Spectra Systems (SPSY) - Making Money from Making Money
In the literal sense, Spectra enables central banks to print money. But is this a dying industry?
Current holding. First bought in Mar21 at 164p, topped up in Feb22 at 148p. 25p of dividends since then.
I’ve held Spectra for quite a while now, and have been pleased with the steady progress of the share price, now at 221p. This is a medium sized holding for me (5-10% of portfolio).
Slow and steady is probably how I would describe the company, and the description is both a good and bad thing here. There is the positive stability and predictability in its earnings. However, there’s also a degree of negative sluggishness and glacial progress in growth.
However, the company is promising some ground-breaking tectonic shifts in growth and profitability in the coming years. Can it deliver?
A brief summary of what do they do
Spectra can probably be described as a security solutions company, where “product” security & authentication is required. There are two key customer types that it focuses on: the banknote printing industry, and everything else.
In banknotes, they are literally supplying the raw chemicals and ingredients (“covert taggant materials”), to banknote printers and central banks. These additions to banknotes make them hard to counterfeit. Spectra also does consultation work with central banks, as well as provide other goods and services - ie sensor hardware (to detect the covert taggant materials in a banknote to authenticate it as genuine). All of this is to say they are experts in making banknotes more secure, counterfeit proof, and the authentication solutions. Critical features for banknotes.
In “other industries”, they have used their security and authentication expertise to sell solutions to other industries. Everything from tobacco packaging, coffee pods (K-Cups in the USA), lottery tickets, passports, etc. Basically, any product that has a high problem with counterfeiting and the need to authenticate whether it is genuine, potentially is an area that Spectra could solve.
Banknotes and central banks are their key revenue drivers, although they have never broken down in detail what each business line contributes.
Stable, predictable revenues
The key strength in the investment case for Spectra is the stability and predictability of their revenues. They have clients (central banks) that are very sticky. I believe I read somewhere that their largest client has been with them for over 20 years.
Central banks don’t frequently change the banknotes they print, so you can imagine that the revenue is very sticky and predictable. Furthermore, banknote volume supply into the economy is predictable, either to increase supply or replace damaged notes.
Their other lines of business are less sticky, mostly consumer goods (K-Cups, cigarette packs, etc). But in the case of lottery tickets and passports, one can imagine constant demand.
Spectra will continue to see stable revenues even during economic recessions - demand of banknotes, lottery tickets, and passports are anti-cyclical. This for me is one of the key investing points of Spectra. Not only is there good forward visibility of revenues and profits in the years ahead, but also that it is a defensive investment. Not quite anti-cyclical as Begbies Traynor, but closer to that end of the spectrum.
Moat & high margins
In addition, Spectra possesses a big moat, through their IP in covert materials and authentication solutions. This translates to pretty high margins - rock solid 30% plus operating margins, repeated year after year. All in all, a very lucrative business.
The other moat, as I alluded to above, is the long-term nature of their contracts and relationships with central banks. If a country wanted to change suppliers away from Spectra, they would probably need to redesign their bank notes to accommodate different covert materials and security features, and change the authentication guidelines and sensor hardware required. All quite big changes.
The moat and margins at Spectra reminds me of the best SaaS providers; once embedded in a client, very hard for the client to extricate and migrate suppliers.
There are some big risks though
The key one is their client concentration; they have never revealed explicitly, but it seems like their largest central bank customer makes up a big proportion of their revenues, and so if they were to lose that customer, that would be calamitous for their revenues and profits. So far, things look like they are going well with the customer. So good, in fact, that they have a huge sensor development & supply contract that will bring US$50m of revenues over 3 years for the hardware (from FY25-27), and another $8m a year in service revenues after. The current revenues are only $20m a year in FY23!
The other risk is of course that banknote usage is declining globally, due to the rise of digital payments. However, this decline is not as fast as I initially thought it would be; and every time I look up statistics on the volume of banknote circulation, the numbers show just a gradual decline, rather than any disruptive drop. In fact, I recently read a good article from Deutsche Bank on this topic, debunking the myth that cash is approaching terminal death.
The other big trend is that as more banknotes are produced using polymers, the replacement rate is lower as the banknotes are more durable. This means lower production run-rates, which require less covert materials and substrate. Also, Spectra does not have a solution for polymer banknotes at the moment, but is working on it (see more below in Growth Prospects).
