastructure investing.  RTT's balance sheet is acceptable enough for now, but not capable of handling extensive losses.

RTT is very lightly traded and hard to buy or sell unless there is someone big on the other side.  This stock only makes sense for someone with a longer term perspective.

Year end numbers will be out before the end of the month, and I have no idea how they will compare with existing shareholders' expectations.


In the short run, none that I know of.  Over the next few years, one main catalyst will be the introduction by more medical device companies of products that make use of RTT's sensors.  As that business grows, and if the Civil Engineering segment grows as well, there should be substantial increases in earnings and cash flow. 

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