Spectra Systems - Cleaning Up

http://www.spsy.com/

Spectra Systems Corporation (LSE:SPSY) has long been something of an enigma. Since listing on AIM in 2011, the share price has fallen substantially, and the retail market has failed to grasp what the investment proposition really is. It is for that reason that the share price stands at just 18p (having listed at ~75p) and the market cap stands at a lowly £8.15m. There is a little confusion that reigns around the stock because it had a second line of stock under the ticker SPSC, but that was only in place to cater for the mixture of US and UK investors, pre-IPO. It is therefore important to recognise that the stock with value is the SPSY stock. Despite the lacklustre share price performance, and the illiquidity of the stock, the market looks to be severely undervaluing Spectra's prospects.


The technical outlook for Spectra is very unclear, as if normally the case with illiquid stocks. The company's share price is currently just above all-time lows, at 18p, although the illiquidity does mean that Spectra has a wide spread, and that will ultimately deter some investors. However, when a company is suffering from such chronic undervaluation (as was MTI Wireless Edge, which was also illiquid), then having to pay materially above the mid-price is not as deterring a proposition. The reported spread for Spectra is 17p - 19p, although the obtainable spread is narrower at around 17.1p - 18.3p, so investors do have to take an immediate ~3.9% 'loss'. Given the upside potential, that is not a real concern.

The investor base of Spectra is superb, with many well-respected institutions holding material stakes - these institutions include Albany and BlackRock. Recently, Hargreave Hale (the vehicle for Marlborough funds) increased their stake to 5.5% earlier in the year, and that was counter-acted by Artemis reducing their stake marginally to 4.4%. Several other institutions hold stakes. A few directors also hold very material stakes in the company.

One point to address here is that the company is based in the US. Usually this draws scepticism from the investor community because it begs the question: "Why list in the UK, when you can list in the US? Is there something to hide?" That question is perfectly valid, although the reasons why Spectra listed in the UK are not only clear, but also convincing. The reasons were threefold. Firstly, it expanded their geographic reach and built their overseas presence, which is required given that Spectra's operations are global. It also positioned them alongside their major UK exclusive licensing partner, De La Rue. Secondly, the company was considered too small to list on the main, reputable US exchanges, and thirdly, it probably suited their pre-IPO investor base. As will become clearer later, the quality of the client base means that doubts over the UK listing should be dispelled. Exchange rates shouldn't prove to be much of a problem given that most costs are incurred in the US.

Based in Rhode Island, Spectra provides highly complex technology solutions that are used primarily to authenticate and process banknotes, although inroads are being made into other sectors. The company was founded in 1996 by CEO Nabil Lawandy, and was spun out of Brown University where he was formerly a professor. The company's security solutions include consumable materials, hardware and software systems, and is from these that revenue is derived. These can be broadly categorised as follows:

- Internal Control Systems (ICS) Software = For the lottery industry, fees are derived from licenses, consultancy work, and support work
- Overt/Covert Materials = For central banks, revenues from this division form the bulk of current revenues
- Hardware/Support = For central banks. Primarily consists of authentication and quality control equipment
- Other materials/Hardware = A recently acquired division which is used to support tax stamps/brand authentication

The immediate point to draw from Spectra's operations, is that is a highly sensitive industry, and thus competition is not as large as most industries. The second equally important point is the quality of Spectra's customers - global central banks (Spectra currently serves 19 central banks, some of which are within the G8, so even more reputable). That client list in itself enhances Spectra's credibility, and although Spectra is not specifically allowed to release specific details, for security reasons, documents from the US treasury show that they have multi-million dollar contracts in place with Spectra. That is testament to Spectra's products, beyond doubt. A further point to be made is that Spectra's revenues are extremely high quality (as high as there typically is). The reason for that is that contract lengths are very long. For the lottery industry, they are typically 5+ years, yet covert materials contracts with central banks can last over 30 years. As an example, a G8 central bank has already contracted use of one of Spectra's covert machine-readable technologies for a term of over 20 years. Those are recurring revenues at their best.

