Banking on more cash returns

It's also an area of stockpicking you can easily do yourself if you know the specific characteristics to look out for in the first place. This is why I covered this subject in great depth in my new book, Stock Picking for Profit, revealing how I go about uncovering these golden nuggets. It's also a subject that is highly relevant to me right now because several of the companies I follow are in the process, or have recently, made capital returns to shareholders so need updating.

Cash returns to spark a re-rating

As regular readers of my columns will be aware, I have been a fan of Aim-traded investment company Spark Ventures (SPK: 12.25p) for the past 14 months, having first recommended buying the shares at 7p ('The spark for a re-rating', 10 Jul 2012) and repeated the advice four months later when the share price was 8.75p ('Time to spark a re-rating', 8 Nov 2012). These buy-in prices have been adjusted for the 2.5p-a-share issue of 'B' and 'C' shares in January this year. Ahead of full-year results at the end of July I reiterated the investment case at 11p ('Awaiting another spark for a re-rating', 9 May 2013).

The results not only exceeded my estimates by a large margin after the company boosted net asset value per share by 12 per cent to 15.1p a share in the 12 months to end March, but for good measure Spark announced yet another capital return of 2p a share through the issue of 'B' and ‘C’ shares. The circular for that capital return has been posted so you need to act now.

The options for shareholders are quite simple: if you want the 2p-a-share distribution treated as a special dividend then opt for the 'C' shares, but bear in mind that if you are a higher-rate taxpayer then the effective tax rate on dividends is 32.5 per cent. So, adjusting for the 10 per cent dividend tax credit on the 2p net dividend paid, this would leave you with a liability of 0.5p a share in tax. The dividend is paid on 10 October. Alternatively, the distribution will be treated as a capital return if you opt for the 'B' shares. These shares will then be bought back by the company at 2p a share next month, which means that the return is treated as a capital gain and you can use your £10,900 capital gains tax allowance to offset the tax liability on the profits made.

No matter which option you decide to go for, I have no hesitation in reiterating my positive view on the shares.

Asset disposals underpin case for investing

That's because, having analysed Spark's investment performance in quite some detail, I am confident we can expect further large cash returns over the next year, as well as more upside on the investment portfolio.

For instance, after the March year-end Spark sold 65 per cent of its stake in Kobalt, one of the world's leading music publishers, for £10m. This disposal not only resulted in a revaluation of the holding from £8.9m to £15.5m in Spark's accounts, but also means that the residual stake is still worth £5.5m, or 1.4p a share. To put the deal into some perspective, Spark has 410m shares in issue net of 40m shares held in Treasury, so the £10m share sale brings in 2.4p a share of cash.

At the end of March, Spark also held £3.6m of cash on its balance sheet and this will be bolstered by a further £3.6m, or 0.9p a share, in just over three months' time when the company receives the outstanding consideration following the sale of semiconductor business Aspex to Ericsson.

In other words, the current share price of 12.25p is in effect backed by 4.2p of cash, of which 2p a share is being returned next month. Strip that cash pile out and it means that investments worth £46m, or around 11p a share, are being attributed a value of only 8p - a hefty 27 per cent below their carrying value even though Spark's board is in active talks concerning even more asset disposals.

Spark Ventures investment portfolio September 2013

Unwarranted discounted to sum-of-the-parts valuation

Clearly, a discount of that order would be fully justified if Spark's investment portfolio was underperforming. However, this is blatantly not the case. In fact, since the company changed its investment strategy in March 2009 in order to realise the full value of the investment portfolio over a five-year period and return the cash back to shareholders, the board has increased net asset value by 48 per cent. That equates to an annual growth rate of 10 per cent per year. And there is scope for additional upside in the portfolio as it is sold off.

