Trucking is pretty damn dangerous. Anyone in Ontario will likely recall this accident, which killed three and closed the 400 highway southbound lane for over a day. Some of you reading this may have heard of Operation Air Brake, which involve “blitzes” of commercial vehicle inspections, and always ends up taking hundreds or thousands of trucks off the road for brake related violations.
In Toronto, there is a small (and I mean small) company making products that would help prevent many of these violations, which means the truck keeps rolling, the freight gets where it’s going, etc. The value proposition is pretty clear for Spectra Inc.
Luckily for me, Spectra offers an excellent investment opportunity.
Spectra Inc. is pretty easy to understand. Spectra own 67.73% of its operating subsidiary, Spectra Products Inc.. Spectra Products manufactures and sells a series of products which enhance the monitoring of a truck’s air brake system, as well as lug nut locks (and monitoring), and a line of lubricants.
For those unfamiliar, one of the items that air brake inspectors (such as those that carry out Operation Air Brake) is the adjustment of air brakes, which is essentially how far the brake chamber pushes out the pushrod to apply the brakes. This distance is referred to as the stroke. Air brakes are pretty simple if you spend some time studying them, but for the purpose of this thesis, what I’ve said above and this picture should be enough knowledge.
The brake has optimal braking power within a certain stroke distance range. If the stroke is too long (the pushrod pushes out too far) the braking power is compromised in the event heavy braking is needed.
As part of the circle check of their truck, drivers are “required” to check the adjustment of their brakes. Required is in quotations because as you can see from how many trucks are cited for brake adjustment violations, it’s clear not all drivers are doing this. The reason is it is a pain in the ass to check. The old school way is to go mark the pushrod with chalk at the base of the brake chamber, go into the truck and apply the brakes, using a long vice or board or something to keep the brake pedal down, get out and make a new chalk mark a the base of the chamber, and then measure the distance between the marks. Then you repeat this for every brake chamber.
On the back brakes of a tractor or truck this often involves laying on the ground and scooting under the truck to get at the brake. This is a pain at the best of times during the summer. Enter winter, snow, rain, puddles, etc, and you can see why a driver would avoid this.
Spectra’s flagship product is Brake Safe®. It is a visual indicator with “goalposts”. This reduces the act of checking brake adjustment to hitting the brakes, then walking around and seeing if a pin fell between these goalposts. If it did, the brakes are in adjustment and the trucker can drive without fear of a brake violation (pretty well). Spectra claims this reduces the time of checking brake adjustment from 20 minutes to 3. Having checked the adjustment on brakes, I certainly believe this claim. I absolutely would be buying this if I were to drive a truck.
Spectra also sells other products like I said, including an in cab brake monitoring system. The value proposition is very easy to see by just illustrating Brake Safe though.
In 2016, Spectra had just $1.5 million (M) in revenue, so I’m not exactly surprised most don’t know about it. But that revenue is growing.
|Year||Revenue ($)||Change (%)||Earnings ($)||Change (%)|
|2017 (to September 30th)||1,332,592||10.5 |
(over 1st 3 quarters of 2016)
(over 1st 3 quarters of 2016)
2016 was a down year, caused by lower sales in the US and China, but 2017 has gotten the company back to growth. Part of this growth has come from introducing products into the US and China. In 2017 sales in China have increased from none to $28,894 and sales in the US have increased 44% to $594,916. It was losing a significant amount of revenue from these two countries that led to the down year in 2016, so it’s encouraging to see these numbers.
It is tempting to annualize 2017’s YTD earnings and the market cap of Spectra and think Spectra tades at 7x earnings and is undervalued. Spectra very well might be undervalued, but there’s more to the story.
The DVOF is a labour sponsored investment fund available to Ontario residents. I can hear the rest of Canada getting upset, but fear not! Since inception in 1994, the DVOF has returned 1.3% annually. Not a typo. Now sure, the appeal of these funds are tax credits and helping upstart Canadian businesses, but still, ick. For comparison, the MER of this fund is 4.4%. Seriously, I wish I was joking.
