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Sepura – Drops off a cliff. Is it still investment grade?

Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.


Sepura, a ‘global leader in the design, manufacture and supply of digital radio products, systems and applications developed specifically for business and mission critical communications’ is down almost 95% from the end of March 2016. Today’s market capitalisation is £50m at 14p per share. This is an almighty value destruction, this article looks at whether there is still value in Sepura at this price. So should you be bottom fishing or steering well clear?

What’s the reason for the sharp change in fortunes for Sepura?

As at the March 2015 year end Sepura seemed to be doing well. It was generating EUR25m of operating cashflow and even a small amount of Free Cash Flow. Back then it was capitalised at £206m(EUR 250m), zero debt and with profit growing 15% year on year. Sepura was even paying a small dividend and had a strong order book going into 15/16, it therefore looked decent value at just £200m. Not a major suprise to see the company continuing to increase in value beyond March to a peak of £300m(EUR 350m) towards the end of 2015.

The troubles seem to have started though with the May 2015 acquisition of Teltronic, a company offering similar products to Sepura but expanding the geographic reach into Iberia and Latin America, most notably Brazil. Sepura paid EUR127m in cash using a combination of debt and new equity to pay for it.

Amazingly Sepura also announced in September 2015 it was commencing a share buy back program for up to 1.8m of shares, bear in mind the share price was around £1.80 at this point in time, Sepura was therefore placing itself on the hook for upto £3.25m. Granted it isn’t the biggest share buy back programme in the world, but why did the company need to do this without at least waiting until the new acquisition had settled in? Sepura was/is in net debt so why should it be doing a share buy back at all?

Things really started to head south though with the release of the March 2016, announced on 27th June 2016, almost a full year after the Teltronic acquisition. Revenue was way up and this was almost entirely contributed by Teltronic, but operating margin fell through the floor and cash conversion was woeful, i.e. Sepura was not turning its working capital into cash. Trade receivables almost doubled from EUR47m to EUR88m, the question therefore is the additional revenue that Teltronic contributed, did any of the customers actually pay for it? Not only was the cashflow poor the company was now in a net loss position of EUR10m. See below for a breakdown of the key metrics:

screen-shot-2016-09-15-at-19-16-28
Fig 1 – Source: Sepura 2016 Annual Report

Sepura does not come out and say explicitly how Teltronic has performed at a cash generation/profitability level, but can we deduce the Sepura collapse in fortunes down to this acquisition? I can’t see the company has acknowledged this, but it’s no coincidence that Brazil and Saudi revenues grew in 2016, likely driven from the Teltronic acquisition. Brazil is going through it’s biggest recession in more than a century so is it any surprise its customers were late or non paying? In fact according to the notes of the 2016 accounts some EUR6.4 million of debtors were written off after acquisition, 15% of the total debtors balance. Anyhow no impairment of the Teltronic goodwill was made in the 2016 accounts, but I will be watching with interest when the 2017 accounts come out next year! I wouldn’t be surprised to see the whole lot gone.

screen-shot-2016-09-15-at-21-36-26
Fig 2 – Operating Revenue Segments – Source: Sepura 2016 Annual Report

 

After these dire results the company was forced into an emergency equity raise of £65m with net debt climbing to EUR119m. However, at this time management estimated assured shareholders of a record breaking net profit of EUR21 million in 2017 so all would be fine…

Surely it can’t get any worse then?

And then came a lunchtime trading update yesterday 14th September 2016…

Order intake in recent months has been lower than the Board’s expectations as a result of emerging delays in Device refresh opportunities in a number of key markets, primarily through budgetary pressures which are extending product lifecycles. At the same time, key contract awards in the Group’s Systems business have also been subject to delay. 

The latest sales pipeline and associated timing indicates that order intake for the full year will have a significant impact on the Group’s FY17 revenues. As a result the Board now anticipates adjusted EBITDA for the current financial year could be c. 60% lower than its previous expectations.