For instance, Spark has doubled the carrying value of its investment in California-based OpenX, a business that has developed a free open-source ad server trusted by more than 30,000 web publishers in over 100 countries around the world. OpenX is now developing a set of tools to help publishers make more money from their web presence and is backed by financing from leading venture capitalists, including Accel Partners. Sales growth has been robust, with trailing 12-month revenue figures "significantly in excess of $100m (£65m) and, for the second year running, revenues are over two-and-a-half times the level for the equivalent period 12 months ago". Spark's holding in OpenX is now worth £5m, or 1.25p a share, a valuation in line with a recently concluded funding round from Samsung and Dentsu (a Japanese advertising company).

There is also upside potential in Spark's stake in Mind Candy, the company behind MoshiMonsters, one of the world's leading developers of social multiplayer children's games. In the last financial year, Mind Candy's revenues were up 125 per cent and profits trebled. However, Spark's investment in Mind Candy is still only being valued in its accounts at £3.2m, or 0.8p a share, in line with the price received when Spark sold half of its stake two years ago. That looks a very conservative valuation.

Spark's stake in Notonthehighstreet.com, an internet marketplace for more than 3,000 specialised UK-based businesses selling a wide variety of unique products, also looks conservatively priced at £10.2m, or 2.5p a share, the valuation used at the time of a funding round in May 2012 when Spark sold 7 per cent of its holding to fund manager Fidelity. Notonthehighstreet's revenues surged 66 per cent to £45m last year and the company is "on course to deliver 50 per cent revenue growth this year". That's well ahead of budget.

The largest investment is a £16.2m holding in IMImobile, a highly profitable provider of technology infrastructure for mobile data, voice and video services to mobile telecom operators and media companies. This has been revalued up by £300,000, reflecting the fact that both revenues and cash profits rose in double digits in the year to the end of March. That wasn't a one-off, either, as cash profits have risen by a compound rate of 30 per cent over the past three years. The stake in IMImobile is significant as it accounts for 4p a share, or a third of the current share price.

As a result of strong operational performances by investee companies, Spark's portfolio actually edged up in value in the 12 months to the end of March to £59.1m, even though the company made disposals of £8.7m. That's not the type of investment performance that warrants the shares being valued on a 30 per cent discount to the underlying value of the company's assets once you adjust for the cash on Spark's balance sheet.

Management team incentivised to maximise returns

Importantly, there is every incentive for the management team carrying out the disposals to get the best possible prices. That's because they are entitled to 15 per cent of future distributions made to Spark shareholders once 11p a share has been paid out, falling to 5 per cent once 14p a share has been returned. That's potentially a £3m payout, or 0.75p a share.

The team is making good progress because, including the forthcoming 2p-a-share capital return, 8.5p a share has so far been returned to shareholders since March 2009. It is also reassuring that non-executive director Michael Whitaker, who was previously founding chief executive of Spark, is one of the largest shareholders, with a 5.57 per cent stake. 

Spark Ventures' director shareholdings

Spark Ventures' major shareholders

Target price

Interestingly, Spark's shares have once again closed in on a 12-year high of 12.4p. In my view, a move above this level is looking increasingly likely given the imminent cash return, potential for investment gains on the portfolio and disposals that in turn would lead to additional capital returns. The company is also due to report interim results in early December so we are guaranteed newsflow, which will undoubtedly be positive. In fact, the company stated seven weeks ago that "we have seen investment values grow in most of the major portfolio assets and the groundwork has been laid to enable the realisation of Spark's other significant investments over the rest of the financial year".

This news seems to have been overlooked by investors. In fact, I have upgraded my fair value target price to a range between 13.5p and 14p to reflect imminent disposals, which could realistically be priced at a premium to book value. This takes into consideration the cost of the aforementioned management incentive scheme and likely asset sale prices.

Spark's board has a March 2014 deadline to complete the asset disposal programme, so the realistic possibility of a further 15 per cent share price upside over the next five months is an attractive prospect. I therefore continue to rate the shares a buy on a bid-offer spread of 11.75p to 12.25p.

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