SPSY - A Money Laundering Opportunity

I recently put together a presentation for a group of investors on the subject of a share I think is significantly mis-valued by the market - Spectra Systems (SPSY). Rather than do a post on them I thought I'd just share the presentation material. The El1te Trader has also done a good write up worth reading. First though, I recommend taking a look at this video:

https://www.dropbox.com/s/wzrqjfmzoj435td/Spectra%20systems%20-%20SPSY.pptx

Long SPSY

PFLM - Powerfilm

I must admit I'm not really much of a pure Graham & Dodd guy. I've always thought that not considering the quality aspects of a business and looking purely for the cheapest valuation metrics is a bit like buying a car with a clapped out engine, no doors and only one wheel because "my god it's so cheap compared to book value!" and then being surprised when it doesn't drive. However, on the twin axes of Quality and Value, sometimes I find something so ridiculously cheap on the value axis that I'm compelled to buy it despite significant quality misgivings, like when I bought PVCS because it was quite clear they could pay out the entire market cap in cash and still be a viable business (and they did!). PFLM falls squarely in this category.

Powerfilm floated back in 2006 at 125p. They reached a high of 485p back in 2007 on the back of euphoria about their products and market potential. Since then they have become a member of the -99% club as I managed to pick up some shares at 4.3p back in the end of November (I really need to get faster at doing write ups...). The shares last traded at 7p. I've learned to cease being surprised at how drastic the swings of euphoria and despair can be in equity prices.

Historically, Powerfilm has been the equivalent of a busted flush draw. Their expected explosive growth never happened and sales have, given the recent trading update, been essentially flat since 2007 at $8.2m. Reported profitability has deteriorated too, and the company haven't made a profit since 2008. The company is a ‘developer and manufacturer of thin flexible solar panels’ and their consumer products are quite cool, although the market is pretty saturated and price competitive hence the lack of profitability. The company has made the sensible decision to focus more on smaller niche markets where they can try to achieve pricing power and recent R&D and sales efforts have been in the Military and custom OEM
markets (although trying to sell in to the US military right now isn't the easiest of tasks).

The attraction for me at the current share price isn't the operating business (which looks like it's struggling in a pretty competitive environment) but the assets. Against a last traded price of 7p you're getting 50.3p of tangible assets. Net cash per share is 14.7p. My estimate of a conservative liquidation value (cash at book, property at 75%, non-cash NCAV at 50%, PP&E at 0%, all liabilities at book) is 26.2p. That's a 110% upside to net cash, 274% upside to my liquidation value estimate and a 617% upside to tangible book. This is after the stock has almost doubled from my original purchase price - you can see why I thought the company was (and still is) stunningly cheap.

These are the sorts of figures I expect in scenarios where the company is either a) insolvent b) is burning through assets at a rapid rate c) a fraud (Hi Naibu!) d) has terrible corporate governance issues. The business isn’t insolvent – they have more cash on the balance sheet than the sum of liabilities. Despite the big reported losses (pre tax $2.2m in the trading statement) cash burn is much lower due to heavy depreciation, at $0.5m per annum, so it'd take them roughly a quarter of a century to burn through their current pile. The company have confirmed to me that capex is being deliberately limited whilst they are undergoing the current solar market turmoil and won't be increased unless higher capacity is needed (They also note: "We do expect a need for future capacity expansion and are holding the cash to meet that that expectation").

The company doesn’t appear to be a fraud either, they are American and incorporated in Delaware (the US state most businesses are incorporated in due to it being business-friendly and they have a lot of business case law to draw on) and operate out of Iowa. Muddy Waters won't be chasing them down any time soon.

There’s some concern on the corporate governance front given the two founders own ~2/3rds of the company, however their track record towards minority shareholders has been very good. No insider of the company has ever sold a single share, even at the market peak of 485p when the company was clearly incredibly overvalued and trading on a huge multiple of sales (>10x revenues). Management bought back shares in 2008/2009 explicitly because:

‘The Board of Directors of PowerFilm approved the share repurchase based on the view of the management of the Company that the shares of the Company are undervalued.’

A move that was accretive to NAV per share. In fact, since I contacted the company asking (amongst other things) about share buybacks, they've restarted them:

PowerFilm, Inc. acquired 245,000 common shares in the Company at an average share price of US$.09 per share.  Following this acquisition, these shares are being held in Treasury.  The PowerFilm, Inc. Board of Directors approved the share repurchase based on the view of the management of the Company that the current trading prices of the shares of the Company (on the LSE AIM) were substantially below the inherent value of such shares.

The amounts spent are small but to be fair to the company I can confirm, from experience, that buying stock in any significant quantity for this company is pretty hard. It's more the shareholder value orientation message I value.

The founders aren't extracting value from the company at the expense of shareholders via compensation either. The CEO is paid a measly $131k a year, with the rest of the board on salaries under $25k a year and apart from the CEO leasing a building to the company for $90k a year there are no other related party transactions. Their prime economic incentives are aligned well with minority shareholders.

