Net sales in the quarter was SEK21.4m, against our estimate of SEK22m, corresponding to a c3% miss. Sales amounting to SEK19m were announced through orders beforehand (including SEK11.5m postponed from Q1 announcements), meaning that most of our forecasted sales was already known in advance. The “unannounced order flow” was thus SEK2.4m, and we view an increase in this number as an important part of the case, as it provides a stable flow of revenues in the periods where no large orders are announced. Compared to last year, sales were down 35%, but this was due to the large SEK27.5m order from Proengin in the comparable period.

The gross margin in the quarter was 73%, compared to last year’s 74% and our estimate of 70%. We consider this to be solid, as last year’s figure was most likely slightly boosted due to the higher volumes stemming from the SEK27.5m Proengin order. The company estimates the gross margin to move towards 80% territory over the coming years following improved component sourcing, and this quarter seems to be a step in the right direction.

Net income was SEK3.6m, against our estimates of SEK2.8m, which was 24% better than we had foreseen. This implies solid cost control, and we expect the company to remain cost-conscious throughout the remainder of 2024e. The only planned increases in costs are related to recent hires being included for a full fiscal year.

Looking at the quarterly figures since Q1 2020, we can see that the variations are significant. As mentioned, the comparable quarter from last year includes a SEK27.5m order from the company’s US-based partner, Proengin.

We view variations as inevitable and encourage investors to examine Serstech’s performance over a longer time horizon than individual quarters. Nevertheless, our estimates for the remainder of 2024e assume total sales of SEK50m in Q3 and Q4, which means that the estimates for the full year require at least one larger order to materialise.

Looking at the LTM figures instead, the development looks a little more stable. The muted activity during the pandemic was a result of the purchasing process often requiring physical product demonstrations, which sent sales into hibernation during the pandemic. Since then, there has been a rebound in activity, partly due to pent-up demand but also as a result of increased narcotics problems and geopolitical uncertainty.

The gross margin improved to 73% in the quarter, compared to 74% in Q2 2023 and 65% in Q1 2024. The company has previously been guiding for gross margins to increase over the coming years on the basis of more intelligent component sourcing. We are encouraged by the sequential improvement and assume that the 1pp decline against last year is a result of the higher volumes in that quarter.

The average number of employees was 22 in the quarter, resulting in an annualised cost per employee of SEK996k. This was an increase in the cost compared to last quarter, which was expected given that management has been guiding personnel costs to be somewhat higher throughout 2024e, as the full cost for recent hires is included in the figures.

The overall performance in terms of working capital management was solid. An increase in DIO was offset by an increase in DPO. The total CCC declined slightly compared to last quarter. We look for the CCC to successively decline with increasing volumes.

The order intake in the quarter was a result of two orders, both stemming from the US. We provide commentary below:

An order amounting to SEK5.6m was announced on May 21 from its US partner, Proengin. This was the second order from Proengin in the past 12 months (Proengin was responsible for the SEK27.5m order last year), and it is encouraging to see that customers are returning with several orders over time. We have seen similar behaviour from multiple partners, including Kaiser-SGI in Singapore.

While on the topic, it might be relevant to elaborate slightly on why these customers are returning as often as several times a year, while the current budget cycles for the company’s customers are generally 7-8 years. In essence, it can be a result of partners selling to a new customer, which means that the end customer is not recurring (at least not in the short term), but the partner is "recurring". It could also be the case that the end customer is, in fact, recurring, for example, by first purchasing the product for one department and then returning for another. Repeat purchases can also be a result of customers first trying the products before returning for a larger order. This brings us seamlessly into the second order.

The SEK1.9m order from another US partner, Field Forensics, is for a smaller order value, but according to the CEO, it is more important for another reason. The end customer, in this case, is the US military, which is currently trialling the company’s latest product, the Serstech Arx mkII. Naturally, if the company can build a relationship with the US military, this has the potential to drive significant volumes over the coming years.

We think one specific aspect related to this order should be considered in greater detail: the unique feature of the Arx mkII, which is communication via a military network (we believe Serstech is the only company providing this feature worldwide). This means that the devices could communicate with each other and provide valuable information for other operators in the field.

