Spectris plc: Wonderful Company Flying Under Investors' Radars

seekingalpha06-17

U.S. large-cap stocks have outperformed major markets over the past decade, with SPY delivering 50% higher returns than URTH.Spectris plc is a UK company in the measurement equipment industry with a ...

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Spectris has an impressive dividend track record, with 34 years of increases.   Unaihuiziphotography/iStock via Getty Images If something cannot go on forever, it will stop. - Stein’s Law There is no doubt that over the past decade, U.S. large-cap stocks have outperformed most major markets. This can be seen, for example, if we compare the iShares MSCI World ETF's (URTH) total return against the S&P 500's (SPY). Over the past ten years, SPY has delivered more than 50% higher returns to investors than URTH, in large part thanks to massive growth from companies like NVIDIA (NVDA) and Apple (AAPL). The problem we see is that while some of this was the result of fundamental growth in revenue and earnings, a big part came simply from multiple expansion. Data by YCharts As can be seen in the graph below from World PE Ratio, the U.S. (VTI) is now trading more than two standard deviations above its 20-year average price/earnings ratio. Other similarly expensive markets include Canada (EWC), France (EWQ), India (INDA), Australia (EWA), Taiwan (EWT), and South Korea (EWY). One of the major economies not massively overvalued is the UK (EWU), in part due to the uncertainty created by Brexit, but that means it is a good place to look for attractively priced companies. In fact, private equity appears to have noticed the lower valuations of small and mid-cap stocks in the UK (EWUS), making several takeover offers in 2023. In a previous article, we argued that while UK stocks in general look relatively attractive, it is the relatively smaller companies that look like real bargains. With that in mind, we have been looking at small and mid-cap UK stocks looking for promising ideas, and we think we found one with Spectris plc (OTCPK:SEPJF)(OTCPK:SEPJY). Despite being a wonderful business, the last article written on Seeking Alpha about it was in 2018, and it appears to have only 334 followers. This company is definitely flying under most investors' radars. worldperatio.com Company Overview The company is part of a very attractive industry of measurement equipment, similar to lab equipment giants Agilent Technologies (A) and Danaher (DHR). More specifically, Spectris focuses on \"particle measuring systems\". There are a few reasons why we like this industry, including the fact that customers are less focused on price and more on quality and reliability. This is the result of lab equipment making up a relatively small percentage of their customers' R&D spending, and they certainly do not want a breakthrough innovation failing to materialize because they bought faulty equipment or expensive chips rendered useless because there was particle contamination. Another reason this industry is attractive is because it tends to generate recurring revenue from service agreements and consumables. Some of their key end-markets include life science and pharma companies (IBB), tech companies (XLK), and semiconductor companies (SOXX). The company has even created a very nice inspirational video showing some of the industries they impact.   Spectris 2023 Annual Report Strong Competitive Moat Spectris derives its competitive moat from a combination of factors. These include significant intellectual property as the inventor of laser particle counting, and its equipment is backed by roughly 260 patents. The company also has a strong brand with a reputation as a world leader in monitoring solutions for ultra-clean manufacturers where detecting the smallest particles is mission critical. Finally, there are significant switching costs, as customers usually sign long-term service agreements and have spent money training their employees on the use of these devices as well as fitting them to their factories and labs. The company should increasingly benefit as the installed base grows, as that means more service revenue opportunities, repairs, and software licenses. The installed base has already surpassed 80,000 instruments in the field. In fact, CEO Andrew Heath commented on this benefit and the related recurring revenue in his letter to shareholders in the 2023 annual report, where he wrote: Our large and growing installed base has allowed us to build a strong aftermarket annuity, with recurring and service revenues now accounting for around a third of Group sales with software accounting for approximately a third of that. And through new innovations such as SMART Manager, which enables connections to customers’ instruments in the field, we are expanding the range of aftermarket services that we provide. - CEO Andrew Heath R&D Spectris reinvests a significant percentage of its revenue into research and development, which has resulted in several new and enhanced products and is why the company is hoping to make market share gains. The company employs over 1,300 engineers, roughly half in software. This has allowed the company to deliver impressive innovations, for example, Spectris claims that its semiconductor product offering is the broadest with the highest sensitivity, which has resulted in strong collaboration with major players and contracts that include service and after-sales support. Spectris Investor Presentation Over the past three years, the company increased its R&D investment as a percentage of sales from 6% to around 8%, and it is committed to maintaining R&D investment at or above 8% of revenue going forward. There are some examples in the annual report of recent product launches resulting from these