The reason why I know what the DVOF is, is because it has a substantial interest in Spectra. Remember how I said Spectra Inc. (SSA) owns 67.73% of Spectra Products (SPI)? The DVOF owned the rest until recently.
Not only that, the DVOF owns 18,133,000 shares of SSA (29.97% of the company). The DVOF also has the “royalty debentures” you’ll find on the balance sheet, which have the following terms:
On August 6, 2004 the Company closed a debenture financing arrangement with DVOF whereby DVOF
advanced $750,000 to Spectra’s subsidiary, SPI. In consideration of the advance of these funds, DVOF is
entitled to receive royalty payments equal to the greater of $100,000 per annum or 10% of the total annual
gross revenue generated by SPI. Twenty-five percent of each royalty payment shall be allocated against the
principal amount of the debenture. The royalty payments shall continue until the earlier of (i) the date that the
royalty debenture has been fully repaid and (ii) 15 years from issue date, at which time any remaining principal
amount shall be due.
As you may figure out, these debentures mature on August 6, 2019. Right now there is $652,065 of these debentures on the balance sheet. The DVOF had been a benevolent dictator to Spectra: in 2016 the fund waived its royalty payments in exchange for 100 shares of SPI (valued at $750/share), and in 2017 has waived its payments again.
However, on December 20th Spectra announced that Glen Campbell (director of the company, not the late singer of this fantastic song) had purchased the DVOF’s royalty debentures, and its shares of SPI. While the press release does not state what Mr. Campbell plans to do regarding the royalty payments, it does say that SSA’s ownership in SPI will not drop in the future, so I doubt he’ll take his royalty payment in SPI shares. It remains to be seen what will happen with these royalty payments though. The purchase seems to be for the purposes of freeing cash flow, so I’ll assume Mr. Campbell waives his royalty payments.
Mr. Campbell also purchased the DVOF’s preferred shares of SPI. These shares were convertible to SPI common shares, redeemable for $1000/share on May 31, 2018, and the DVOF had waived its dividend on these shares since 2013. As part of the deal, Mr. Campbell has extended the redemption date to 2020, and waived his right to convert the shares to SPI common shares. The release doesn’t say whether Mr. Campbell will waive his dividends as well, but it stands to reason that he will.
The DVOF presumably still owns its 30% stake in SSA.
While the sales of the royalty debentures and SPI preferred shares is good news, it doesn’t completely clear up the debt issue. The debentures and preferred shares combine to give Spectra $1,283,616 of debt becoming due in the next three years:
- August 6, 2019 – $652,065 (debentures)
- May 31, 2020 – $658,141 (SPI preferreds)
I think this is the reason that Spectra trades as low as it does. But Spectra should be able to pay this debt, as I intend to show and assuage some fears out there.
How do we get the cash to pay this back?
On September 30th Spectra had $145, 467 of cash. In the fourth quarter last year Spectra had operating cash flow of $23,516. There is no more long term debt repayment, so if Mr. Campbell declines royalty payments and preferred dividends, all future OCF becomes free cash flow. Not to mention this year is much more profitable and there is more revenue. The fourth quarter should increase the cash balance by $68,000 to ~$213,000.
In 2018, assuming no growth in sales or margins, free cash flow should be ~$290,000, increasing cash to $503,585.
The debentures come due in August, meaning that we can include seven full months of free cash flow in our August cash balance. Based on 2017 (again assuming no growth), the first six months of the 2019 should provide almost $24,000 of cash per month. So Spectra should have the cash to pay off the debentures around the first week of July, 2019. Just getting there by the skin of its nose, but it works for our purposes.
Of course this is assuming that every single dollar of cash is used to pay this debt. That’s some Shoe Dog stuff right there, and not really a prudent way to run a company.