This feature might be easy to copy, but we argue that it provides advantageous dynamics for a first mover, as it incentivises end customers to purchase its devices from the same supplier to facilitate intra-device communication. We were discussing this in greater detail on page 26 of our initiation report, where we wrote the following:

"A final (potential) barrier to entry which is yet to be fully put in place, is the intra-device military communication that Serstech has built into its latest device, the mkII. As the company describes it: “Serstech Arx mkII is the first and only handheld Raman instrument that can communicate over military networks using ATAK (Android Tactical Awareness Kit).” If this is successfully introduced into customers workflow, it will introduce a barrier where the same customer will be reluctant to switch to a new brand of device unless it can communicate with the existing devices in its fleet. The company has already signed contracts with the American military where ATAK has been one important USP, and we argue that this is likely to continue being a driver."

We encourage readers to check out the section in the initiation report referenced for a more elaborate description of the case’s competitive dynamics (from our point of view).

In addition to the two orders from the US, there were also SEK11.5m in known revenue from Q1, pushing the total figure for known revenues to SEK19m. Thus, the SEK21.4m topline figure that was reported was entirely expected, which makes the initial c20% share price reaction somewhat mysterious. Nevertheless, as we wrote in our initial comment, the stock has been trading exceptionally strong over the past six months, and it seems the market got slightly ahead of itself in its expectations. Over the remainder of the trading yesterday, the stock climbed back and closed down only a few percent.

The outlook remains very strong according to the company’s CEO, Stefan Sandor, and he writes the following in the quarterly report:

"We continue to see a strong demand in the market from our main segments and we do not see any indications that the positive demand trend should shift downwards the coming years. As mentioned repeatedly, we do however expect large variations from quarter to quarter, due to the nature of our tender-driven business. We remain optimistic about the coming years and are confident in our long-term growth targets."

We have previously used known business opportunities (KBOs) to gauge the sales trend (see chart below for the figure from the initiation report; we have not been able to update the graph due to not having updated figures for KBOs), but this report does not provide any such information. This is nothing that worries us, given that the company has not historically posted this information every quarter. Nevertheless, with no quantifiable information pointing to the opposite, we argue that the positive trend from the past few years, coupled with the positive outlook from management, points toward continued strong performance from the company.

In the report, Mr Sandor wrote another thing that piqued our interest.

"Production is still in its ramp-up phase and when the quarter closed, we had a backlog of orders to be delivered over the summer. By August, we expect the current backlog to have been delivered and that the production capacity will be able to fully meet the demand."

Now, we covered the company’s production capacity in great detail in our initiation report, where we learned that the company’s production capacity was the following:

There are a few ways to interpret this statement, but at first glance, it seems as though the company has secured four weeks of production to be delivered during Q3. If one would assume the same production capacity as in the table above, this would imply SEK24m-SEK32m in Q3 sales on top of any other production during August and September. However, the first part of the quote adds uncertainty to this speculation. It seems likely that additional efforts will be required to calibrate production for a new entity of this type, and it seems likely that production, in general, would be slower during the summer months. Thus, we do not consider it likely that the company will produce SEK24m+ during July, and we think that investors should be careful in combining the two pieces of information to reach some form of conclusion. Nevertheless, we consider it positive that the company has built an order backlog for its new product.

We also note that the company has been focused on securing deliveries of components (inventory going from cSEK4.1m to cSEK4.7m sequentially) and that, according to management, it will intensify these efforts further. This seems to hint at the company seeing solid demand, as it would make no sense to increase inventory in the face of lower customer activity.

Despite the implications that can be drawn from the reasoning regarding production capacity above, we see no reason to change our top-line estimates drastically following the report. We forecast SEK50m in sales to be realised during H2, and for this to materialise, one or a few large orders will have to be secured.

We increase the total OPEX base by successively increasing the payroll expenses to reflect the recent hires’ full inclusion while holding most other costs (except COGS) constant in the near term. It is worth noting that these are no major adjustments but simply what would be called regular modelling housekeeping. The changes in absolute amounts are very small.

According to the company, the quarter’s drop in D&A is due to older capitalised development costs now being fully amortised. Thus, we decrease the estimates for D&A and adjust the investment in intangibles to be slightly larger than the amortisation over the coming years, as we estimate the company to be a net investor in intangible assets as it grows.

At the bottom line, net income estimates are increased for 2024e but then reduced for 2025e as the relative effect from the OPEX base becomes larger than the decrease in the depreciation.

We also make slight changes to the long-term ratio between inventory and sales in the NWC calculation, where we count on the company maintaining a little more inventory in relation to sales. Terminal NWC/LTM sales is increased from 2% to 4%.