With dominant insider shareholders there's always the risk of the company being taken private on the cheap, although theoretically Delaware also has laws protecting minority investors from being forced out of their investments at disadvantageous prices (See https://www.marshall-stevens.com/index.php?content=entire-fairness-test and http://valuationspeak.com/fair-value-statutory/statutory-fair-value-1-an-introduction/) a delisting would still be possible. It's a risk, but given management's fair treatment of minority shareholders so far I think it'd be out of character.

So what's going to happen with Powerfilm? Where's the catalyst here, what's the end game? Powerfilm reminds me of a post I read by Bristlemouth which I agree with strongly. There's no obvious great narrative here and plenty of negatives, but investors tend to overpay for narratives and forget how rapidly and unpredictably things can change, both for the better and the worse. Many things could happen to Powerfilm in the future and I make no prediction as to what the likely outcome will be (except to say I'm rooting for all the good ones) but I don't think I need to for this to be a good investment. I'm happy that I'm buying assets at a gigantic discount with a management who are economically aligned with shareholders. To quote the Bristlemouth blog:

Ok. So we bought a stock without a clue as to its future and got lucky. That’s one way of looking at it. But we prefer another. When you buy with a big enough margin of safety, you don’t need to predict the future.

General portfolio update: 

Since my last update I've largely been selling / top slicing stuff which has appreciated towards fair value and/or grown to an uncomfortably high portfolio weighting. This includes some ZIOC, 3LEG, PVCS and JDG.

I completely sold out of VNET after coming round to the idea that they aren't all that cheap when you factor in the fact their exceptionals are anything but exceptional and I'm not all that comfortable with their business given the declining pub market and I'm not convinced they add value to their customers outside of being a policeman for the large Pubcos. Despite the disappointing results they put out, I managed to make a small profit on the sale and collected a dividend along the way so it's not turned out terribly.

The new addition to the list is CMCL, a gold miner in Zimbabwe (yes, I'm feeling perfectly well, thank you for asking). I now have 4 stocks with different natural resources exposure (3LEG - Polish shale gas, SEA - Irish sea oil, CMCL - Zimbabwean gold, ZIOC - Congan iron ore) which all share a common feature of being cash rich relative to their market cap except for SEA, in which I'm largely interested in their software business and the LOGP stake is 'in for free'. This means I now have 22.6% of my portfolio allocated to natural resource stocks (or 13.5%, if you exclude SEA) which says more about the prices available than about my actual level of enthusiasm for the sector in general, which is pretty low. I'll do a write up about CMCL soon as I received a few questions about it after I posted about my purchase on twitter.

I really, really want to top slice SPRP after recent strong rises although I decided a while ago that I was going to wait till the move to AIM to top slice it as I thought the price was likely to appreciate significantly as a much wider range of investors got a look at this company. The stock is doing it's best to tempt me out of my stance but I'm still resisting, for now. The stock still doesn't look all that expensive either if 2014 expectations come close to being met, as it's currently trading at 12.3x 2014F and 17.6x 2013 numbers (which management have confirmed are in line), and those forecast numbers don't include any benefit from the renegotiation of the distribution agreement.

2013 - Year in review

So as the markets close for the last time in 2013 I've totaled up my figures for this year in terms of investment performance as well as over my investment lifetime. All stocks are valued to bid prices, with dealing charges and stamp duty costs included (but before capital gains tax). As I am often adding to / withdrawing from my portfolio for various reasons I track IRR as my main investment metric and benchmark myself to the FTSE All Share and Small Cap Indices:

2013

My IRR: 50.45%
FTSE All Share IRR: 14.22%
FTSE Small Cap IRR: 40.00%

Lifetime (Began 2011):

My IRR: 44.88%
FTSE All Share IRR: 9.48%
FTSE Small Cap IRR: 29.06%

So it's been another year of a strong bull market in small and micro caps UK stocks and a rising tide has lifted all boats - my 50.45% IRR doesn't look all that exceptional when you consider the Small Cap index has risen a whopping 40% this year. In fact I'm surprised I'm actually ahead of the index at all as looking around the UK small cap market now the equities that are really taking off are often low-quality 'story stocks' as the bull market becomes more mature. This year I feel like I've been pretty lucky overall with my investments as I've had so many different ones work out positively and few losers (C21, CLIG and 3LEG have been the main detractors). I certainly still expect my Lifetime IRR to trend down over time to a more reasonable figure as the benchmark IRRs mean-revert to their long term averages although I'm happy with a ~16% out-performance since I began investing.

My main mistakes this year have been those of selling investments too early. As a fundamentals-oriented investor, I have a natural bias towards over-focusing on two of the three main sources of empirically confirmed equity out-performance (value and quality) and ignoring the third - momentum. Whilst I'm aware of this and try to compensate by holding on to well performing equities that were cheap until I feel full value has been realised I have sold a number of stocks that have gone on to do very well in a relatively short period post selling. Staffline I sold at 339p and it went on to touch over 600p. I sold ACSO at 340p and it's now trading at 780p. I don't feel that bad about the prices and multiples I was generally able to sell these at (I sold ACSO at a ~30x multiple at the time and it's gone to ~55x!) but I often find that I when I sell a well-performing share they often go on to do another 15-20% in a short period afterward, although that's probably an artifact of the bull market in general anyway.

