Hunting for compounders - Spectra Systems

Spectra Systems (LON:SPSY) is a fascinating company but summarising its operations is a challenge. That’s because there’s just so much going on at this industrious, innovative small cap.

Maybe we can crowdsource some additional insight in the comments… I’m keen to see what people make of this one.

It’s been on the research list for a while - possibly as a future Investment Club pitch - but while I’ve been taking a closer look, the shares have gone up 10% or so this past week due to a promising contract announcement (covered below).

For those companies with substantial upside though, a 10% rise should be loose change in the grand scheme of things.

Spectra is a profitable, innovative, cash generative technology business with no debt, stable long-term income streams, and some fantastic growth opportunities. The high StockRank is no surprise:

The group has pumped millions of pounds into research and development in order to get to its current position, and it has the proprietary tech and materials to show for it.

It also faces into some substantial markets for a £90m small cap:

• Banknotes - over 150 billion banknotes manufactured annually vs. 45 billion banknotes with Spectra security features worldwide,
• Global lotteries - estimated at over $300bn, per MarketWatch,
• Tobacco manufacturing - Spectra TruBrand ™ materials on 6m packs of cigarettes in FY19, with billions more likely to come,
• Keurig coffee machines - optical materials used in disposable coffee K-cups.

With all this activity and potential, if you take a step back then a 10% move doesn’t mean you’ve missed the boat.

So let’s take the contract announcement and strong share price as a sign that we might be onto something here, and continue with the research…

What does it do?

Spectra’s core profit and cash engine is longer term contracts providing products and services to help authenticate and process banknotes.

It makes the fancy bits in banknotes and passports that shift and shimmer under the light among other things.

Company accounts

That’s the simplified version, of course - there’s plenty more going on at Spectra. It’s clearly a smart, ambitious firm with its sights set on multiple ways of providing product quality and security services.

And you might think that banknotes are on the way out given the widespread adoption of digital payments, but apparently not.

In its first half update, Spectra said:

discussions with central banks during H1 have reinforced our belief that worldwide demand for banknotes will be significantly higher this year than last year and that this will positively impact our earnings in H2 of this year.

As of FY19, the group reported two operating units:

• Authentication Systems - $11.83m of revenue (89%) and $5.07m of adjusted EBITDA (92.5%) , and
• Secure Transactions Group - $1.41m of revenue (11%) and $0.41m of adjusted EBITDA (7.5%)

Authentication Systems includes Spectra’s central bank banknote dealings, consumer product authentication, and its optical materials which allows k-cups to be more compatible with Keurig coffee makers (K-cups being those little containers of coffee that coffee machines puncture and then flow water through).

Digging a bit deeper, Authentication Systems seems to be the real money maker here.

Spectra supplies an impressive list of clients, including national central banks, global security printers and papermakers, nationally approved lottery operators, passport makers, and multinational consumer product companies.

For all that though, client concentration is a risk with more than 50% of revenue coming from just two customers in the prior year.

History

Spectra is the ever-evolving brainchild of founder and current president, CEO, and 5% shareholder Nabil Lawandy, who set it all up in 1996.

Before that, Lawandy conducted pioneering research into lasers at NASA and earned a tenured professorship in Engineering and Physics at Brown University.

Quite the resume… But what matters to investors is not the professional history of Lawandy but the commercial prospects of Spectra Systems.

On that note, Spectra’s impact looks to be quite far-reaching, with:

• $1m of lottery and gaming transactions processed by Spectra every day,
• 800m banknotes passing its authentication systems annually,
• 950m of energy drinks sold per year containing its materials,
• 10m bottles of wine protected by its technology over the past three years,
• 155m American passports protected by its materials in the last 10 years, and
• 45bn banknotes in circulation containing SPSY materials.

Spectra has spent millions in research and development over the past decade - about $22m or so. We can see the fruits of that labour in the group’s double-digit returns on capital and expanding operating margins.

The group has proven adept at deploying its capital and continues to generate cash from long term security contracts with high quality clients. It all points to scope for substantial future value creation if Spectra can commercialise its product pipeline.

In the meantime, it is already a profitable, cash generative technology business with no debt, predictable long-term income streams. Revenue and profits have both trended higher over time.

This mix of profitability, cash generation, and technological expertise and innovation is worth paying attention to - especially when comparing today’s market cap of £90m to the sheer size of many of the markets Spectra is either already in or looking to crack.

Strategy - multiple shots on goal

Spectra has so many initiatives the question becomes which lines of development will be material further down the line.

Group strategy is focused on 1) brand authentication, and 2) commercialising covert security technologies (with an emphasis on polymer banknotes and technology).

The brand authentication sector offers short-term growth potential and some large opportunities for smartphone-based technology, while the covert banknote security sector provides stable long-term, multi-decade revenues once new contracts are locked in.