Despite the company historically being loss making (as will be revealed later), there is a strong case for a premium valuation on the above basis, alone. The intellectual property also is likely to have material carrying value, as the company has a portfolio of over 100 patents and a further number in the pipeline. Therefore, intangible assets are actually important in the case of Spectra. Most patents are wholly owned, although some are exclusively licensed from Brown University at a 5% revenue royalty.

The company's consumable materials are available in several formats including inks and coatings. These incorporate engineered signatures and codes, which are superior to chemical signatures in that they can be customised to give a greater depth of security. Their hardware systems include products such as high-speed currency authentication sensors that are capable of checking 40 banknotes per second, with errors typically at less than 1 per 100,000 checked.

The market for the products is obvious (tackling counterfeits), and that is why the uptake of the products has been strong. Estimates suggest that banknote authentication will become a $1 billion market by 2015. Importantly, I wondered whether the security solutions were limited to just traditional note materials, or whether they could be applied to new generation materials such as polymer, which the UK said it would switch to in 2017. Indeed, they can, and tests have already been conducted with Spectra's UK partner, which have been successful. Theoretically, these can therefore be rolled out to countries such as Canada who have adopted polymer. One of the main milestones made over the last couple of years is that Spectra have brought their manufacturing in-house, and that has been cleared by a G8 bank plus quality assurance has been granted. This milestone has, and will continue to allow greater control over the manufacturing process as well as providing Spectra with a higher margin after the initial outlay.

One of Spectra's most recent moves was to acquire InkSure's intellectual property and business. The acquisition looks smart as the cost only totalled $1.36m (£0.81m), yet Inksure brought revenues of $1.1m and gross assets of $1.2m. Admittedly, Inskure was loss making to the tune of $0.85m, but the acquisition provided diversity (into tax stamps and brand authentication), plus the majority of costs could be absorbed into the current cost base. That should allow the business to be turned around materially. Inksure's technology is also applied to consumer items and high value documents using a proprietary verification system that is available on most smartphones. Once again, the objective is to tackle counterfeiting. Aside from that, the deal gave Spectra access to Inksure's intellectual property and access to a high margin business that can be used as a platform for development.

"The expansion of Spectra's business beyond physical banknotes and secure transactions into consumer goods and particularly tax stamps, will allow us to utilise our blue-chip credentials with central banks and the gaming community to gain market share throughout these segments of the authentication industry,” said Chief Executive Officer Nabil Lawandry.

So what do the numbers hold? This is what has been Spectra's pitfall over recent years. They have been affected by the de-phasing of revenues, and this has had the effect of leaving the figures unimpressive. That said, growth was seen in 2012 both organically and acquisitively. Revenues stepped higher to $9.4m having trodden water since 2008, and the authentication materials division traded significantly higher than expectations. The real details are in the latest set of figures, release in September 2013 - the below were from the interim results:

- Revenues marginally ahead at $2.76m
- Pre-tax loss of $1.43m
- $14.2m in cash and investments (since drained by the $1.36m of Inksure's costs and cash outflows)
- Net operating losses of ~$26m to be carried forward. These expire between 2017 and 2032

However, contracts for upgraded sensors to a central bank plus a 50% share (of $5m) for a G8 central bank will have boosted results in the second half of the year. Nonetheless, the loss is disappointing. It was partly the result of low phosphor sales, which was due to a shift in the manufacturing of certain note denominations. The company stated that this was likely to correct itself in due course. Indeed, that was confirmed in early 2014. The 2013 results are expected to come in at a £0.54m loss and negative EPS of 0.78p, so that's nothing to shout about. However, Spectra is forecast to move back to profitability in 2014, for the first time in years, with £0.78m in profit forecast and EPS of 1.14p. At the current level, that would put Spectra on a PER of 15.8, which would probably be the right sort of ballpark given the earnings quality.

That said, the EPS figures have been downgraded numerous times in the past, mainly as a result of the long sales cycles that is experiences. That is the problem with the revenues, and what has held the share price back historically - time lags have delayed the generation of the long-term revenues, thus not allowing them to accumulate. Now that this obstacle is partly mitigated, the company can move into an era of profitable growth. The EPS downgrades from broker WH Ireland have consequently led to share price target downgrades, although the target still stands at a lofty 40p/share, which is supposedly over 100% of upside. The catch is that Spectra has an extremely strong balance sheet. With cash of £8.62m back in June last year, cash is now probably around £6.5m - £7m. Compared to a market cap of £8.15m, it's not difficult to see that Spectra is fundamentally undervalued. In fact, it is trading at around the value of the net current assets alone. Importantly for a currently loss making business, the balance sheet is rock solid with total current assets 5.4x total current liabilities and total assets being 6.8x total liabilities. There is plenty of room for manoeuvre, and it should be trading at a much higher level.

