Packaged for material gains

I first noted the upside potential in API's shares when I revisited the investment case for Aim-traded investment company Crystal Amber (CRS: 131p) six months ago (‘Small caps to buy now’, 3 December 2012). The fund's holding in API made up around 6.5 per cent of Crystal Amber's investment portfolio at the time (currently around 7.5 per cent) and, on the basis that the board of API had put the company up for sale following pressure from major shareholders, and the sale process was ongoing, a takeover of API looked likely. US activist fund and 32 per cent shareholder Steel Partners and 28 per cent shareholder Wynnefield Capital both wanted to sell out, so it looked odds on that a deal would be agreed, with the most likely bidders being trade buyers in Germany and the Middle East, foil makers in Asia or even Illinois Tool Works which had an offer of around 100p a share turned down several years ago.

I was also attracted by the fact that API had a valuable asset in its New Jersey site, which "covers 20 acres within the Manhattan commuter belt and is potentially worth a significant part of its market capitalisation", according to Crystal Amber, adding that even without a bid "reorganisation, investment and marketing initiatives combine to offer share price upside well in excess of 100p". I agreed and advised buying shares in the packaging materials group at 70p (‘Small caps to buy now’, 3 December 2012). Indeed, I was so convinced that the company would be taken out that I reiterated that advice again when the shares were priced at 83p ('More upside to come', 22 January 2013) noting "speculative upside in API shares to 100p a share in the event of a bid".

Low ball offers

It therefore came as a shock when API's board stated in late January that indicative proposals from bidders were below 90p a share. To put that into some perspective, the company was forecast to make underlying EPS of 8.8p in the 12 months to March 2013, so the indicative offers didn't even equate to an exit multiple of 10 times earnings estimates. The shares duly slumped back to 70p on that news, but I still believed it was worth holding on as any bid would have to be north of 80p to win the approval of the major shareholders. But that failed to happen and bid talks with all parties terminated in mid-February, prompting API's share price to slump once more, to 59p. To compound matters, API's management also warned that results for the financial year to 31 March 2013 "will be marginally below previous management expectations". With investors positioning themselves for a bid, the news prompted another wave of selling as the hot money headed for the exit.

But the fundamental case of investing still held and I concluded: "Although the bid support has disappeared, and so has any bid premium embedded in the share price, I am willing to hold on for API's share price to recover back to my 70p buy-in price driven by the operational performance of the company." Following the release last week of the company's full-year results, API's shares have now breached the 70p level, which is why I have been taking a close look at the investment case once again to determine whether there is further upside in the shares.

Solid results

It was difficult not to be impressed by API's full-year results last week. Buoyed by demand at the higher-margin laminates and foils businesses, and with the benefit of lower material prices and cost savings, operating margins improved markedly from 6 to 7.5 per cent. In turn, this drove underlying operating profits up 23 per cent to £8.5m despite a 1 per cent fall in revenues to £112m. The lack of top-line growth reflects a lacklustre performance from API's holographic business, which failed to win enough new business to offset the loss of a contract (brand protection holograms) as a major customer took work in-house. This resulted in the division posting a £300,000 loss, compared with a £1.5m profit in the previous financial year, on revenues down from £13m to £9.6m. To address the situation, around £500,000 of costs have been taken out of that business and £1.6m has been spent on upgrading production facilities, providing additional product features and funding a new joint venture.

The other business units all performed strongly and, with the company's borrowings cut by another £1m to £3.6m, the interest charge was reduced, which explains why API's underlying pre-tax profits soared 35 per cent from £5.1m to £6.8m in the 12-month period. On this basis, adjusted EPS rose from 6.4p to 8.7p, just shy of the 8.8p a share guidance given by management four months ago.

Moreover, with cash generation strong - operating cash flow rose 16 per cent to £5.8m - and the balance sheet lowly geared (net debt is only 11 per cent of shareholders' funds of £22.9m) this opens up scope for dividends. In fact, the board has stated that it will declare a dividend at the end of November alongside the half-year results to end-September. Analyst Charles Pick at broking house Numis Securities expects a 2p-a-share dividend in the current financial year to March 2014. On this basis, the prospective yield is 2.8 per cent. That looks a fairly safe assumption when you consider the strong earnings growth expected this year.

Strong earnings growth

Numis is currently forecasting an 18 per cent rise in adjusted pre-tax profits to £8m in the current financial year, which would produce EPS of 9.9p. This means that a 2p-a-share dividend would be covered a comfortable five times. That is not an unreasonable profit estimate either, considering that API has clients in some pretty defensive sectors - tobacco, beverages and health and beauty products - and three-quarters of revenues are derived from the EU. The UK accounts for a quarter of the company's sales and Europe around a half. The laminates business, accounting for £6.5m of API's £10.1m operating profits last financial year (before deducting £1.65m of central costs), achieved record volumes and profits. Moreover, this trend is likely to continue as the unit is making "good progress" with a new laminates supply contract.