Right now I'm finding it harder and harder to find undervalued equities in the micro and small cap markets although I'm still happy with my existing investments - the nice thing about micro caps is you can be very selective and there's always something about that's cheap. On a valuation basis most markets seem at best 'fair value' to me and often quite a bit toppy - some of the small caps have re-rated on to multiples that imply low forward returns on any reasonable expectation of business performance and when people can get away with stuff like this you know the temperature of the market is starting to get quite hot.

I hope you've had a good year investing, here's to many more in the future!

CLIG - City of London Investment Group

There’s been a few mentions of CLIG on TMF before so I have to give credit to other write ups worth reading: Burgdorf’s, TMFFlaneur’s and TMFMayn’s but I’ll try and synthesise these all together, with my own comments.

CLIG are an asset manager focused on emerging markets (EMs). EMs have had a pretty rough time recently compared to developed markets and so are fairly out of favour (See the performance of the Vanguard EM ETF here) after having an exceptional run for many years prior to 2008. This has impacted CLIG pretty badly as revenues and earnings are tied to the assets under management (AUM) the firm has. This means that AUM falls in years where the EM indices fall, and rises when the EM indices do – consequently earnings also follow the same pattern.

From 2005 to 2011 CLIG grew AUM from about $1.6bn to $5.8bn through a combination of raising more capital and EM index growth and hence earnings also shot up from 11.85p to 34p. However, since then earnings have fallen to 24.6p as AUM has fallen to $3.7bn. This is due to the underperformance of EM markets as well as a big loss of one client who took their business in-house and away from CLIG. Due to this fall it’s likely earnings will also fall for next year – brokers forecast a consensus of 19.3p but TMFMayn has used the earnings model CLIG provide in their annual report to calculate that their current run rate is 17p.

CLIG have a great management culture and a pro-shareholder attitude. The founder, Barry Olliff, owns 11.4% of the shares whilst other directors, staff & ESOP own another 12.1% of the company. The staff also participate in a profit-share agreement, whereby 30% of PTP is allocated as bonuses, so staff have a strong incentive to grow earnings and shareholder value over the long term. It’s worth quoting Barry Olliff himself on this structure in 2012:

"As shareholders are aware, we run a business with a very simple business model. We collect fees from our clients for our services, we pay our bills which are both forecastable and to a great extent fixed. We don't use leverage, nor off-balance sheet instruments, nor do we trade derivatives as principal (other than occasional low level hedging). There are no associated companies or minority interests within the Group. We do not use tax havens. We do not handle client monies. We have a significant amount of cash in the bank relative to our size and we basically stick to what we know.

With regard to remuneration we continue to distribute 30% of our profits as profit-share. Our staff, clients and shareholders understand this formulaic approach. It's a pity that this approach has not been embraced by the financial service industry generally. As it is, in many parts of the financial services industry it seems as if losses are not the responsibility of mangers rather it's the shareholders who take the rap. Whilst our formulaic approach seems out of keeping with many in our industry, at least our shareholders have an idea that our returns go up and down together with theirs 

We have continued to manage our business very conservatively. We have continued to attempt to keep costs down. We do not spend shareholders' funds entertaining and we generally attempt to manage our business as if shareholders were present in our offices every day of the week. One reason I would suggest that expenses are kept down is because staff are either shareholders themselves or own shares via the CLIG ESOP. At present staff own (including ESOP ownership) 27.9% of CLIG shares, and 75 out of 82 of us are incentivised in this way (a handful of more recent recruits do not yet hold options).”

Importantly for an asset management firm, I think CLIG’s investment strategy adds excess returns (‘Alpha’ in the financial lingo) and hence is a desirable one for long term asset allocators (i.e. potential customers). CLIG’s main strategy is investing in closed-end funds, funds which have a fixed AUM (pre-distributions & returns) and have shares which trade publically. CLIG like to buy these when the share price trades at a discount to NAV, hoping to benefit when the discounts return back to their historical norms. They meet with all the managements of the funds they invest in and try to influence their use of strategies which help narrow that discount (87% of the funds they invest in have an Open Market Repurchase Program in place)) as well as investing in funds where they think the managers are better than average.

Unfortunately, this strategy has done badly recently as the Size Weighted Average Discount (SWAD) has risen from 8% back in 2008 to almost 14% in 2013, providing a headwind to their main source of excess returns. However, this headwind is sure to turn in to a tailwind as discounts mean-revert. This should also be a marketing advantage, as this is a simple message to sell to new clients (“Come invest now at the highest discounts we’ve seen in years and take advantage of the tailwind for excess returns!”). In fact, CLIG are looking to do just that and given the recent loss of a client have capacity now to add new clients and expand AUM. They are looking to raise $500m in 2014 and potentially another $500m in 2015 to replace the $1.3bn lost in FY12 and FY13.

