Mpac – Catch up

The purpose of this article is to provide a catch-up of what has been happening at packaging machinery supplier Mpac. You can find all my past articles on it here, although I haven’t written about it for a while, for reasons explained here.

I’m going to concentrate on four updates as illustrative of what is going on at Mpac, and which may also cast some light on my investment process with read-across to other companies. You will find links to the announcements in the headings. Since writing this article I have done further research on the FREYR battery contract and this will be the subject of another piece to be published imminently.

The best place to contact me and to discuss Mpac is Small Caps Live, although feel free to use the tools provided here also.

Acquisition of Lambert

On 1st May 2019 they announced (my emphasis):

Mpac Group plc (AIM: MPAC), the global packaging solutions group, is pleased to announce that it has acquired the entire issued share capital of Lambert Automation Limited (“Lambert”) for an initial consideration of £15.0 million to be paid in cash (the “Acquisition”). Further deferred and earn-out consideration may become payable as set out below.

Lambert was founded in 1973 and is a provider of technology leading automation solutions to the medical and consumer healthcare markets.

Mpac will enter the medical and healthcare product assembly and packaging market fulfilling the expected increase in demand for wellness products.

Yet despite this I persist in describing them as a “packaging company”. Why? Two reasons: firstly because I try to filter out marketing fluff and get to the crux of things; and secondly, because they went on to say:

The Acquisition represents a compelling fit with Mpac’s strategic intent of being a market leader in the provision of full-line packaging solutions for the pharmaceutical, healthcare and food and beverage sectors.

FREYR Battery Contract

On 26th July 2021 they announced (my emphasis):

Mpac Group plc, a global leader in high-speed packaging and automation solutions, announces that its Mpac Lambert (“Mpac”) business has signed a contract with FREYR Battery (“FREYR”) for the supply of the casting and unit cell assembly equipment package to the battery cell production line at FREYR’s Customer Qualification Plant (“CQP”) in Mo i Rana, Norway.

FREYR is a developer of clean, next-generation battery cell production capacity. Mpac was prequalified to participate in the competitive tender following nearly three years of cooperation with 24M Technologies (“24M”) on industrializing and scaling 24M’s SemiSolid lithium-ion battery platform technology.

Once again there is a focus on “automation solutions” rather than just packaging. And, while (upon research), part of what they are doing is “encapsulation” of the cells which is a short skip via “wrapping” to “packaging”, the casting part is definitely not packaging: “casting” implies deformation of the item whereas the purpose of packaging is to avoid precisely that.

In July 2021 the market was in a full-blown tech bull market. This was an era where Triad (TRD) quadrupled their shareprice in two months apparently just by employing a consultant with “blockchain” on their CV, when investors believed fairy stories such as Reach (RCH) being the next google, and when Cathie Wood was an investing genius. Clearly the very mention of involvement in battery manufacturing made the company a buy, and indeed that’s what I did.

But what I’d like to concentrate on is why my purchase of the shares was merely a cynical play of market sentiment and why I fully sold again over the following six weeks.

When a company says they are involved in a “next-generation” technology, alarm bells should be ringing because by definition this means it is not currently in use. There are a number of risks common to such situations, but I will address the Mpac battery contract as can be understood from the RNS statement in particular:

