James Faulkner on Sprue Aegis: Small Cap of the Week!

This week’s small cap is a company we originally looked at on the t1ps.com website when it was listed on ISDX and trading at just 103p to buy. It recently made the move to AIM and the shares are currently switching hands at 251.5p. That said, we believe they are still worthy of investors’ attention, even after the dramatic rise in the share price over the past year or so.

The Business…

Founded in Coventry in 1998 and listing on the old OFEX market back in 2001, Sprue Aegis has grown over the years to become a leading supplier of home safety products and manufactures one of the world’s smallest carbon monoxide sensors for use in carbon monoxide alarms. Products are designed in-house, with the majority of manufacturing being outsourced to contractors in China.

From its initial product, the Fire Angel smoke alarm, which fits into a standard ceiling mounted light fitting, the company has built up a strong presence in the UK retail and trade market, as a supplier to the UK Fire & Rescue Services, and has also made significant progress in Continental Europe. Its status as sole supplier to a number of major retailers in the UK provides significant barriers to entry, as do its 68 granted patents, further 27 patents pending globally and safety certifications for its products from various regulatory bodies.

Sprue doubles in size and shows its force…

In April 2010 Sprue entered into a five-year agreement with BRK Brands Europe (a subsidiary of consumer products giant Jarden Corporation). The deal gave Sprue the exclusive rights to distribute BRK’s range of fire, smoke and related safety products and safes in Europe, in return for a fixed distribution fee of £4.16 million per annum. This was a significant milestone for the company, which at a stroke removed a competitor from the market, secured entry into Europe and in effect more than doubled annual sales.

Following the deal BRK acquired a 29.9% stake in Sprue, and in April 2013 it made a bid for the whole company, using the relative illiquidity of the shares and the fact that the company missed broker forecasts in 2012 as arguments for accepting their cash offer, made at only 90p per share. The Sprue top brass – who hold a sizeable stake themselves – rightfully rebuffed the offer as “unwelcome, highly opportunistic and wholly inadequate” , and the share price performance has since vindicated their stance.

However, it is the story of what happened after the bid that is most revealing. BRK made a number of threats to Sprue in its offer documentation should the bid not be successful. In particular, BRK commented that it would “need to consider the viability of its ownership position and the Distribution Agreement when its initial term expires in 2015”. BRK added that it would explore alternative long-term arrangements for distributing its brand outside of a workable business relationship between the two companies. Given that sales under the deal amounted to around £16 million at the time, this represented a significant threat.

However, in reaction to BRK, Sprue commented that not renewing the distribution agreement would not be disastrous for the business and could in fact be value enhancing. This was based on a number of facts, including that Sprue had launched over 20 new products in Europe since 2006 while BRK had not launched any new alarm products other than variants. On further appraisal then, it seemed that BRK needed Sprue more than Sprue needed BRK.

And surprise, surprise! In March this year Sprue extended its existing exclusive distribution agreement with BRK for three years with effect from 1st April 2015. What’s more, it even secured improved terms for the deal – the annual distribution fee, which is currently £4.2 million, will be reduced to £3.5 million in 2015 and then to £3 million and £2.9 million respectively in the following years. These cuts should effectively go straight to the bottom line for Sprue.

Re-rating…

It appears that much of the recent re-rating can be accounted for by a change in investors’ perception of the relationship between BRK and Sprue, although the move to AIM hasn’t done it any harm either. So what next for Sprue? Alongside its 2013 results, the company announced its intention to raise approximately £8 million (£7.2 million net) by way of a placing of new ordinary shares with institutional and other investors, which will be used to provide additional working capital to support sales growth, particularly in France, and to fund product development.

Also of note is the fact that Sprue has secured North American UL component recognition on its Gen 1 carbon monoxide sensor to sell that component in products in North America, which could in time pave the way for the company to enter the huge US market. Closer to home, sales growth is set to be driven by product replacement cycles on the continent and further legislation in the UK. All in all, investment in product development increased by 40% in 2013 to £1.4 million, which underlines Sprue’s continued commitment to innovation and its drive to remain at the cutting edge of the industry.

Further to go?

Sprue has an excellent track record of revenue and profit growth over the past six years. Between 2006-2012 revenues grew at a compound annual growth rate (CAGR) rate of 49.12%, with pre-tax profits growing at a CAGR of 32.84% between 2007-2012. Since announcing a maiden dividend in 2009, the annual payment has risen from 0.5p to 6p per share. With plenty of new products in the pipeline and international expansion on the cards, I believe Sprue is well placed to continue grow in the coming years.

House broker Westhouse anticipates earnings growth of 37.7% in 2014 to 15p per share, which implies a current rating of 16.8 times. It has also pencilled in growth of 33% and 26.2% for 2015 and 2016 respectively, which implies a forward rating of 12.6 times, falling to just 10.1 times. A healthy prospective yield of 3.1%, rising to 4% for 2015 and 4.8% for 2016 means the stock also has income as well as growth attractions. These are good metrics for a business that benefits from a defensive and reliable source of demand underpinned by legislative and regulatory action with significant barriers to entry.