CLIG also have another tailwind from the run-off of their marketing commission structure over the next 7 years. They currently pay £3.6m in commissions to marketing firms for introductions to clients they have however by 2020 this will have reduced to nearly £0 and the benefit should all flow directly to the bottom line. CLIG have also introduced nearly £1m of cost savings in the past year from closing underperforming products, reduced headcount and lower business development costs.

The other large negative factor weighing on the share price recently has been the departure of CEO and the FD under unexplained circumstances. It does appear to be fairly amicable however when Roger Lawson asked at the AGM no further explanation was given as to the reason behind it. It seems highly likely that due to whatever agreement was signed the board are unable to give the real reason for the departure. The question is what impact is this likely to have on the business? In the short term £1.1m had to be paid as termination fees to the departing management (although this was offset by Barry Olliff volunteering to waive his bonus) but the longer term fear is that this is sign of internal trouble within the staff – a very bad sign in a business that is highly dependent on the people it employs. This is partly offset by the fact that Mr Olliff believes that CLIG’s investment strategy isn’t dependant on ‘star managers’ but rather a ‘star process’, allowing internal talent to be developed. Also the firm’s focus (driven by Mr Olliff) on otherwise very good corporate governance and a pro-shareholder mentality offers reassurance, although this is clearly an area to be kept a strong eye on as prospective clients will want to see a solid investment team

On a valuation front, CLIG don’t ‘appear’ cheap as they trade at over 12x forward earnings (broker forecasts) however this is perhaps the wrong metric to focus on as earnings are volatile and the business is operationally geared. Given CLIG have the SWAD tailwind, the marketing run-off tailwind, the £1m cost-savings and are looking to raise ~$1bn of extra AUM over the next two years it seems likely that earnings could be significantly higher in 2-3 years time as AUM (and hence revenue) grows whilst costs come down. PTP margins are currently at 31% (a relative low) but have been as high as 41% previously and have averaged 34.2% since 2005.

Valuations for EMs also appear attractive and the case for EM investment is as strong as ever (See Wexboy’s excellent analysis) so it would not be unexpected to see a recovery in EM indices, further boosting AUM and earnings.

Investors are also paid handsomely to wait, with a 10% dividend at the current price (only just covered by earnings and probably uncovered next year, but 15.6% of the market cap is made up of cash on the balance sheet so CLIG should be able to maintain the dividend whilst earnings build back up). The wonderful thing about asset management businesses is that they are very high quality – earnings convert predominately in to cash and the business takes next to no capital investment in order to grow, so growth is highly value creating for shareholders. To confirm this, CLIG have earned an average of over 50% return on equity over the past three years. This lack of a requirement for earnings to be ploughed back in to the business means management have excess cash which can be distributed as dividends or used for acquisitions to expand the business (CLIG have tended to be more generous with the former, growing the dividend from 10p in 2007 to 24p today). It’s a great business to be in.

In conclusion, I think CLIG are both a great ‘value’ and ‘quality’ play (Stockopedia agrees with scores of 89/100 for Value and 88/100 for Quality) together with a number of favourable tailwinds and mean-reversion factors which should come through in the medium term, combined with top-notch corporate governance. I look forward to seeing them present at the next Mello event and highly recommend investors come and take a look at what I think is a great business at a great price!

An update on my portfolio since the last update: 

I've added SEA at 22.75p (yay!), NCON at 15p (yay!) and 3LEG at 24p (D'oh!). I bought more LCG at ~33p average price and topped up ZIOC at 15.6p as attractive prices presented themselves. I top sliced RNWH at £1.60 and TNI at £1.58, £1.72 and £2 as prices appreciated. I completely sold out of C21 for a big loss at 6.2p and out of JD. at £11.33 (too early, but at a decent profit) I've also bought one more 'mystery stock' I've blocked out of the list above as I'm still accumulating and it's a very illiquid stock. A full year review of my investment performance to come soon!

Portfolio Update

I've made quite a few changes in my portfolio recently so thought I'd better do an update to keep track of my thoughts. Here's my portfolio as it currently stands:

Here's a list of each of portfolio actions since my last update and an explanation:

Sold out of KENZ

I started top slicing KENZ as the price rose for portfolio balancing reasons, with sales at £4.10 and £4.48, but I sold out of my holding at £5.84 entirely after they disclosed that a few bid offers had been turned down. Looking back over my (short) investment history, I realised I'd repeatedly made the wrong decision in potential bid situations (CHG and LCG come to mind). To combat this, I've come up with a new heuristic for dealing with them - I imagine that there's no bid, then take whatever action I would do anyway had the price just risen to that market price regardless. That generally means that at least top slicing is necessary, but in this case I felt that KENZ was close enough to what I'd consider fair value such that I sold out completely to invest elsewhere. Given a ~50% rise from my average cost for KENZ, this investment played out well.