All the above is before Spectra's newest 'groundbreaking technology' is factored in. Working in the bank authentication industry, management noticed that one of the main reasons for bank notes being rejected by sensors was because they were soiled. In other words, oils secreted by human hands (sebum) discolour the notes, and this makes them less usable. These notes are then taken out of circulation by central banks and replaced at a cost. The company therefore developed a method by which the sebum can be removed and the notes 'unsoiled'. This disruptive technology is used Supercritical CO2 - CO2 that has the density of a liquid that allows oils and dirt to dissolve, but behaves like a gas so it is able to penetrate even the smallest pores on the banknotes. The method does not damage security features or wear the notes. This may not at first seem like a big market opportunity, but it certainly is. Estimates by the company say that a 15% reduction in replacement banknote orders can result in global savings over $1 billion annually.

Of course, this method (Aeris) cannot repair/strengthen notes presently, although that is a possible area of research. The potential is huge, and the company hasn't kept that particularly quiet, with it already having had interest shown in it from the European Central Bank and the US Federal Reserve. The technology is still early stage, and patents are only pending, but there is definite enthusiasm for Aeris, albeit not from banknote producers who could lose out should the technology work economically. That said, tests have already been run and show that Aeris works on stacks of 100 notes, with 4% of the initial stack weight being removed through the process. High pressures and temperatures and time are all required for the process, although it should be scalable. Crucially, there are incentives for central banks to take on this technology (if proven), because it would lead to cost savings (not having to produce new notes), and environmental savings (less notes disposed of). The Aeris technology can be used on both paper and polymer banknotes.

CEO Lawandy commented: "The Company’s breakthrough process for cleaning soiled banknotes has enormous potential for creating a new and long term revenue stream which leverages the continued growth in banknote production worldwide, the potential for significant savings to central banks, and the positive ramifications for the environment impact of not disposing of unfit banknotes. We have received immediate interest in this technology and will be refining its capabilities and the economic model for the Company’s patent pending technology over the next year."

Recent newsflow has also picked up. In November, Spectra sealed an $8m sensor contract with a G8 central bank, and reduced the potential damages of a long-running lawsuit, to $1.27m. Management defend that the lawsuit has no merit. Spectra also entered a testing program with a G8 central bank for the Aeris technology, and then a second testing period with a second G8 central bank in January. Those tests will commence in April 2014. That is significant because Spectra will provide data to the industry from the first trials at the Banknote 2014 conference in Washington, in early April. Those results will be incredibly important with regards to Aeris' potential. Financial results for the year are also expected in April 2014.

On the contrary, it wasn't complete plain sailing as a G8 central bank customer cancelled a trial program for new generation covert materials and sensors, also in January 2014. That caused the slump in the share price, unjustifiably. After all, only negligible revenues were factored into forecasts, so the share price opportunity at the moment is not reflective of the underlying condition of Spectra. Furthermore, the IP developed during the trials with the G8 Central bank can now be transferred and pitched to other central banks - admittedly lead times are long though, so timescales have been pushed back, and that has always been the risk. Positively, phosphor sales levels were back to their highs and the financial results were to be in line with the market expectations aforementioned. All current sales to the central bank for current generation products will continue.

Heading further into 2014, Spectra's revenues should start to re-phase, and the company should therefore stand to benefit from long revenue cycles. The Inksure acquisition has also opened doors into new marketplaces that Spectra can seek to gain market share in. Progress and decisions should also be seen with regards to Aeris and its economic potential. If the trial results come back positively, then a major corner will have been turned. Investors therefore get a mix of growth into profitability and blue-sky potential in a company that is heavily backed by net assets, and that is trading at a level that doesn't appear to factor in the intrinsic patent, client and asset value. It would be good to see any return to profitability marked by a very small token dividend, as a sign that shareholder value can start to be fully delivered.