Then there is the key man risk. Nabil Lawandy is founder and CEO of Spectra. My feeling is that he has considerable influence still, and probably is “the business”. BJ Penn is technically the non-exec chairman of Spectra, but you never hear anything from him in results or elsewhere. Nor from the CFO or other key executive leaders.
Still, Nabil has been a steady pair of hands and delivered good, stable returns for investors over the years. He also owns just under 10% of the shares, so has a personal vested interest in the continued growth of the company and share price.
Growth Prospects
Growth for FY25-27 looks secure, solely based on the sensor hardware contract they are progressing for their central bank customer. However, this is a one-off, albeit with a smaller recurring service contract after.
There are some smaller growth opportunities in the “other industries” part of the business - finding more use cases for security and authentication solutions in other products. However, this looks like it might just produce modest new revenue streams.
In the meantime, Spectra are progressing with their big opportunity - cracking the polymer banknote market by supplying the polymer substrate to central banks. Polymer substrates are the sheets of plastic, embedded with security features, which are then used by central banks to print banknotes on. They took a big step last year to establishing this capability by acquiring Cartor. This company is more well known for its stamp production, supplying Royal Mail with the new barcode stamps for example. But over the last few years, Cartor and Spectra have been collaborating on cracking the polymer substrate market, and this acquisition means there is now a full end-to-end polymer substrate capability within Spectra.
There are ongoing trials and collaborations with a central bank at the moment for Spectra’s polymer solution. The wording from the latest results RNS suggested that the relationship is very friendly; the central bank is collaborating with Spectra, on how to meet all their requirements, and jointly running trials. In short, Spectra still has not achieved “qualification” status yet in polymer substrates, but is getting there. And once they’re there, it looks like they will then participate in a tender process by the central bank.
In the latest FY23 results, they clearly state their ambition: to disrupt the duopoly in polymer substrates by CCL Industries and De La Rue. I’ve not seen such a strongly worded statement from Spectra before, nor the explicit mention of these two competitors they are gunning for, so I am impressed by the boldness of this statement. Nabil must really think that they have everything they need now, with Cartor acquired, to make a good go at disrupting this market.
Tempering expectations… I don’t expect any contracts to be won earlier than say mid-2025. And then after that, there is probably phases of design, approvals, ramp-up… and I would guess the first revenue recognition of polymer substrates might probably only happen in 2027-2028. So this is a medium-term opportunity for growth.
The key risk is that this new revenue stream from polymers will only get going after the wind-down from the sensor hardware contract (2025-2027) which might lead to a gap of 1-2 years of negative growth in revenue and profits.
Why I’m invested
Looking at the broker forecasts, there’s an increase from 12.4c (FY23) to 15.5c (FY24) and 21.4c (FY25) forecasted. The broker, WH Ireland, has stated that they are forecasting conservatively, only including fully contracted revenues known right now. I’ve tracked their forecasts since 2019, and can say that the final results from Spectra always met or beat WH Ireland’s forecasts. So they do seem very conservative. My own calculations for Spectra assume a small upside to the FY24 15.5c number, and potentially quite a bit more to the FY25 21.4c number.
Even if we take at face value the 21.4c EPS for FY25, the current share price is valuing it at 13x PE, when I think Spectra should trade between 15-20x when we get to end of 2024, closer to 2025. That would give a share price range of 250p to 340p, which is quite a bit higher than the current 220p. In my mind there is almost zero chance that there is a miss to 21.4c EPS, given it is all based on already contracted revenues, so we can take the FY25 numbers as almost in stone.
I have strong conviction that Spectra deserves a 15-20x PE rating, given the stability in revenues, the forward visibility, the huge margin and moat it has, as well as potential growth opportunities.
If there is positive news later this year about the polymer banknotes opportunity, I can see this trading closer to 25x PE, in anticipation of a big new revenue stream in the years ahead. That gives a potential target share price of 420p.
However, there is also some black swan risks: potentially losing their existing clients, or key man risk of Nabil - age 67. Therefore, I would probably take some profits if it gets over 300p before the end of 2024, and completely exit at 350p and above.
In the meantime, there is a good steady stream of dividends to collect while parking my money here. Just under 4.5% dividend, close enough to the risk-free rate.
Spectra shares are thinly traded though, and there is sometimes a long wait in between updates, so this is one not one for short term traders.