Bought in to RNWH

I actually attended an investor presentation by RNWH back in March 2012 and decided against investing in them at 75p. At the time they were lowly rated relative to their profits but I was concerned by the quality of earnings - there was a large exceptional cost in the final results and the cash flow generated was pretty poor relative to profits. 

However, I changed my mind and bought in at 115p after taking a second look recently. Their interim results were impressive, with profits continuing to grow, only a small exceptional charge and FCF above reported earnings. Combined with this, the order book was up 19% year on year, continuing the impressive growth management have made in engineering services. The nature of the work they do (essential maintenance & renewal) gives me more confidence that profits will be less cyclical and their margins are high given the sector, confirming higher than normal barriers to entry from other firms bidding for the same business. Despite the price rises recently the business is still on a single digit P/E, which seems harsh given management now have a decent track record of both organic and inorganic growth and the positive outlook for the future.

Since I bought, Renew announced another acquisition at a similarly low multiple which should further boost earnings and supports the thesis that there's plenty of inorganic growth available at an attractive price in their sector. They also announced a number of exceptional items, the net result being an exceptional profit and a large cash injection. I must admit I'd completely missed the extra value from the land they owned so this is a really nice boost and the cash freed up means that they are already 'reloaded' from the latest acquisition and hence can go back on the hunt.

Bought in to ZIOC

Sometimes in investing it's nice to get a large spot of luck. ZIOC certainly falls in to that category. Despite the large portfolio allocation now of 6.1% I actually only put a few % in originally - my buy price was 11.5p. The share price last closed at 24p. ZIOC is, technically, a miner - an area I profess little expertise in and normally would consider outside my circle of competence however ZIOC is more of a special situation relating to whether or not they can sell their share of the assets they own. There's a really good post and discussion over at the Motley Fool which contains a write up of the situation.

What really attracted me to ZIOC was the asymmetry in the investment. They have a genuinely world class asset supported by work done by Xstrata (now Glencore) and it's right at the bottom of the iron ore cost curve. Whilst the market was panicing over the well publicised collapse of the iron ore market the share price was, indirectly, implying a near zero percent probability for ZIOC being able to derive value from their assets. I felt that ZIOC was a bit of a case of throwing the baby out with the bathwater - most junior miners are (rightly) seen as value destroyers with low quality assets. In the case of ZIOC we have a business that's majority owned by insiders so the incentives for value destruction are low and an asset that could be worth many multiples of (even the current) market price. Due to the low free float, aggressive selling by Blackrock trashed the price and created this interesting investment opportunity. Doing some quick expected value calculations told me that the market was pricing in a tiny probability (a few %) of a sale going through which seems like a mispricing given the obvious quality of the asset they have.

Whilst the price is much less supported by 9p of cash on the balance sheet now than it was at 11p I'm trying to let this position run - I originally priced it as a small % of my portfolio so I could afford to lose it on the basis that I'd let this fairly binary investment play out to conclusion - either they sell the asset and I get a huge multi-bagger or they can't and I make a small loss (supported by the cash position). That being said, as the price rises it does get tempting to take profits...

Topped up ARGO

With ARGO still trading at an attractive valuation I topped up my holding with the capital I'd gotten from selling out of KENZ. Wexboy has just given his assessment of the value here and I'm a fan of discount-to-asset plays, especially given the business still is throwing off a large dividend and is profitable.

Sold out of TRCS

This was a tough one for me and required a lot of thought - I first wrote about Tracsis here where I reasoned that they were a good long term bet. I'm still convinced of this, although now I have more valuation concerns. I was expecting significant profit growth this year, especially given the boost to earnings from Sky High, but it appears that EPS should only grow slightly. This is all down to how much profits are dependent on the MPEC division now, where revenues are dependent on winning contracts. As I've seen with my C21 experience, markets don't tend to look too favourably on short term disappointment. Given what I thought was disappointing growth in earnings combined with a ~10% share price appreciation since my original purchase made me re-assess how much margin of safety I had.

I still really rate the management of Tracsis and I think the business will be worth considerably more 5+ years down the line but I'm more concerned about the near term future. Arguably this is a mistake and a longer term horizon would prove more rewarding but when I start having doubts about an investment decision I tend to err on the side of caution and sell - I really want the valuation discrepancy to be shockingly large and not a close cut thing. I'll keep an eye on TRCS though and would love to buy back in at a lower valuation.

Bought in to VNET

This was another tough one, as there's a multitude of things I dislike about Vianet, but in the end the price has proved too tempting. VNET has fallen from ~120p earlier in the year to around 68p now on the back of disappointing results and the news that there's a consultation in to regulation regarding pub ties which could impact them negatively. Other negatives are a seemingly endless decline in revenues and profits and a number of divisions which seem to repeatedly lose money. Quality of earnings is also a concern of mine, as they do capitalise a lot of costs and repeatedly have exceptional costs (they aren't exceptional if they happen every year!).