This only leaves about ten months to acquire the cash to redeem the preferred shares. At $24,000 per month that isn’t enough obviously. It is up in the air that the redemption date is May 31st, 2020, as the press release just says the redemption date was pushed into 2020. I think this wording implies Mr. Campbell would be willing to push it later in the year.
While this may seem like the company will fail, I have assumed no growth in cash flow (unlikely based on what we’ve seen this year) and that Mr. Campbell doesn’t restructure his debts at all. From where I sit, the most likely outcome is that either the preferred shares, the debentures or a bit of both are restructured as a loan. Paying 10% interest on $658,000 is better than having to come up with that much money in 30 months (from now).
I mentioned that there is a way that Spectra can pay off its debentures without growing cash flow, as I wanted to check for a margin of safety. But Spectra should grow its free cash flow from now through to the redemption of the preferreds.
Through three quarters of 2017, revenues have increased 10%, with a small increase in selling costs and a small decrease in administrative expense. It seems that costs are mostly fixed, so increases in gross profit (gross margin in 2017 is ~56%, down from 59% in 2016) drop mostly unchanged to the bottom line.
If we assume revenues (and therefore free cash flow) can increase at 10% from now until 2020, Spectra will have enough cash to redeem the debentures by mid-May 2019. Free cash flow would bring in another $600,000 by the end of 2020.
After the debentures are redeemed this company will have debt/FCF of 1.85x, and free cash flow would cover interest (if he even elects to take dividends) nine times over. There shouldn’t be any reason the company couldn’t refinance this debt, without relying on the kindness of Mr. Campbell.
Based on my estimate of cash flow, Spectra trades at just over 10x EV/FCF. If I’m close that Spectra can grow at 10%, that’s reasonable. However, at the end of June 2019, a share price of .03 would translate to just 7x EV/FCF ($350,000 FCF).
What Needs to Go Right
This isn’t a simple case of X is cheap and people aren’t seeing it. There are real warts on this. I think there’s a good chance these warts can be lasered off, or the frog is still pretty with them (not sure how to continue that analogy), but they need to be acknowledged going into this investment:
- Growth isn’t necessarily going to continue. This is a small company with limited resources. Increasing revenue and cash flow will take a real entrepreneurial effort. Right now it’s going well, but nothing says it can continue.
- The debt obviously. Spectra has over $1.2 million of debt coming due in the next 24-36 months (depending on when the preferred shares actually redeem). Subtracting the cash Spectra has today, it would take roughly 40 months for Spectra to bring in that cash. The discrepancy means that management will need to come up with a creative solution. This could come from issuing shares (very unlikely given the market cap), obtaining a loan or operating line (the chance of this increases with every profitable earnings report), or the new benevolent dictator extending the debt. The last option seems the most likely, and would be the most beneficial to all involved.
- Given the increasing revenue in the US, whatever comes of NAFTA talks could have an effect. When compared to other risks to revenue, this is likely low. Ideally no radical NAFTA changes occur.
- The main product doesn’t seem to be that hard to replicate, so a competing product could come in and steal market share. As such, hopefully no competitors enter the air brake adjustment simplification game. Spectra has diversified product lines, but I can’t imagine Brake Safe nor the lubricants (of which there are dozens of competitors) have much moat. The lubricant may very well be a superior product, and this could lead to increased sales if management can get the word out. At work for instance we go through gallons of anti-corrosion lubricants, but I’ve never heard of Termin8R. We use Krown simply due habit and name recognition, and the salesman comes around once a month to stock us up. Mr. Malion, if you read this I’d love to try a bottle of Termin8R!
Insiders of the company hold 9,003,143 common shares of Spectra.
Notable in this number is the former CFO, Michael Faye, who is in the process of retiring. He has been working part time in administratively since June. In that press release it is mentioned that the part time arrangement was meant to last until December 31st. Mr. Faye owns 3,274,177 shares, and one would assume that as he moves along in his retirement he will likely end up selling shares. Any further guesses about when or how he chooses to sell would be pure speculation.
