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.