That being said, there are a few positives amongst the doom and gloom. The CEO owns 15% of the business and was buying shares in significant volume fairly recently at much higher prices (~100p) than today - he clearly believes in his business and thinks there's value here unappreciated by the market (and I'm a big fan of owner-operators - never forget the power of incentives!). The current price offers an 8.7% dividend and a historic P/E of sub-10. It's worth noting that there are a number of loss making divisions which obscure the true earnings power of their core Brulines business, which earns big healthy margins (although sadly in a declining industry - pubs have been net closing in the UK for decades). The current forecast, however, is for a large improvement in profits to 14p a share, probably largely from management expectations that the loss-making divisions will move in to profit. Whilst a doubling of profits seems unlikely to me, even a large miss to say 10p would put the shares on a P/E of under 7. Also, I consider the proposed regulatory changes very unlikely to happen - the Vianet response document is very interesting. Some of the 'arguments' against flow monitoring equipment like Vianets are just plain ridiculous. Consider this one:

5.2 Clearly, it is entirely legitimate for one party to a contract to seek to ensure that the other party complies with the terms of that contract. However, the model of the tied public house has been part of the British pub industry since at least the 18th century and for the majority of that time modern flow monitoring equipment has not been available. It is therefore clearly possible to operate a tied estate and to enforce the tie without the use of flow monitoring equipment.

Vianet's response pretty much sums up the rational response to such a statement:

Whilst pubs may have operated successfully before the advent of beer line cooling, electronic point of sale and electric lights were invented, nobody is suggesting they should go back to warm beer, paper book-keeping and the use of gas lanterns and candles.

I think the market is over-pricing in the risk that this proposal could ever become law and is capitalising the losses from the loss making divisions (which really should be seen more like startups in their own right) creating this attractive entry price.

Sprue Aegis - Hidden value

Sprue Aegis (SPRP) are an ISDX listed company that are, in their own words, "one of Europe's leading home safety products suppliers and manufactures one of the world's smallest CO sensors for use in CO alarms." For those who aren't aware, ISDX is an even smaller version of the AIM market run by ICAP. This is indeed a company listed on a market most aren't even aware exists - an ideal situation for creating big security mispricings. I believe SPRP to be one such mispriced security.

@Glasshalfull has done a write up fairly recently on Sprue Aegis over at the Motley Fool which covers a lot of the background to Sprue. The one big event since that write up that hasn't been covered is a 90p a share offer by a 30% shareholder, Jarden Corporation. Before I get in to all that though, let's look at the background of this company.

Graham Whitworth, the CEO and Nick Rutter, the MD are long timers at Sprue with Graham joining as CEO and Chairman in 2001 and Nick being a founder in 1998. The FD, John Gahan, joined in 2010 with a background from KPMG. Sprue is an owner-operator company, with insiders and their family owning 25.2% of the business.

In that time, management have built sales from zero to £37.2m last year. The CAGR of sales for the past five years is 38.6% and the most recent trading statement indicates that H1 sales are up 28% on last year. Sprue have been included in the SundayTimes FastTrack100 (for the 100 fastest growing companies in the UK) for five consecutive years. Sales growth is being driven by a series of recent significant contract wins with distributors such as B&Q, British Gas and Baxi. Management credit the impressive performance of the company to significant investment in their product range by aiming for best-in-class products. Sprue have 68 patents granted and a further 27 pending. Stiftung Warentest, the German equivalent of 'Which?' magazine, recently rated their ST-620 product as having the joint highest score out of all the smoke alarms they tested, beating products from larger competitors such as Kidde. This product investment is paying off as Sprue win contracts and take market share from the incumbents.

Sprue operate in both the retail and trade areas with specialised products and brands for each. As well as smoke alarms they also produce carbon monoxide detectors. Retail has lower gross margins than trade although fixed distribution costs are lower. Both areas have significant tailwinds from increased household penetration (especially CO detectors - 85% of UK homes have smoke detectors but only 20% have CO sensors) and increasing legislation mandating the installation of such important safety products.

Geographically Sprue started out in the UK and hence have the highest market shares there, although European expansion is their current focus. Especially so in France, given the legislation for all homes to have smoke alarms installed by 2015 in order for insurance to be valid, and Germany given the recent Stiftung Warentest award.

Capital allocation has been largely focused on fueling organic growth, although given the business is highly cash generative and not capital intensive (Retail requires more WC than Trade, but it's still pretty capital unintensive) management have been returning excess capital in the form of dividends. Last year the dividend was doubled to 4p, from 2p the previous year, itself doubled from 1p the previous year, itself doubled from 0.5p the previous year..! The balance sheet is also rock solid, with zero debt and £6.2m of cash.