The low market cap that Spectra Systems currently trades at is a direct result of poor liquidity. The spread is wide, but the upside potential here is strong enough to overlook that, and any return to profitability in 2014 (as expected) is likely to see the share price much higher than the current 18p level, especially given the cash backing. Operating in a niche market, the company has strong institutional backing and is entering an exciting period, especially with respect to the supercritical CO2 development that adds major blue-sky potential to a turnaround story (financially). Given that the Washington presentation is set for April, the next few weeks will help delineate the future of Aeris, and could catalyse a re-rating of Spectra. There is inherent value in the intellectual property plus the customer base, and given the potentially large-scale disruptive nature of Aeris, the value is being missed by the market. I have therefore put a Buy tag on Spectra Systems.

25 comments:

  1. Excellent write-up. Balanced report & pleased to see that you found it worthy of research and drew similar conclusions to myself.

    Kind regards,
    GHF

    ReplyDelete
  2. El1te,

    Thank you for finding, analysising, and sharing your thoughts on Spectra. What an incredible company and it's so incredibly cheap!

    I can't quite believe what a gem you've found. Bravo!

    Libero

    ReplyDelete
  3. Good write up thanks. I do wonder about the impact of increasing use of CC, mobile payments etc and governments attempts to move away from 'cash societies'.

    ReplyDelete
    Replies
    1. I doubt that any moves towards a cashless society are going to have a major impact for the foreseeable future, especially since it would require extensive adoption and would take (possibly decades) to implement. The lack of any foreseeable threat is evidenced by the Bank of England setting out the plans for polymer notes in 2017. Bear in mind that Spectra also supplies to 19 central banks, so it is well diversified. There is no chance that lower income countries would position themselves towards a noteless economy in the foreseeable future either.

      Ironically the Aeris system could lead to lower sales in other areas of the business because less notes would need to be produced, thus volumes would fall. Any success with the Aeris product, and implementation of this disruptive technology, would have far-reaching impacts on other companies in the sector. It would, however, be transformational for Spectra. It's far from being proven commercially, but the concept is very promising

      El1te

      Delete
  4. Nice work el1te, as always you give much more information than most would ever get a hold of from their own research
    Thanks again.

    MTJK

    ReplyDelete
  5. There's a mention on interactive investor of the aeris presentation that was being shown at banknote 2014. Plus a big trade yesterday (almost 2% of the shares in circulation) following on from the banknote conference - clearly someone is convinced by the potential for aeris !

    ReplyDelete
    Replies
    1. Yes, plus Spectra released a video regarding Aeris today. It's viewable if you go in Spectra's website and then click on the 'News' section. The figures within are encouraging.

      El1te

      Delete
    2. I agree - it does look like the basic concept has been proven - is there any information about how they will offer the Aeris process - as a service or as a machine that banks buy and operate themselves. The former would sound like a more profitable prospect.

      Delete
    3. Given the high-security nature of Spectra's operations, it'll almost certainly be as a machine. I suspect that they will however, have a recurring revenue stream through providing 'support' and maintenance.

      Delete
  6. As usual, terrific research El1te, thank you.

    ReplyDelete
  7. Hello there.
    Interesting piece, especially in combination with canteatvalue's presentation.

    Some questions for you -
    Do you suppose that raising money specifically for cleaning technology was a main reason for the IPO, or has the idea been dreamed up more recently? Otherwise they raised much more than they seem to have needed, given the value of firms acquired? If it is then the development seems a bit slow.. which you counter by suggesting central banks move like glaciers..
    What's the quality of the IP on the invention? On wikipedia there's a page on supercritical co2, and a section about use as a steriliser when introducing extra compounds into the vessel.
    Thanks. The people in firm itself have good records. I wonder what the success rateis for hi-tech university spin-outs?