It's also worth noting that, due to the availability of tax losses, the tax charge on those profits will be low. The company still has £2.8m of tax losses in the UK; unrecognised capital allowances of £3.9m in the UK to offset against future taxable profits at the rate of 18 per cent a year on a reducing basis; and unrecognised US Federal tax losses of $8.9m (£5.9m) available to offset against future profits for a period between 10 and 18 years. The US foils business made a £1.9m profit on £14.5m of sales last year, so these tax losses will have a material impact on reducing the cash tax charge. It also means that, with tax payments so low, more cash flow can be recycled into capital projects to generate earnings - but without leading to higher borrowings. In fact, in the 12 months to end-March, API raised capital expenditure from £3.5m to £5.1m, but still cut net debt by £1m. Not that credit lines are an issue: UK bank facilities of £12.8m with Barclays have been extended to July 2014; and US credit facilities of $6.7m (£4.4m) with Wells Fargo are in place to April 2015.

Target price

Interestingly, post last week's full-year results, API's share price finally broke above the 67p level it had been trending at since early April. In my view, this sets a very realistic possibility of the price making decent headway back to January's high of 92.5p. The fundamental case for investing certainly supports a higher share price. In fact, even at 90p the PE ratio would only be nine for the current financial year and the prospective yield would be 2.2 per cent. From my lens, that is too low for a business set to grow EPS by 14 per cent this year. I rate the shares a very decent medium-term value buy and have a target price of 90p. If achieved, this will offer us 25 per cent upside with the shares trading on a bid-offer spread of 70p to 71p, valuing API at £54m.

Amber Alert

We have made decent paper profits on our holding in Aim-traded investment company Crystal Amber (CRS: 131p) and fully supported by the performance of the company.

When I made a strong investment case to buy the shares in December they were being offered in the market at 97.25p, around 17 per cent below my estimate of its pro-forma net asset value of 116p (‘Small caps to buy now’, 3 December 2012). The good news is that the company has just updated the market and the latest net asset value is 135p a share, 16 per cent higher than six months ago. However, the share price has done even better, up a third from 97p to 131p, and this is in no small part being driven by a share buyback programme.

Moreover, now that the share price discount to net asset value has narrowed markedly, Crystal Amber's management team has been in discussions with major shareholders regarding the potential to finance further investment opportunities through a secondary issue of shares. By increasing the size of the fund, the company will be able to acquire larger holdings to potentially increase its influence in those companies, invest in a wider portfolio of companies and also provide greater liquidity for shareholders. Any secondary issue of shares would be priced in line with the prevailing net asset value per share, so existing shareholders will not be diluted.

Strong investment performance

In my view, this is good news as it will raise the profile of Crystal Amber and is a vote of confidence in the ability of its investment advisers to continue their strong performance. In fact, since the start of last year the company's net asset value has risen by 51 per cent, which compares favourably with any index you care to benchmark the performance against. For instance, in the same period, the FTSE All-Share index is up 17 per cent, the FTSE 250 index is 37 per cent ahead and the FTSE SmallCap index is up 40 per cent.

But ultimately, prospects for further gains are dependent on the fund's asset allocation. So, it's good to see that, of the 10 largest holdings, accounting for 70 per cent of the book value, half of the shares in those companies are rated buys by the Investors Chronicle and we have hold recommendations on the rest. The buys are Crystal Amber's top five largest holdings: sensor and electrical components company TT Electronics (TTG: 165p); tile and shower specialist Norcros (NXR: 16.75p); software and technology provider Tribal (TRB:171p); Plymouth marina and property investment company Sutton Harbour (SUH: 24p); and API (API: 71p). The magazine has hold recommendations on Crystal Amber's next five largest holdings: food producer Devro (DVRO: 321p); printing and marketing products company 4imprint (FOUR: 510p); van hire company Northgate (NTG: 340p); newspaper distributor Smiths News (NWS:172p); and long-term savings provider Hansard Global (HSD: 130p).

Table: Crystal Amber's investment portfolio (31 May 2013)

So, on the basis that I can see further upside for equity markets once the current market correction is over, it is only reasonable to assume that Crystal Amber will benefit from more gains on its portfolio, while an ongoing share buyback programme is very supportive of the share price, too. Trading on a 4 per cent discount to net asset value of 134.4p a share, and with 10 per cent of the portfolio is cash and available for new investments, I would run your hefty profits.

Finally, Sutton Harbour (SUH: 24p) is due to release full-year results for the 12 months to end March 2013 on Wednesday 19 June. The shares are priced on a hefty discount to a very conservative book value of 38.3p a share, and I remain positive on the medium-term upside from the holding. I will update the investment case post results.