  • The technology is not proven in the field and may have unforeseen problems. Longevity (materials may break down / performance may degrade over time) and safety (may cause fires) are the obvious risks here.
  • Even if the technology works, it may be impractical, for example required tolerances may be too fine for mass production, or it may be too labour intensive, or some of the materials may have insufficient supply / be too expensive. These issues may not become apparent until mass-manufacturing starts.
  • Even if it works and is practical, another technology may prove to be better for the application. There are certainly 10s and probably 100s of novel battery technologies being developed at this moment, most of which are claimed to be revolutionary. Far better qualified people and better resourced researchers have very little idea which will be successful, and so the base estimate should be that 24M stands no more chance than any of its direct competitors.
  • Even if it is the best technology (for a particular application), doesn’t mean that it will win out. Random factors come in to play such as politics and contributions from gifted individuals, but once critical mass is reached development effort is focused, and an inherently inferior technology will often go on to outperform technically.
  • Even if 24M becomes the predominant technology, e.g. for grid scale storage, doesn’t mean that FREYR battery will achieve significant success with it. These are just a few of the business risks:
    • FREYR is newly formed and has no corporate experience in anything.
    • They are reliant on technical people who naturally have no experience with this technology.
    • They are particularly dependent on the skills of salespeople to get grant funding, offtake agreements from customers and capital from banks, investors etc.
    • They are subject to cost/time overruns in building the plant that could make them uncompetitive.
    • While teething problems with the plants are almost inevitable, the scale/impact is unknowable.
    • They may find themselves at a disadvantage over raw-material supply compared to competitors.
    • Part of their business model is to form Joint Ventures which are a notoriously difficult to make work.
    • They are at risk from “natural” disasters such as fire, flood and pandemics.
    • They are looking at alternative technologies to 24M and could switch entirely.
    • But, Mpac as a supplier rather than a shareholder does not need to worry about excess dilution during normal or rescue fundraisings at FREYR, just that they are ultimately successful operationally.
  • Even if FREYR are successful in commercialising 24M technology, does not mean they will do so using Mpac’s technology:
    • The contract is only firm for the FREYR Customer Qualification Plant (CQP), with only an “option” for larger factories.
    • The announcement does not even say they a sole supplier in the CQP.
    • Mpac may fail to deliver working assembly equipment. The casting part in particular seems a departure from their core competency and they have had contracts go badly wrong in the past.
    • Even if their equipment is first choice for subsequent plants, Mpac are a small company and may not be able to ramp up production quickly enough, leading to another supplier being used.
    • There may be requirements for improvements to the equipment during the transition from CQP to mass-production that Mpac cannot meet.
    • If there is a competitive tender on price then Mpac could be undercut by better funded competitors willing to risk a loss for strategic gain.
  • Even if Mpac’s technology ends up being in Gigafactories, no revenue numbers were given making it hard to estimate the revenue benefit.
  • Even if revenues are material, the gross profit may not be, for example due to interim cost inflation, competitive tendering or overruns.
  • Even if gross profits are material then high marketing or support costs could mean net profits are not.
  • Even if net profits are material then returns on capital may not be due to high capex to produce the machines.
  • Even if returns on capital are high, costs of capital may be higher still, for example if they are forced to raise equity at a low share price.
  • Even if everything goes fantastically well, the management could accept a takeover offer at below intrinsic value.
  • Even if everything goes fantastically well and the share price 100-bags in 5 years, if an individual shareholder overpays for the shares in the first place and/or is forced to sell to raise money for a margin call / personal reasons and/or gets frightened out of the shares by some bad news in the interim, they could still lose money.

So quite a long list. And, according to Leo’s Law of Long Lists, there is sure to be at least one important thing missing from it.

FY Results / AGM Statement

Skipping several updates in the interim, the next important thing to discuss is the most recent annual results and current trading.

Mark and I looked at their 2021 results in detail on Small Caps Live on 17th March. If you have Discord open then you can jump straight to the discussion by clicking here. You will see there was a difference in emphasis, but we both agreed several factors were important.

Trading

Trading was strong with a combination of revenue and margin growth leading to underlying profit before tax of £8.6m, up 36% on 2020. Although this includes some recovery from covid this should not be overstated as: the impact in most of Europe and especially the US did not come until 2-3 months into 2020, they have significant recurring service revenues, were able to introduce remote Factory Acceptance Tests, and they focus on healthcare, food and beverage packaging.

But the really impressive number was the order book at £78.4m versus £55.5m the previous year. The order book entering 2019, 2020 and 2021 was 60%, 62% and 59% respectively of final revenue, whereas for 2022 they have 75% coverage of current forecasts. In the AGM statement a month ago they reiterated that “the current orderbook is significantly above the previous year, providing extensive coverage over forecast revenue.”. As with many such companies right now there are of course risks are around supply chain and costs.

Pension

The company has a pension surplus on the balance sheet as calculated to IFRS standards. Pension accounting is complex, but the fact that Mpac are currently making pension recovery payments should be a common sense indication that the true position is not as rosy as it appears. The reason for the contradiction is that the recovery payments are based on the triennial valuation carried out by the trustees which use different assumptions from that shown on the balance sheet, in particular regarding the discount rate.

Both pension recovery payments (£2.3m) and the administration costs (£1.2m) of running the pension scheme are excluded from the underlying profitability figures.

I have examined this several times before as you can see from my previous coverage, but it is now time for an update, especially given recent developments in interest rates and inflation. I address only the UK scheme as the US is very small in comparison.