Despite a slightly disappointing profit result last year due to impacts from FX and a one-off warranty charge (and lower quality of earnings - something worth keeping an eye on in the next results), Sprue confirmed they are in-line with PBT expectations for this year of £5.3m. If achieved, the company would be trading on an EBIT multiple of only 8x, itself hardly demanding given the company's outstanding historical performance and fantastic growth opportunities (It's worth pointing out that, due to Patent box legislation applying to Sprue's products, management expect the medium term tax rate to approach 10%). The latest broker note believes £10.2m of PBT is possible for 2015 - whilst such growth is so high as to demand prudent skepticism it would imply an EBIT multiple in the future of only 4x. As it stands, Sprue already looks cheap on FY13 expectations (which the company say they are so far on track to meet) and ludicrously cheap on (admittedly ambitious) FY15 expectations.

However, I haven't yet touched on the title of this post - 'Hidden value'. Whilst the impressive performance of this company has remained under the radar because of it's ISDX listing there is another important valuation element not immediately observable for Sprue. It lies in the details of the distribution agreement between Sprue and their partner-turned-suitor Jarden Corporation.

Back when Sprue signed the DA with Jarden in 2009 Sprue had no trade brand to call their own - they were purely a retail focused company. Jarden, impressed by the performance of Sprue's management, asked if they would take over running their UK and European operations of their trade brand - BRK - and they took a 30% stake in Sprue with an agreement not to increase their stake which expired earlier this year. Shortly after the expiry of that clause, Jarden launched at 90p a share offer for Sprue, threatening to terminate the DA if Sprue shareholders didn't co-operate. However, Sprue management put out a robust defense urging shareholders not to sell their shares. It appears Jarden's hand is not as strong as they'd like Sprue shareholders to believe. To quote the defense document Sprue put out after the 90p share offer:

BRK’s UK business was fully integrated into Sprue over the last 3 years, with all its
• staff transferred to Sprue
• customer contracts novated to Sprue
• IT systems upgraded onto Sprue’s IT platform
• warehouse and office facilities integrated into Sprue’s organisation

A lot has changed since 2009 and Sprue have since developed their own line of products to obsolete the brands they inherited from BRK. Again from the defense document:

Due to changes in market demand, Sprue has already replaced a number of BRK’s products with Sprue’s own products and technology
• With new potential third party sourcing arrangements and market demand moving towards more sophisticated technology, the Independent Directors estimate that between 2012 and 2015, sales of BRK’s products are expected to substantially decline as a proportion of Sprue’s total revenue
• Save for a relatively low amount of sales through Mapa in France, Sprue is not contractually obliged to sell BRK’s brands anywhere in Europe
• Sprue is free to replace existing BRK products with its own products at any time

My view is that Jarden have realised that they are now in a weak bargaining position with Sprue given the DA is up for re-negotiation in 2015 and are trying to buy the company (and their superior products) at an opportunistic moment. It's especially interesting because the DA's terms masks the underlying true earnings power of the business as it stands:

 • Under the terms of the Distribution Agreement, Sprue pays BRK c.£4.2 million p.a. before other costs
• As sales of BRK’s products are expected to decline, the distribution fee may not represent “value for money”
• Within 12 months we have the opportunity to serve notice not to renew the Distribution Agreement
• We have almost two years to replace BRK branded products with other brands and products
• Sprue has plenty of time to source its smoke products away from BRK to an alternative supplier at potentially lower cost

The implication of this is that, if FY13 forecasts of £5.3m of PBT are made this year then the "Sprue Enterprise" as a whole will actually make £9.5m of PBT, except Jarden currently capture a fixed £4.2m of this through the fixed distribution fee (as well as creating other unnecessary servicing costs for Sprue). This highlights the impressive moat and pricing power that the business has given this implies that the real operating margins of the enterprise are above 20%. Given the obsolescence of the under-invested BRK brands and the expiration of the DA in 2015 this creates a near-term opportunity for Sprue shareholders to recapture some more of the earnings power of the enterprise as a whole. In the very long run, Sprue could even eat BRK's own lunch back in the North American market where BRK are already losing market share to competitors (A tasty line from the defense document: "CO sensor approval process underway in huge North American market" - clearly I'm not the only one anticipating this potential move!).

What could the Sprue business look like in 2015 after the BRK deal expires? Let's consider two scenarios: first, FY13 PBT of £5.3m doesn't grow at all and only half the distribution fee gets renegotiated (Base case) and second that broker forecasts of £10.2m PBT are achieved and the whole distribution fee is cancelled (Bull case - I have confirmed that the broker forecasts assume no change in DA). In the base case, PBT is £7.4m putting Sprue on an EBIT multiple of 5.7x at the current share price. The bull case would mean Sprue would be doing an astonishing £14.4m of PBT at a current EBIT multiple of below three. It's not hard to imagine multi-bagging scenarios under even the base case assumptions.

In summary, I believe Sprue shares to be an absolute steal even after significant price appreciation this year. Investors are buying a management with a focus on long term shareholder value and a great track record of value-creating growth at a multiple normally reserved for much weaker businesses. Given the near term catalysts of impressive organic earnings growth and a potential move to the AIM market, as well as medium term improvements from the DA renegotiation, I think current shareholders will be richly rewarded both in the short and long terms.

Disclosure: I'm, obviously, long SPRP.

