Spectra acquisition: a licence to print money?

Aim-traded Spectra Systems (SPSY:192.5p), a leader in banknote authentication, brand protection technologies and gaming security software, has announced the strategic complementary acquisition of Cartor Holdings. The company has worked with Spectra for the past two years to develop the necessary expertise to produce FusionTM substrates for qualification by central banks and leading polymer banknote printers.

In addition, Cartor supplies postage stamps to more than 180 administrations globally, and produces tax stamps, vouchers, coupons, certificates and security documents. It differentiates itself from rivals by using state-of-the-art technology to make it difficult for counterfeiters to operate in industries with high monetary or intellectual value products and services. The acquisition will consolidate the supply of Spectra's FusionTM polymer substrate within the enlarged group, increase margins on polymer substrates, and open new sales opportunities for Spectra’s own security products.

The group will also benefit from increased product development capabilities by having access to Cartor's state-of-the-art printing facilities in France and the UK, giving it a presence in four G7 countries. Replacing current supplies to Cartor with Spectra's optical materials will boost earnings, too.

In the year to 30 September 2023, Cartor generated cash profit of £2.5mn on revenue of £16.2mn. The company closed the period with net assets of £4.9mn and low-cost borrowings of £4.5mn, which Spectra will assume on completion. The debt has an average interest rate of 0.3 per cent. The consideration payable to the vendor comprises cash (£5.5mn), new Spectra shares (£3mn) that are subject to a 12-month lock-in period and a contingent share payment (£2mn) in the event Spectra has qualified its FusionTM polymer substrate for tender submissions with a central bank customer within 18 months. The maximum consideration equates to six times cash profit to enterprise valuation.

Hefty earnings upgrades

The structure of the deal and the fact that Spectra can fund the cash consideration internally makes it hugely accretive to earnings per share (EPS). To put this into perspective, analysts at house broker WHIreland upgraded their 2024 pre-tax profit estimate by 19 per cent to $10mn on revenue of $45.1mn, up from $7.9mn and $20.8mn, respectively, forecast for the 2023 financial year. On this basis, expect 2024 EPS to rise 22 per cent to 15.4¢ (12.2p).

Moreover, given Castor’s manufacturing facilities are well invested, there is little change in capital expenditure plans so Spectra should continue generating significant cash. The brokerage expects Spectra to end 2024 with net cash of $13.1mn (23p), thus enabling the board to pay a high proportion (12.3¢) of EPS as a dividend. This implies the shares are rated on a forward price/earnings (PE) ratio of 15.8 and offer a prospective dividend yield of 5.1 per cent.

The rating not only fails to factor in the explosive growth in Spectra’s earnings in 2025 that is already underpinned by major central bank contracts (‘Spectra’s profits could grow 50 per cent by 2025’, 25 September 2023), but it ignores the additional 12 per cent EPS upgrade to 21.6¢ (17p) following the Cartor acquisition. The dividend is expected to be lifted again to 13¢ (10.3p), implying the shares are rated on a 2025 forward PE ratio of 11.3 and offer a prospective dividend yield of 5.3 per cent.

The smart-looking acquisition attracted investor attention, hence the 9 per cent rise in Spectra’s share price on the day. It means the holding is 49 per cent ahead since I initiated coverage (‘Alpha Research: Don’t miss out on the authentication boom’, 22 August 2022), massively outperforming the FTSE Aim All-Share Total Return index which has fallen 18 per cent in the same 15-month period.

I expect the outperformance to continue, and with good reason given the low forward rating and high EPS growth forecast. Furthermore, I am raising my target price to 250p (from 200p) based on a fair value PE ratio of 14.5 for 2025. Please note that Spectra has two classes of shares and the unrestricted ones (AIM:SPSY) are the most liquid. Buy.

■ SPECIAL OFFER. Simon Thompson's books Successful Stock Picking Strategies and Stock Picking for Profit can be purchased online at www.ypdbooks.com at the special discounted price of £5 per book plus UK P&P of £4.95, or £10 for both books plus UK P&P of £5.75, subject to stock availability.

They include case studies of Simon’s market beating Bargain Share Portfolio companies outlining the characteristics that made them successful investments. Simon also highlights many other investment approaches and stock screens he uses to identify small-cap companies with investment potential. Full details of the content of the books can be viewed on www.ypdbooks.com.