Spectra also comments in its recent half year results:

Over the past four months, the Company has continued to explore possibilities of diversifying the business beyond authentication in areas where we can support this initiative with our world class core competencies in optics, engineering, physics and chemistry. We have identified certain intellectual property owned by another company, obtained academic feedback from Harvard University on this technology, and are now in the process of having the issued patents valued through an independent third party which has expertise in this area. The current candidate technology has applications to biotech assays, point of care testing and metrology. We expect to have made a decision on this specific technology by the end of H2.

The group seems to be pushing on a lot of doors and there is plenty to look forward to. It splits opportunities between short term (2020-2022) and longer term (2023-2025).

Short-term opportunities:

• Fulfillment of large orders for materials to a central bank customer;
• Additional funding beyond the currently contracted research program with a central bank customer;
• A multi-million dollar sensor development contract with a central bank customer;
• Increased number of tobacco packs sold in China with TruBrand materials and smartphone App;
• Adoption of phosphors for use by a supplier of products to a major Asian central bank;
• Expansion of the optical materials business with compostable K-cup customers;
• Sales of Spectra’s newest patent pending phosphor product; and
• Sale of its first Aeris banknote decontamination system to a gaming casino.

The longer term opportunities are:

• A licensing and supply agreement for polymer-based technology developed with a major central bank;
• Supply of further upgraded sensor capability to a central bank customer following the contracted development phase; and
• Sale of secure polymer substrate to central banks, which combines high security and a durable substrate in one product.

The group itself believes this combination of initiatives should be enough to continue revenue and profit growth through to 2025 while providing organic funds for investment in cutting edge technologies.

Catalyst - strong H1 trading and big contract win

The H1 figures are strong given the COVID backdrop:

• Revenue +1.8% to $6.5m
• Adjusted earnings per share down from 4.8c to 4.6c
• Cash from operations +14.6% to $2.3m
• Special dividend +28.5% to 9c
• Net cash down slightly to $10.9m

And hopefully there is a little more growth in store than what’s on show above. Operational progress is robust and broad-based, with strong sales of optical materials for K-cups, lottery contracts, and R&D.

The company certainly sounds optimistic of its prospects and ‘expects to significantly exceed market expectations, in spite of the COVID-19 pandemic’.

Maybe when it said that it had one eye on its most recent announcement just a couple of days ago - a contract announcement with a central bank.

This contract is split into a few phases:

• $1.9m to initiate Phase 1 development work,
• $5.6m in Phase 2 development through 2023,
• as much as $34m for the delivery of an as yet unspecified number of sensors, and
• a service component worth approximately $7.5m

It’s a promising hint at the scale of business SPSY could drum up in future.

Valuation - relative premium justified

This latest contract win validates the good work Spectra appears to have been doing for many years now. It also provides some useful forward visibility.

Beyond that, opportunities are rife and include:

• TruBrand’s Chinese tobacco printing trial,
• Continued strong sales of optical materials for K-cups,
• The launch of a new phosphor that performs better than rivals and can be sold for less,
• Increasing levels of polymer banknotes that can increase authentication revenues, and
• Ongoing COVID-19 studies on Aeris.

All of these opportunities are relatively advanced.

While a precise appraisal of its various business lines and prospects is probably beyond the scope of this article, brokers have raised their target prices on the back of this contract announcement from 200p to 240p.

What is more immediately obvious is Spectra’s strong financial position.

The only fail in the F-Score is a slight drop in the current ratio from 7.6x to 7.1x - still extremely comfortable, given that anything above 1.5x is typically seen as safe.

On that note, all of the group’s liquidity ratios are strong.

This is no doubt helped by the company’s prudent net cash position over time:

When you couple this strong balance sheet with the group’s cash generation - free cash flow regularly exceeds earnings per share - then SPSY passes some basic financial health checks with flying colours.

So that’s quite a promising picture of a sensibly managed, innovative, cash generative small cap with a probably big market opportunity and a founder-CEO that retains a stake in the business.

The above in my view justifies a premium relative valuation, with a good chance of upside in future once you take into account the group’s intellectual property, history of R&D and innovation, and stated target markets.

Conclusion

There is scope to increase market share of the growing polymer banknote authentication market here. And, as shown in the above, there are many other irons in the fire at Spectra.

That potential blue sky upside is supported by Spectra’s existing profitable operations, which are underpinned by stable contracts with high quality institutions. These contracts are cash cows that help fund all the other smart things the team is working on that might in time diversify revenue.

An exciting company with some promising prospects then, and certainly worth taking to the next level in terms of research.

No stock is perfect though and there are potential issues here too.

Even after a fair bit of research I haven’t yet got a firm handle on Spectra’s existing operations and the commercial scope of the company. And then there is the client concentration, possibly offset by the long term nature of contracts.

The good outweighs the bad here, in my view, but I’m interested to hear what others make of Spectra - did you buy, have you kept it on a watchlist, or did you find something that ultimately put you off?