Obviously written by the PR people, but I can roughly translate to, ‘lower device sales and less new major contracts’. By the way it irritates me that they haven’t actually stated the expected EBITDA for 2017 now, instead investors have to trawl through the releases until they find the original guidance. From what I can see this was EUR27m, so now EUR10m.

Sepura were not done with that shite news though, two other bombshells; they warned they are likely to breach covenants on the borrowings from March 2017 next year. We are not told by Sepura what the current net debt position is though (another thing that riled me about this RNS). The final bombshell was saved for a separate RNS:

[Sepura] has been notified by Gordon Watling, its Chief Executive Officer, that he has received medical advice to take an immediate and extended period of absence, in order to recover fully from injuries sustained in an accident earlier in the year.

Richard Smith, Chief Financial Officer, has been appointed Acting Chief Executive Officer with immediate effect in addition to his existing responsibilities.

What? So Gordon injured himself earlier this year, but he only needs to take time off now, just happens to be the same day as the company releases the Profit Warning from hell? What exactly did he injure himself on, did an angry investor repeatedly smash him over the head with a walkie talkie? And why has it taken so long for the symptoms to take effect? On a serious note, best wishes to Gordon but this stinks of some sort of PR cover up. Has he been pushed?

So should I be tempted to bottom fish?

The company based on its revised guidance is now expecting around EBITDA 10 million. At a net profit level this will likely be close to £nil. The big question will be whether some of the working capital in March 2016 can be converted into cash though.

The management has clearly made some shocking decisions over the past few years, the acquisition was a poor one and starting a share buy back scheme shortly afterwards whilst not material, wreaks of poor decision making. With the CEO Gordon Watling now out of the scene this gives the remaining management chance to refresh things.

The liquidity situation is not critical in that Sepura does not need a fresh funds today, but it will need to talk to its lenders in the next 6 months. I certainly don’t think it is the end of the road for Sepura yet, but the next 6 months will be critical to keep net debt levels under control and at least demonstrate an improving picture.

Sepuras current Enterprise Value is £50m Market Cap plus I estimate £80m of Debt, i.e. £130m, so if the business can restore itself to its former glory when it was generating CFO of EUR 25m then this valuation is cheap. The other real possibility is a hostile move from a rival, the valuation could now be attractive, there was a brief bit of interest at the end of July but the counterparty pulled out. Some of the major contracts Sepura have could be interesting and there may be synergies at play, the tax losses of EUR25m (and counting!) could be an attraction also. Even if you double market cap this still only gives you an EV of £180m, this doesn’t look unreasonable given £20m CFO a year and given what Sepura paid for Teltronic, i.e. £100m (although the later is perhaps not a great benchmark!). However, If this offer doesn’t come in the next 1-2 months then I expect any potential buyers will instead wait it out and talk to the bondholders instead down the line.

If no buy out offer comes and/or management fail to turn around the company then I can see a looming debt for equity swap. It is pretty much out of the question to do an equity raise to pay down debt, last time Sepura went to it’s shareholders it was at a 53% discount. What would it be this time, bearing in mind the size of the market cap now? Mega dilution…

Verdict

SPECULATIVE BUY – Target to Sell at 20p (42% upside)
On balance this is a high risk one but I believe there may be an opportunity to make a quick profit here as people pile on the expectation of a potential take over. However, if the offer doesn’t emerge after 1-2 months then it becomes higher risk as the price will likely drift on no news until we get the next trading update. The big downward pressure on the price could come if some of invested institutions start offloading there shares so watch out for TR1s. A potential strategy could be take a small tranche at tomorrows open and watch for major dips. Note, I only have one or two of these distressed plays on the go at any one time, so make sure you risk manage!

Disclaimer – I have a long position equal to 1% of my net assets in Sepura bought in at 13p. I have no further positions in any of the other stocks mentioned and to my knowledge nor do any close family, friends nor associates.

This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.

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