Friday, 6 September 2013

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.

Monday, 2 September 2013

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.