    ReplyDelete
    Replies
    1. Hi there, Just in regards to your questions:
      - The IPO was, in my view, primarily to gain credibility with European banks, but as you say, to raise cash going forward. They have done well to control cash burn to date, which is more than can be said for a lot of newly listed companies. Upon IPO they raised nearly £13m, which clearly is a lot, but has positioned them well, considering they listed back in 2011. I don't believe that Spectra had developed the cleaning concept at the time of the IPO, rather it was developed in late 2012/2013
      - The board believe the IP quality to be high, and it's essentially applying an existing technique to a new application. They've trialled it extensively and the fact that it works whilst the notes are bundled/shrink-wrapped etc. is a significant bonus. The company are confident of getting the patent, and there does not look to be a patent specific to this application

      I hope that helps - I can't say I know the success rate, but Spectra has a firm foothold in a niche industry. It's a company ready for long-term expansion.

      El1te

      Delete
    2. I suppose definitions and control of IP is a central focus for these spin-out types working between industry and academia. Given some of the activities of trolls putting patents on very broad and vague ideas, it seems possible they could get one on small-ish tweaks to an existing idea. Google has a patent search function: once you put 'banknote' in along with 'supercritical co2 cleaning' you turn up Lawandry et al.

      Delete
  8. SP up today on news that Spectra has entered into a testing program with the Banco de Mexico for its Aeris Banknote cleaning technology - good news !

    ReplyDelete
  9. Given what you say above about Aeris being offered as a machine, rather than as a service, is there any more information about the prototype shown - specifically its engineering and safety.

    The post here (http://www.iii.co.uk/investment/detail/?display=discussion&code=cotn:SPSY.L&it=le&thread=11292431) raises concerns about the pressures involved - it seems that the engineering necessary is more on a par with deep sea exploration equipment - rather different to Spectra's background in detectors and optics.

    Even if Spectra (or perhaps partners) can access such engineering know-how there's the potential time and cost in getting safety certifications in lots of different territories, with the upside being perhaps only one or two machines being sold in each territory.

    ReplyDelete
    Replies
    1. The forces derived by the poster are spot on, but the industry has been using pressures such as these for decades. The example in the video is not an accurate model as the real system uses a threaded mechanism as opposed to a rubber seal - in addition a rubber seal would be chemically damaged by the CO2. That allows the chamber to comfortably withstand the pressures exerted upon it

      El1te

      Delete
    2. Sounds interesting - where can we find any more information about the real system, as opposed to the demonstration model that's shown on the discoveraeris website

      Delete
    3. If you contact me via the site email then I'll send you the email address of CEO Nabil Lawandy. He is very good at communicating with investors so I'm sure he could provide you with additional materials

      El1te

      Delete
  10. 6 days after the discussion about the inherent challenges in building such a cleaning system (high pressure and degradation of seals seeming to be the major ones) spectra has an RNS describing how it is dealing with these issues. This is either incredibly coincidental timing or a company that is very aware and sensitive to investor sentiment - with your discussions with Dr Lawandry does the latter make sense ?

    ReplyDelete
    Replies
    1. I believe that the signing up of partners was already part of the strategy - they didn't intend to build the products alone. From my perspective, there are not any major challenges with the product design having talked to NL. That said, clarity is always welcomed from a company.

      El1te

      Delete
  11. Thank you for your great insights into the long-term potential of this stock. Please excuse what must seem like a stupid question from a novice investor, but I've just put it on my watch list on LSE and I see that the stock is marked SPSY (UNRES). What does this acronym - which I gather stands for "unresolved" - signify, please?

    ReplyDelete
    Replies
    1. When Spectra listed on AIM, it listed under two stocks since it is based in the US and suited the share structure. The first stock was SPSC which is the restricted stock and the second was SPSY which is the unrestricted stock. Over time, the restricted stock had certain restrictions released and was transferred over to the unrestricted section. All of that has happened now so there is no restricted stock. The UNRES does not mean anything now and SPSY is like any other stock.

      El1te

      Delete
  12. Thanks for the explanation. Much appreciated.

    ReplyDelete
  13. How can I invest in the unrestricted stock? I am based in Australia.

    ReplyDelete
    Replies
    1. The first point to note is that you would be looking to purchase the stock under the London ticker SPSY, not SPSC.

      There are certain hurdles to go through given that SPSY is based in the US: presumably you have a broker who can source stock for you from outside the ASX? If so, then the best way would be to just give them a quick ring and ask what the process is.

      Delete