Glen Campbell (not seen here singing Gentle on my Mind) owns 1 million shares, as well as the previously mentioned preferred shares and debentures. Glen Campbell recently purchase 500,000 shares at $.025, not much dollar wise, but sentiment wise it looks good.
The DVOF also holds their 18,133,000. As of August 31, SSA common shares make up 0.7% of the fund. Assuming I’m reading their report right, the fund’s average cost is somewhere around $.032/share. It doesn’t seem like the fund has any interest in making good investments (1.3% annual return since inception), but now that it has unloaded the Spectra debt, the DVOF is likely interested in selling these shares for a gain (this will be a new strategy for the fund). Because of this, it’s likely that there could be a wall of shares being sold at anything over $.035. Again, this is pure speculation on my part.
Between these four shareholders they own 44.8% of the company.
A target for Spectra is pretty tough to come up with. The entire future of the company depends on the resolution of the debt. The debt is in the hands of a friendly creditor (Glen Campbell is more Bailey than Potter) so I think the odds are that the debt will be extinguished in a satisfactory way for shareholders.
For the purpose of my target I will assume debt gets resolved fairly (for Spectra, not Mr. Campbell), yet repaid in full. I’ll also go with my assumption that Spectra grows at 10% until 2020. Determining a multiple is tough, as the growth isn’t automatic, and as I mentioned, the products have little moat. My gut tells me 7x P/E is too low, but 15x would be too high, so I’ll go with 10x.
In March, Spectra should announce 2017 earnings of ~$250,000. 10x earnings would come out to a share price of $.04, 33% upside from today’s $.03. Debt that almost (due to it being the CFO who holds the debt) can’t bring the company down does not warrant a 33% discount. EV/FCF at $.04 is 11.6x.
Once the debentures are redeemed 20 months from now, with free cash flow of $350,000, to trade at 10x EV/FCF gives us a share price of $.045.
Just to throw out a guess at how the remaining debt is handled, I predict that Spectra will take out a loan for about half the amount it owes Mr. Campbell, which along with cash flow should be enough to pay out the preferred shares. So at the end of 2020, Spectra will have just $300,000 of debt while generating free cash flow close to $400,000. EV/FCF of 10x = $.06.
Possible Upsides to Targets
Several simple things can happen that would add to Spectra’s results, and therefore increase free cash flow and my targets.
- Management seems to suggest that there will be $100,000 of salary saved by replacing Mr. Faye as CFO. I know, Stockhouse posters aren’t a reliable source, I will be asking the company this question as well. But adding $100,000 to free cash flow, at a 10x multiple, increases the share price by $.015, changing the 2019 target to $.06 and 2020 to $.075.
- As mentioned above, there should be a possibility to increase the sales of Termin8R. Just getting the name out there would help. Private label sales in the US have helped, but there should be lots of opportunities just in Ontario.
- There are going to be more and more regulations in the trucking industry, and keeping brakes in adjustment is probably the simplest thing a carrier could do to increase the safety of its fleet. If/when autonomous trucks enter the picture, the first few generations will still likely rely on “drivers” to do most of the pre-trip inspection. Autonomous trucks do not present a threat to Spectra yet, and won’t for probably 10-15 years.
- The company signed on a new distributor with 250 locations in the US. How much it helps can’t be determined yet, but it certainly can’t hurt.
There’s a good chance that without the overhang of the debt Spectra could demand a higher multiple than 10x EV/FCF, but even without that upside, Spectra is undervalued. In the coming years Spectra will grow free cash flow and clean up the balance sheet. Buying at $.03 or below offers considerable upside with very little downside. And the low float and low share price should present an opportunity for the share price to run in a rally well past fair value.
Disclosure: Small position in SSA, will be accumulating more (I strongly doubt anything I write can move even a tiny stock like Spectra)