The assumption underlying our Base Case can be seen in the table below:

Our Base Case builds on the assumption that the company grows rather rapidly over the initial forecasting period, manifested by a topline CAGR of 23% (22%) between 2024e and 2028e. The 1pp increase against our previous estimates (CAGR expressed in percentage points) is due to holding the magnitude constant while shortening the time period by one quarter.

We estimate that the company’s excellent scalability, shown in the c66% incremental net margin in FY2023, will continue, and assume that the EBIT margin will reach a high of 36% (38%) in 2028e before fading on the back of competition and increased price pressure. Our terminal assumptions include an EBIT margin of 20% and growth of -2%, which intends to further capture the high probability of increased competition over the long term. We assume that the long-term NWC/sales will stabilise at c4% (2%) by 2028e, thus having only a small negative impact on the conversion between net income and operating cash flow over the long run.

Using a negative terminal growth rate could be seen as an excessively pessimistic practice, given that one generally accepts c2% to be a sustainable growth rate for global GDP. However, we argue that it intuitively captures the dynamic of operating in a fast-changing technological environment. Further, most of our valuation is derived from the 2024e-2036e period leading up to the terminal value, resulting in changes to the terminal growth assumptions not having a case-altering impact on our valuation. A sensitivity analysis covering the discount rate, terminal EBIT margin, and terminal growth rate is shown below.

The assumption underlying our Bull Case can be seen in the table below:

Quantitatively, the only thing that differs between the Base and the Bull Case scenario is a higher growth rate, and subsequent increases to the margin profile. Compared to our Base Case, the sales CAGR increases from 23% to 28% and 5% to 11% for the initial and momentum period, respectively (2024e 2028e and 2029e-2036e). Peak EBIT margins reach 38% (40%) in 2028e before fading to their terminal levels of 30%. We assume 1% terminal growth in our Bull Case scenario.

The difference resides in our reasoning regarding finding attractive reinvestment opportunities presented in the Estimates section of the initial report (see pages 42-44). Our Bull Case implicitly assumes that the company can continue to find attractive opportunities for further expansion along one or several of the four expansion verticals we presented (or others). A sensitivity analysis covering the discount rate, terminal EBIT margin, and terminal growth rate is shown below

The assumption underlying our Bear Case can be seen in the table below:

Our Bear case assumes a sale CAGR of 13% (12%) between 2024e and 2028e. After that, we assume that sales flatten out, failing to ever reach the levels of cSEK250m-300m that management considers relatively achievable even in the medium term. The margins still improve markedly from this point, reaching 26% (28%) in 2028e, but falls more rapidly than in our other scenarios to 12% by the end of the forecasting period. A sensitivity analysis covering the discount rate, terminal EBIT margin, and terminal growth rate is shown below.

We use peer valuation to inform our fundamentally derived DCF fair value estimate. Finding Swedish companies within the space for handheld Raman spectroscopy is relatively challenging (impossible), given that no such companies exist in a listed environment. Instead, we choose to look at companies that are in relatively similar stages of development and where we see potential for each company to be a strong player in a niche market. We have tried to focus on companies selling a combination of hardware and complementary software, but Avtech and Codemill are more pure-play software companies. In these instances, we see the potential for similar margin profiles and strong niche market positions rather than any similarity in the product offering.

Serstech is generally trading at a premium to the median and average for the peer group in 2024e, whereas they fall significantly below comparable companies in 2025e and 2026e. There are two potential explanations for this. Either the market does not believe in the company being able to scale as profitably as our estimates foresee, or the company should not have the same multiples as the other companies on the list once they reach stable profitability. We argue that it is likely to be a combination of both. Some of the other names on the list should have a significantly longer organic growth runway in their current verticals, such as Gasporox and Vertiseit, which would warrant a higher multiple (all else equal). Further, many companies succeed in reaching breakeven, but it is entirely different for a company to become consistently possible. As such, we argue that the market’s scepticism regarding Serstech reaching sustainable profitability might be (at least partly) warranted, and thus, we view this as a clear catalyst for the share once it materialises over the coming years. Also, we would like to accentuate that are estimates are currently pricing in quite a lot of growth despite the visibility into future sales being limited. Thus, we would be positive to the announcement of new orders, as that will be critical in derisking our forecasts.