research and development efforts, which meet specific needs of several of its different end-markets. Spectris 2023 Annual Report Financials Not everything is perfect with Spectris, as the company is relatively cyclical and significantly dependent on capital expenditure spending. During recessions and other difficult economic periods, companies tend to cancel or push into the future expansion plans. This tends to directly affect companies that sell expensive equipment for labs and factories, even if most of the company's end-markets have above GDP growth rates. During the start of the Covid pandemic, when there was a lot of economic uncertainty and many companies stopped non-essential spending and investing, the company saw a sharp decline in sales and profits. More recently, some of its end-markets have been softer than expected, resulting in weak financial results for Q1 of 2024, which saw sales decline 8% on a like-for-like basis. Still, the company managed to increase the order book by about 3% and is forecasting a stronger second half of the year. Despite the cyclicality, the company has managed to average a return on equity of roughly 15%, and operating margins above 10%. In terms of revenue growth, the company has a target of delivering organic growth between 6% and 7% over the cycle, with some added M&A growth from bolt-on acquisitions. Data by YCharts Balance Sheet The company also has a balance sheet that is in terrific shape with £109.0 million ($138 million) in net cash at the end of March, and Spectris should have received £228 million ($289 million) in April from the sale of its Red Lion Controls division. Red Lion Controls was a non-core business that offers solutions for industrial cloud connectivity. The sale of this business will leave the company very well positioned to make strategic bolt-on acquisitions and finance share repurchases. The company currently has a £150 million ($190 million) share buyback authorization. Future Outlook The company has guided for better results in the second half of the year, and that it continues making progress towards expanding its adjusted operating margin towards their target of 20% or higher. It plans to further improve growth through M&A and capacity expansion. For example, it is investing in a new, state-of-the-art manufacturing and innovation center in Colorado that is scheduled to open in the second half of 2025. The company is also working on improving the efficiency of its business processes, and it has shared that between the operating leverage from higher sales and operational efficiencies, it has a line of sight to its operating margin target. Spectris Investor Presentation Dividends We were surprised to learn that the company is an international dividend aristocrat, as Spectris has a track record of increasing its dividend every year for the past 34 years. At current prices, shares yield 2.53%, after the most recent 5% increase.   Spectris 2023 Annual Report If we look at the shareholder yield, which includes the buyback yield, things get more interesting, as the company has recently been repurchasing shares aggressively, pushing the shareholder yield above 6%. It is also worth noting that the current dividend yield is slightly higher compared to the ten-year average. Data by YCharts Valuation Spectris can be an interesting option to consider for those wanting exposure to the attractive lab equipment and measurement equipment industry without paying exorbitant valuation multiples. While Danaher, Waters, and Agilent Technologies are wonderful businesses, their valuation multiples are certainly quite stretched. Spectris Price/Earnings multiple is considerably lower, despite having a balance sheet with a net cash position. Data by YCharts Similarly, Spectris' Price/Sales ratio is considerably lower than of its larger U.S. peers. This could make the company an attractive take-over target for one of its bigger competitors, which would result in a quick gain but potentially deprive investors of an attractive long-term investment. Spectris is also trading at a very reasonable Price to Cash Flow from Operation of around 17x, and its dividend payout ratio is conservative at ~39%. Data by YCharts Risks The company is exposed to the capital expenditure cycle, and it has recently pointed out weakness in machine manufacturing affecting its sales. The increase in interest rates to fight inflation has resulted in manufacturing capital expenditures trending down since early 2022. If the economy enters a recession, companies could cancel or delay more industrial expansion projects, resulting in a significant headwind for Spectris. Data by YCharts This cyclicality risk is mitigated by geographic revenue diversification and exposure to strong end-markets growing at above GDP rates on average and a solid balance sheet. Currently, one of the weakest regions for the company has been China.   Spectris Investor Presentation Conclusion Spectris is a relatively small UK business that is not receiving much attention from investors. Still, it appears to be a great asset-light business with strong intellectual property and respected premium brands in the precision measurements industry. It also benefits from end-markets that have attractive growth rates. The company has a very reasonable valuation, pays an attractive dividend, and is aggressively repurchasing its shares. While the company is exposed to the manufacturing CapEx cycle, it has a very strong balance sheet with a net cash position, which it could leverage to make attractive bolt-on acquisitions. Spectris appears to be a wonderful company at a fair price, but it is not appearing on most investors' radars.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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