Half year review - Part 3

LCG - London Capital Group

I did my main write up on LCG here. The two big bits of news since then for LCG have been the trading update and the change (again!) of the CEO, Mark Slade. With regards to the CEO, I'm sorry to see Mark go after such a short period but it does seem genuinely to be for non-business related reasons (and on the bright side, the overly generous options package granted to Mark will no longer dilute shareholders). The new CEO's background seems well suited to the role and he's already a shareholder so knows the business well.

The trading statement generated a bit of positive movement for the shares as it confirmed that the core business had grown from £12.8m to £13.2m (and this is based on the good H1 last year, not the bad H2) although the institutional FX and broking business declined from £4.8m to £3.1m. They claim an "adjusted" profit before tax of £3.1m compared to £2.7m in last year's H1. There's the expected IT platform cost (they are running two platforms concurrently whilst they perform a migration and should cease when completed) and some restructuring costs (which I think should be expected, given they are going through a much needed cost cutting process). Even being cynical with regards to how non-recurring these costs are, that's still an annual run-rate of £3m PBT (£6.2m if you think they are genuinely non-recurring) compared to a market cap of ~£23m (as I write, the shares are up today). They've disposed of two loss making divisions as well, which is good news. I still think there's plenty of upside left here.

PVCS - PV Crystalox Solar

All seems suspiciously quiet on the news front here from PVCS, as shareholders have been expecting a large return of capital (7.25p per share, compared to a market price of ~11.5p) for months now. Correspondence with the company has sadly only yielded a "wait and see" message, as they wait till the next trading update to announce what they'll do. The proposed tariff on Chinese imports on solar panels in to the market materialised, although they were somewhat less drastic than what was hoped for they still offer some degree of relief for the market. PVCS is still a net-net and all the reasons I have for holding still stand, although quite why the return of capital has taken so long is worrying.

TNI - Trinity Mirror

Trinity Mirror recently released their latest results and they were pretty impressive. Debt continues to be paid down from the huge cash flow generation and they even managed to grow operating profits despite the continued decline of newspapers. Many analysts still point to the huge pension deficit, which currently is larger than the market cap of the company. In many respects, owning the equity here is akin to a large bet on pension discount rates and their assumptions (although I still think the shares are cheap even if the liability is as stated). I made a comment on Stockopedia about my thoughts with regards to these assumptions and it's fair to say I want to bet on the overs when it comes to how realistic the current discount rates are (and hence I think the liability is considerably overstated). People also seem quick to forget the ~£300m of property assets they own as well as the fact cash flows are greater than profits due to depreciation being greater than capex.

The one thing I'm much less sure of, having given it some thought, is how well newspapers can handle the transition to online. Even with the huge growth figures being quoted for page views etc by TNI the actual revenue generated from their online operations is absolutely tiny - their tiny online recruitment businesses dominate their online news business. I did some research looking at DMGT (The Daily Mail group) and in their accounts I found that the group of businesses of which the Mail Online (the famously successful online tabloid and the world's most popular news site) is one contributed only £100m of revenues last year. Given that the wildly successful Zoopla group is one of those (who take up at least £30m of those revenues) that means the world's most successful news site does less than £70m in revenues a year. It certainly doesn't look like the monetisation of online news is anywhere near solved and, whilst I think there will always be a need for journalism, I'm not sure I know what its future looks like anymore. That said, some very bright people still think it's not all over yet...

TRCS - Tracsis

The only big news on the Tracsis front since my original post about them has been the trading update. To be honest I was surprised that profits were merely in-line, as the acquisition of Sky High should contribute significantly to profits in absence of any organic growth. Given so much of the profits come from the Condition Monitoring division, what do management have to say about it?

The Group is currently involved in negotiations with a major customer to continue the next phase of a significant Framework Agreement for its condition monitoring technology. The timing of the prospective contract extension indicates that potential major orders for the Group are expected in late 2013 or early 2014, assuming successful renewal. A further update will be provided in due course.

So it sounds like profits might be subdued somewhat until these orders arrive. I'm happy to hold here in the mean time, although I'll need to re-evaluate when the full results come in. I still think Tracsis has great long-term growth opportunities and the fact that they entered the rail freight market has gone largely unnoticed by the market. When I spoke to the CEO at an investor presentation he confirmed that they were pursuing the (much, much larger) American freight market and Tracsis still seem to be the only company dominating their market niche of crew scheduling software. I'll pay up for companies (within reason) where I can see a) very strong long term growth tailwinds in their market niches b) an excellent record of capital allocation and c) owner-operator management with an eye on the long term. Currently only JDG and TRCS fill this 'GARP' niche in my portfolio (although I'd argue ALLG should be considered a long-term GARP share, even if it's more deep value at the moment!) mainly because I find it hard to find many companies who tick all the boxes, especially box b).


Sharp eyes might have noticed I've missed off SPRP from this post. Given it's such a large proportion of my portfolio at the moment and I've not said a word about it I felt it deserved its own write up, so expect a full post on my first ISDX stock soon!