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.


  1. Excellent post CEV...and a scenario that I fully concur with.



  2. excellent writeup

  3. Also an ''open'' Company which in the past has welcomed PI communications. PJ

  4. I like this analysis. Interesting angle.

    Will managment tell you what % of BRK sales have been replaced with Sprue's own products since inception of the distribution agreement in 2009? i.e. is there any evidence of them actually doing this?

    Would the bear case be they lose the distibution agreement, and lose the sales from BRK and unable to replace them. What would that do to ebit do you think?

    Prior to singning the distribution agreement I think the highest margin they produced was close to 16% in 2009. Perhaps there has been some underlying improvement since the distribution agreement, but 20% seems quite high.

    I dont think they disclose the sales via BRK but they could be in the region of 16m if you just look at the change post the distributin agreement in sales. So perhaps they can do 24m of sales without the distribution agreement, and on a 15% margin that would give them 3.6m of ebit.

    This would leave them on 11.8x EV/EBIT.

    I have been an owner for some time but just trying to establish the downside. I would be interested in your thoughts.

    Many thanks for publishing this.

    1. Apologies. The sales number was a bit harsh. We could assume 34m of sales with a 15% ebit margin, if they lost the BRK contract? So more like 9x EV/EBIT in the worst case?

    2. Interesting thoughts, it's always good to consider the downside (and if anything is the most important thing to consider).

      As for current % of BRK sales I'm not sure, I don't think I've seen it disclosed in any reports. To be fair to management a lot of their replacement products are quite recent (e.g. SONA) so you wouldn't expect them to replace BRK immediately. Also until recently management might have not been so aggressively pushing their own products if existing customers were happy with the BRK products but now will have a strong incentive to switch over as much as possible. I think we'll gain greater insight in how the switch over is going from future statements. The defense doc does say "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" so clearly the shift in sales proportions is largely expected to happen in the future rather than have already happened.

      I think losing sales here is fairly unlikely now because a) Sprue now have their own brands in every product category and b) BRK would need to start from scratch if they wanted to carry on selling their own products as they grandfathered over basically their own European operations for Sprue to manage back in 2009. I can see their sales pitch to existing BRK customers post-DA expiry as being quite simple: would you like to change your current BRK products to our new, upgraded product that does the same thing but better and at the same or lower cost? To carry on buying BRK products, customers would need to change suppliers to BRK who would have to essentially build a business from scratch should they want to re-enter the European market anyway. When you look at the terms agreed when Jardens entered in to the DA you can see they really did hand basically everything over to Sprue who seem to have gotten the upper hand in every aspect - it'd be tough to suddenly start again and win sales back from Sprue.

      As for margins, you are right that 20% implies the highest ever achieved to date but I think it's fair to expect some degree of margin expansion as the business grows overall as fixed costs decline as a proportion of overall revenue - when I spoke to management before they did highlight that they thought the business was operationally geared in this way (although how much of this is due to the fixed DA royalty payment I'm not sure). The 20% figure isn't something I think they could do far in the future - it's effectively what they're already on track to do this year assuming one is valuing the whole Sprue enterprise and not just the earnings accruing to shareholders.

    3. In reality I think the most likely outcome is merely a renegotiation of the DA rather than complete cancellation, but even that could yield a good few million in extra profit (and there's no worry about losing sales from dropping the BRK products). I don't think Jardens really want to lose the DA given how easily they gave up their European operations in 2009 so I think if Sprue feel they still have some value from the agreement they'll renegotiate - the power is in their hands and not in Jardens.

      I think there's a huge margin of safety from the growth available to Sprue, regardless of the outcome of the DA renegotiation. They trade at only 11x 2013 EPS right now (which they say they are in line with meeting) and for a company growing at double digit rates with healthy margins and low capital intensity that's already a huge bargain. Given all the tailwinds they have in their markets and the product advantages they've built over the years I think they are likely to be able to sustain such growth for a good period - and they haven't even cast their eyes outside Europe yet, there's still further growth to be had there should Sprue decide to enter the North American market, for example. I think because there's multiple ways this investment can be a winner, and that helps create a margin of safety.

    4. Thanks for your posts. Have you done much work on looking at what the organic growth has been?

      I hink if you attempt to strip out the extra sales they have aquired through the distribution agreement the organic sales growth over the last few years does not look that great.

      UK Fire Service - Declining market
      UK Retail - Mature, some scope for more Carbon Monoxide Sales growth?
      Trade Market - Very hard to break into - jury still out
      Europe - Jury still out - has not been as successful as they had thought it would be
      Utilities etc - Could be growth here?

      The US could be exciting but it could also destroy alot of value if they were to get it wrong!

      Thanks for all your thoughts.

    5. Sorry for the delay in replying, I thought I'd wait till after the results to get a further view on how things have been progressing before I passed judgement. From the commentary it appears that all the impressive growth is coming from the Sprue own brands e.g. UK Retail - 87%, Continental Europe - 48% ("sales of Sprue's own-brand products in Continental Europe more than doubled and the majority of sales into this sector were of Sprue's own-brand products") and U&L ("Almost all sales in the
      U&L sector were of Sprue's own-brand products").

      The really impressive thing is that this growth is set against a backdrop of significant headwinds in UK F&RS which was down 26%. The good news is that this has hopefully now stabilised ("no further major cuts are expected over the next three years") and that it now represents a smaller % of overall sales as the growth in other areas means they are now more significant, hence the "high growth" segments are becoming a larger proportion of the overall sales base. Also the area that is BRK's big contributor for Sprue, UK Trade, did badly and was down 12% (although they say FireAngel products held flat - so BRK products must be the ones losing market share).

      Re:US as Mark Tughan correctly points out they have tried to enter this market before and it ended badly - once burned, twice shy and all that. I don't think they'll try enter unless they feel it's going to add value to the business.

      My only criticism would be I'd have preferred more hard numbers on the sales split between Sprue own-brands and DA sales - right now we are left with the right impression but nothing is quantified. I'd have loved something like "this time last year DA sales were X% of sales, now they are only Y%" as that's the real key figure for investors but we didn't receive this.

      My take from the commentary is that management are increasingly bullish on their own brands and not so on DA sales which makes it more likely that a re-negotiation or a cancellation is on the cards which would be great for Sprue investors - I think we have a promising few years ahead for Sprue now.

  5. What broker do you use to buy these? My regular brokers don't seem to deal in it.

    1. You need a broker that deals on ISDX - I'm not going to recommend the one I used to buy my stake as they were terrible but I'd recommend a full service broker to ensure you can buy within the spread.

  6. Results out today - I trust you were impressed. On the US, Sprue have been there before in a deal that went sour with DuPont (who actually bought them out of a previous commitment with another partner there). I would have a lot of confidence that this will keep them firmly grounded - once bitten. I would now have a lot of confidence in their international experience and ability to stay focused.

    1. Indeed Mark, on balance I was impressed although the second half does need to be especially strong to make their forecasts and I'll be keeping an eye on the cash flow in the future (I appreciate that the ramp up in retail sales, especially through B&Q, will have changed the working capital profile somewhat). Quite amazing how much they had to spend to defend the bid although I guess they were rightly worried about shareholders getting a terrible deal. The one thing I was most looking forward to which I can't see is a break out of own sales vs DA sales and how that's changed over time - these figures are clearly critical for investors right now given the looming DA expiry and the less than amicable relationship with Jarden. As for the US you are right that they have experience in trying to enter this market and I think management are doing the right thing by not losing focus right now but laying the groundwork for a future entry should it make sense.

  7. Could you be kind enough to list your top ten red flags when looking at a potential investment.

    Thanks in advance.

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