Will the Market Close the Gap on this Small Cap’s Valuation?

Will the Market Close the Gap on this Small Cap’s Valuation?

27 Jun, 2024 | Stock Insight

Often the market will present an opportunity where a high quality company’s true value isn’t reflected in its share price.

“In the short run, the market is a voting machine, but in the long run it is a weighing machine”.

A famous quote from Benjamin Graham. The quote highlights that in the short term, market prices fluctuate due to investor emotions and external events, creating potential mispricings. Over time, however, the true value of a company, based on its financial health and performance, becomes apparent. Thus, despite short-term volatility, long-term investors benefit by focusing on intrinsic value.

Another take from legendary investor Peter Lynch on market valuation:

“The stock market is filled with individuals who know the price of everything, but the value of nothing.”

Lynch considered that many market participants focus solely on stock prices without understanding the underlying business’s true worth. Individuals react to market trends and price movements rather than analysing a company’s fundamentals. Consequently, they miss the real value and potential of the investments, leading to misinformed decisions based on superficial metrics.

We’ve written about Close the Loop Group (ASX: CLG) here, we feel that this could be the best risk reward investment on the ASX.

The Business

As a refresher, Close the Loop Group (CLG) is a sustainability solutions company operating in the circular economy space.

It has two main divisions: Packaging (30% of revenue) and Resource Recovery (70%). The company specialises in manufacturing reusable packaging products, collecting and recycling printer cartridges, and repurposing electrical items such as notebooks, printers, gaming consoles etc for Original Equipment Manufacturers (OEM’s) like HP (NYSE: HPQ). CLG operates globally, with a presence in Australia, the US, Europe, and South Africa.

CLG has continued to make significant strides globally, particularly in the US market. Having acquired ISP Tek Services in 2023, CLG has strengthened its position in the electronics repurposing sector. This acquisition is seen as a key growth driver for the group, offering opportunities to expand work with major OEMs and other manufacturers in the future. CLG continues to explore new opportunities across the US, EU, and Middle East, with plans to establish a new IT refurbishment facility in Mexicali, Mexico, by October 2024.

The company has broadened its product range beyond its original focus on ink and toner cartridges. The company has developed innovative products such as TonerPlas® (an asphalt additive) and rFlex (a plastic resin made from post-consumer soft plastic). These new offerings have opened up additional revenue streams and market opportunities in the sustainable materials sector.

Why Close the Loop is Attractive?

There is an enormous opportunity in the global waste reduction market.

CLG has established a significant number of relationships with the largest OEMs for printer cartridge collection and recycling (300,000 global collection points). In the electronics space, CLG’s subsidiary ISP Tek is a valued partner for HP’s Renew business, which aims to minimise waste while generating commercial returns. Renew Solutions, established by HP in 2023, sells refurbished computers and printers through select partners. In April 2024, HP expanded its Certified Refurbished PC program to the US, Australia, the UK, the UAE, and other regions. ISP is one of a few certified partners and holds an exclusive three-year contract for North America.

This positions CLG to benefit from the increasing focus on sustainability and circular economy principles. For example, HP alone sells over 40 million notebooks pa whilst currently CLG only refurbishes less than 500k pa. We believe there’s a huge opportunity to expand their share and double the revenue from this division by expanding into 1, 2 and 3 year old products under warranty.

So far CLG has demonstrated impressive financial results and growth prospects whilst under promising and over delivering.

The company almost doubled revenue and net profit after tax (NPAT) in FY23. In addition, CLG at the 1H FY24 result has upgraded FY24 revenue to over $200 million, operating earnings of $44-46 million and NPATA of $26 million, reflecting continued growth. The continued synergies developed from recent acquisitions and further organic growth gives us confidence that further revenue growth and operating earnings expansion is achievable in the upcoming financial years.

Often companies that fall under the sustainability theme receive a ‘green premium’ and can often still be traded on potential while building a revenue base and operating at a loss.

CLG is a profitable business and generates healthy operating and net free cash flow. We expect this to continue in the coming years. While the company does have an expensive debt structure following its acquisitions we are hopeful it will be able to refinance this debt in the future on more favourable terms which could add $2 million to the profit line. From a net debt perspective, CLG net debt at the half was only $24 million or 0.5x Ebitda. We estimate a net cash position within 6-9 months as the company generates strong cashflows.

From a valuation standpoint we believe CLG is significantly undervalued.

On the forecast 2024 full year results the company will generate 4.9 cents in Cash EPS versus a share price of 32 cents. CLG trades on a PE multiple of 7x and EV/Ebitda of only 4x. On this multiple we believe the market does not fully appreciate CLG’s potential. Given the recent revenue growth and market potential we feel this is extremely low. Recent M&A in the sector was completed on 10x Ebitda (TES 2022).

Once the markets begin to appreciate CLG we feel there is an opportunity for multiple expansion and significant share price appreciation. Management’s aspirational target is $500 million of revenues in 2-3 years with current Ebitda margins of 20%+ this could potentially yield $100 million of Ebitda at that point. This will require good execution by the board and management, who combined, own 45% of the company and hence are completely aligned and incentivised to create shareholder value.

The TAMIM Takeaway

In our opinion CLG’s depressed valuation and a lack of understanding by investors about the business and opportunity represents the best risk reward investment currently on the ASX.

The company’s growth trajectory, impressive financial performance, and tailwinds of the circular economy sector makes it an attractive investment. As the market increasingly values sustainability and circular economy principles, CLG is well-placed to benefit from this trend. Should the strategic acquisitions continue to provide synergies we expect continued earnings growth providing even more value at the current share price. The company’s innovative products and expanding global footprint, underscore its potential for continued success.

Investors seeking a high-quality, undervalued company with significant growth potential should consider CLG a promising candidate.


Disclaimer: Close the Loop Group (ASX: CLG) is currently held in TAMIM Portfolios. 

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