Composition

It is important to look at the composition of the assets for two reasons: firstly to determine the impact of stock market falls should they occur, and secondly because actuaries employed by pension fund trustees may consider the expected rates of return for each class of asset when calculating the level of assets required to meet the liabilities.

Here I note since my previous coverage a significant further shift from overseas equities to index linked bonds in 2020, and from other bonds into index linked bonds in 2021. This de-risking may lead to actuaries projecting lower returns, further increasing the deficit relative to IAS 19 calculation used on the balance sheet which uses corporate bond yields.

June 2021 Triennial

A triennial valuation is currently underway and due to report imminently with a valuation date of 30th June 2021, replacing that at 30th June 2018. The bad news is that the value of every long-term assumption has gone in the wrong direction between the two dates: inflation is higher, general discount rates are lower, investments have shifted to lower return assets, and life expectancy is longer. Adjusting the present value of the liabilities from IAS 19 to actuarial by a slightly higher factor than in the past to reflect asset mix, I get to a deficit figure of around £50m, up from £35m last time.

As background, this is what was announced on 11th June 2019:

The actuarial deficit in the scheme has reduced from £69.9m at 30 June 2015 to £35.2m at 30 June 2018 on a technical provisions basis.  The actuarial deficit is now expected to be eliminated in July 2024, compared to August 2029 under the previous valuation.  The current annual deficit recovery payments have been maintained but will now cease more than five years earlier than was agreed under the previous valuation.

What they did not disclose was that (from subsequent annual reports):

The principal terms of the deficit funding agreement between the Company and the Fund’s Trustees, which is effective until 31 July 2024, but, is subject to reassessment every 3 years are as follows:

» the Company will continue to pay a sum of £1.9m per annum to the Scheme (increasing at 2.1 per cent. per annum) in deficit recovery payments;
» if underlying operating profit (operating profit before non-underlying items) in any year is in excess of £5.5m, the Company will pay to the Scheme an amount of 33% of the difference between the annual underlying operating profit and £5.5m, subject to a cap on underlying operating profit of £10.0m for the purpose of calculating this payment; this part of the agreement will fall away in 2021 if the funding deficit is below certain levels; and
» payments of dividends by Mpac Group plc will not exceed the value of payments being made to the Scheme in any one year

With underlying operating profit in 2021 of £8.8m, they are already due to make an additional payment this year of £1.1m, giving a total of £3.1m. With the operating profit forecast to carry on growing in 2023 and 2024 there seems to be plenty of scope for the actuarial deficit, which is likely to have shrunk closer to £40m at the time of writing, to be paid off under the terms of the existing agreement, although if I were the trustees I’d be pushing for some kind of inflation linking on the minimum and maximum amounts.

Outlook

The risk is that investors may remember the (company’s) expectation that the deficit would be eliminated in July 2024 and when they see the latest triennial valuation incorrectly conclude that the deficit is never going to go away. But the reality is that the number of members continues to reduce, discount rates are already rising from unsustainably low levels versus inflation and the asset mix is now largely derisked.

In my view the “profit share” element of the contributions to the pension scheme will start falling away under the already agreed formula within the next 4 years, leaving total pension costs of around £3.2m pa. Longer term my greater concern is that pension administration costs are exceptionally high and growing, amounting to 6.4% of benefit payments in 2021. Unless the company get a grip on this their net present value could easily exceed the pension deficit. In the presentation to the annual report they said: “Further evaluation of options for the scheme to be considered in the context of the next valuation”.

Conclusion

The share price has been weak of late, falling below the lows seen upon the invasion of Ukraine and threats of armageddon in March. A rolling forward PE of 11.0x is reported by Stockopedia with EPS growth of 9-10% for the next couple of years which makes it look superficially good value. Furthermore, current revenue forecasts seem too low – current order book coverage suggests £125m revenue rather than the £105m that Shore (and consensus) forecast – plugging that into a model with similar margins as 2021 gives around 50p EPS for FY 2022.

The trouble is that some element of pension costs definitely need to be adjusted back in. If you subscribe to the “black hole” approach of accounting for pension costs and contributions then that 50p EPS comes down to 25p. This is broadly similar to charging a nominal interest rate of 10% of the likely current actuarial deficit. However, if you net off free cash of perhaps £10m then EPS is back to 30p.

So in conclusion, if you assign negligible value future battery manufacturing (of which more in the next article) then the company appears to be somewhere between fully and over valued [edit: at 420p] relative to the other opportunities currently out there, even taking into account a likely beat of forecasts.

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