Is this 'abnormal' share too cheap?

Investors would do well to consider what "normal" means after smoke and carbon monoxide alarm supplier Sprue Aegis promised trading would return to normal in 2017.

Full-year results in the year to December 2015 were anything but normal. The company was the beneficiary of booming demand in France, where new legislation mandated a smoke alarm on every floor of every home in the country.

Revenue rose 35% compared to the previous full year and adjusted profit increased 20%. Cash flowed into Sprue's bank accounts and the year-end balance was £22 million, over a third of the company's market capitalisation. It has no borrowings.

Celebration, though, was never likely, for two reasons. Sprue had announced weeks earlier that it would have to set aside an additional £5.5 million to replace alarms with defective batteries. The sealed-in units are supposed to last up to ten years, but some batteries are erroneously signalling battery failure after three. Lives aren't at risk, but the company's reputation might be.

Sprue has treated this provision, which is its best guess at the cost, as an exceptional item. Actually, after deducting the provision, profit declined by about a third.

It's tempting to believe the issue is temporary and manageable. £5.5 million is a quarter of Sprue's cash balance. The company has apologised, promised to learn from the experience, and believes the provision is a conservative estimate of the likely cost of replacing faulty devices. It's putting more checks in place on the production line, considering redesigning the alarms so the batteries can be replaced rather than the whole unit*, and it may not replace alarms that are returned if no fault can be found.

But, reading the notes to the accounts**, it's clear that Sprue doesn't know how many alarms will turn out to be defective in years to come. If the eventual cost is greater than Sprue reckons, if more people return faulty alarms than Sprue expects, the bill will go up.

A complicated relationship

Curiously, Sprue does not say whether it has any claim against its battery supplier, or DTL, the company that manufactures the alarms for Sprue. DTL is a subsidiary of Jarden Corporation, which, through another subsidiary of Jarden, BRK, is also Sprue's largest shareholder. DTL supplies all of Sprue's own-branded smoke alarms and also a range of BRK branded products, which are distributed by Sprue in Europe.

This complicated relationship is sometimes adversarial. BRK launched a hostile takeover of Sprue Aegis in 2013 and, should Sprue seek, as it has mooted, to launch its alarms in the USA, it would be competing directly with BRK. The fact that BRK regarded Sprue as sufficient a threat - or opportunity - to seek to take it over was one of the reasons I added the shares to the Share Sleuth portfolio, also in 2013. But their interdependence is also off-putting, and one of the reasons I halved the portfolio's holding a year ago.

There were two other reasons. The market was valuing the enterprise at about 18 times adjusted profit (the earnings yield was 5%), but I didn't have that much confidence. Although Sprue has grown consistently and very profitably over the last decade, France is one of Europe's biggest countries and, before the legislation, very few of its households had smoke alarms. Although Sprue anticipates new legislation in other countries, it would be reckless to assume that the bonanza of 2015 would be repeated every year.

There was a large risk that, once the French had installed their alarms, demand would fall substantially. As demand started falling in the second half of the financial year, distributors' stocks accumulated, ultimately resulting in a massive reduction in orders. Sprue is also carrying £7 million more stock than it would have been, accumulated as a buffer in case of problems when Jarden relocated its Chinese factory, CICAM, which it did without a hitch.

The risk was clear, but perhaps not the extent. Sprue expects to lose £1.9 million in the first half of 2016 and make £3.8 million in the second half-year, a total operating profit for the year of £1.9 million compared to nearly £13 million before the exceptional provision in 2015. Revenue will drop from £88 million to £55 million, less than the company made in 2014, but more than it made in 2013.

What's normal?

As it moves into 2017, Sprue expects trading to normalise, but the question is, what's normal? 2015 wasn't, and 2016 won't be. In 2017, Sprue expects legislation in Germany similar to the legislation in France to stoke demand, and thereafter legislation in other European countries, but product certifications have been delayed in Germany. I wonder if there is a connection between the delayed certifications and the battery problem.

Abnormal might be the new normal and the uncertainty probably explains the crash in Sprue's share price. The company now trades on a multiple of four times average profit in 2015 (the earnings yield is 26%). One simplistic way of looking at it is that, if the company's prospects were satisfactory, the shares would be good value if it was earning less than a third of the profit it did in 2015, comparable to 2010 and 2011. In 2016, Sprue won't even manage that, but I'd be surprised if Sprue thinks normal trading in 2017 would result in the levels of profit it achieved six years earlier.

Given the popularity of Sprue products, albeit now tarnished by a defect, and despite the risks, now more apparent, of having such a significant supplier, I'd be surprised if Sprue isn't worth considerably more than its market value now.

That's a speculative view though; like many shareholders I will be seeking reassurance before adding more shares to the portfolio at what may be a bargain price.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

*Sprue may unseal the batteries in some of its models so they can be replaced under warranty, rather than replace the whole unit. While that would reduce the cost of future warranty claims, I believe the company's banking on the built-in obsolescence of sealed-in batteries to drive a ten-year replacement cycle.

The simplicity of the products is also one of the reasons for their popularity. An apparently obvious design enhancement, therefore, to allow the batteries to be replaced, might in fact be a much more nuanced decision and a lack of confidence that the battery issue has been fixed even in current production runs.

**See note seven. Some highlights:

"Determining the amount of the provision, which reflects the Board's best estimate of resolving these issues, requires the exercise of significant judgement. It is necessary, therefore, to form a view on matters which are inherently uncertain, such as the returns profile over time, the final return rate, whether the return rate of each year of production will be similar, whether the return rates from different sales channels will vary and the average cost of redress.

"There is a greater degree of uncertainty in assessing these factors when an issue is first identified, as in the case of the battery issue which resulted in a GBP5.5 million exceptional warranty charge in 2015 where the failure typically occurs around three years from the date of the battery manufacture. Consequently, the continued appropriateness of the underlying assumptions will be reviewed on an ongoing basis against actual experience and other relevant evidence and adjustment made to the provision as required."

"The provision estimate of £6.1 million relates solely to the battery issue and is most sensitive to the assumption regarding the final return percentage rate. For reference, a 10% increase in the estimated final return rate, with no further improvement for each subsequent year of affected production, would result in an increase in the provision of approximately £0.5m."