Close the Loop (ASX:CLG) listed on the ASX for 20 cents per share in December 2021 and currently has a share price of 36 cents rewarding investors lucky enough to participate in the IPO. The stock has some qualities which mark it out for further high potential returns, but whether these eventuate will depend on successful strategy and execution – topics I will be exploring in more detail in the remainder of this article.
The listing was a merger of two separate businesses, Close the Loop and O F Packaging Group, representing two parts of what management refers to as the “Circular Economy ”.
The first business, Close the Loop, is a recycler of printer cartridges and provides services to major global printer OEMs with a presence in Australia, the US and Europe. It also provides battery, cosmetic and soft plastic recycling services to retailers and promises zero waste to landfill. It operates on a fee per volume of per weight model.
The second, O F Packaging Group, engineers sustainable flexible packaging for the food, household products and horticultural industries and operates out of Australia and South Africa.
The strategy of the combined group is focused around trends towards sustainable consumption. Alignment with these forces is prudent, although I question the sustainability of outsourcing production from China and then distributing it globally as is the case within the O F Packaging Group.
Most of the group’s other activities do appear to be helping to protect and preserve the environment and so on balance I can accept that Close the Loop is part of the solution as it claims. Such activities include localised recycling and utilisation of easy to recycle plastics within the packaging businesses.
There is some genuine innovation going on too, as evidenced by the development of products such as TonerPlas, a patented asphalt derivative made from soft plastics and waste toner used to construct roads. TonerPlas improves the durability and decreases maintenance of roads and is currently being used on projects by major engineering firm Downer EDI Ltd (ASX:DOW). Revenue generated by TonerPlas is not broken out in the accounts so is likely to be fairly immaterial at this stage.
Close the Loop has developed a number of other innovative solutions including award winning designs for its soft packaging and rFlex, an injection moulded plastic technique using hard to recycle soft plastic waste.
Group gross margins were 33% in the first half of 2023 which is not suggestive of a high IP business in general, but is somewhat higher than listed packaging peer Amcor PLC (ASX:AMC) at 18%. Then again, perhaps the niches where Close the Loop operates are simply yet to attract significant competition and this may change if market growth forecasts are realised.
In just over a year since listing, Close the Loop has made a number of small-scale acquisitions. These include seafood packaging company Oceanic Agencies, bulk packaging company Crasti & Co, thermal paper company Alliance Paper, niche South African packaging company The Pouch Shop and US industrial scrap recycler In-Plas. These were all purchased at low prices of never more than single digit profit multiples.
I have reservations regarding the handling of one of the acquisitions – that of The Pouch Shop. Close the Loop’s IPO prospectus documented the business as being part of O F Packaging Group and therefore I thought it should have been included in the original merger at the time of IPO. As per section 2.4 of the prospectus:
“Upon completion of the Merger, the business will provide a full range of product development, R&D, manufacturing and recycling services through a number of divisions: specialised flexible packaging through O F Pack; digital printing and pouch manufacturing through The Pouch Shop (TPS); flexographic printing and bag converting through O F Flexo; bag closures through Inno Bag; resource recovery, recycling, reuse and waste services through O F Resource Recovery, and sustainability solutions specialising in Post‑Consumer Recycling (PCR) through Close the Loop with operations in Australia, the US and Europe.”
However, this did not happen and the acquisition subsequently took place a year later with the news tucked away in an announcement about an HP China trial on 19 October 2022. From that announcement:
“Close the Loop has also acquired The Pouch Shop, a niche provider of ready-to-label packaging and pouches for food products in South Africa. The Pouch Shop is the largest stockist of off the shelf readymade pouches in Southern Africa. The company, which is majority owned by CLG Executive Director, Joe Foster, was due to be incorporated in the original IPO. However, due to COVID travel restrictions all due diligence on site was not able to be performed last year.”
As per the above, the deal didn’t happen at IPO due to Covid preventing adequate due diligence. This did not stop 70% owner of The Pouch Shop prior to acquisition, Joe Foster (also CEO of Close the Loop), receiving his full consideration of 64 million shares for his holding of O F Packaging Group as documented in the prospectus:
And, from section 9.4 of the prospectus it is clear that this represents the total consideration for the merger:
“In order to give effect to the Merger, 100% of the consideration payable by the Company under the Acquisition Agreements is payable to the OFP Group Vendors via the issue of Shares following completion of the Offer.”
So it seems to me that he has now received or is due to receive his share of $700,000 additional consideration for the company as per the 19 October announcement:
“Purchase price: 2.66 times the sustainable earnings being R3,000,000. The purchase price will be R8,000,000 (A$701,000) plus stock on hand, less an amount equal to what is owed to trade creditors.”
The transaction consideration was confirmed in the subsequent 2023 half year report:
Sure, Close the Loop managed to outperform prospectus forecasts regardless and this amount is small relative to the value of the remainder of O F Packaging Group, but to my mind there remains a question of principle here. I asked the company for clarification, but have not yet received a reply.
Most recently, Close the Loop acquired US based electronics refurbisher ISP Tek and Captive Trade for up to US$66 million via a $45 million capital raise at 33 cents and a new US$52.5 million debt facility. The transaction is expected to be a whopping 100% earnings-per-share (EPS) accretive and effectively doubles the revenue base of the group.
In addition, there are potential synergies from the latest deal in terms of offering a greater range of services to OEMs already serviced by the print cartridge business. Also, ISP Tek currently only operates in the US and management reckons that it can leverage its European, African and Australian footprints to expand the business internationally.
I can’t help wondering if electronics refurbishment was temporarily boosted by the global chip shortage and note the earnout component of the deal is minor at just US$5 million. ISP Tek enjoyed very strong growth from 2021 to 2022 with revenue increasing 53% to US$49 million. For that growth rate to be sustainable, you would expect the price of the deal to be higher than the five times normalised 2022 earnings which Close the Loop is paying.
As we can see, Close the Loop is moving quickly in its quest to dominate the global “Circular Economy”, and that concerns me a little. Acquisitions take time to bed in and the transformational variety of the type that ISP Tek represents are fraught with risk. Roll-up strategies can sometimes generate huge shareholder value, but these tend to be those that are done in a careful, steady and disciplined manner.I am yet to be convinced that we are seeing this here.
Furthermore, it is not clear that the “Circular Economy” is a coherent concept around which to base a business strategy. Close the Loop could simply be accumulating a collection of vaguely similar businesses with few genuine synergies that becomes increasingly complex to manage as it grows. On the other hand, maybe the benefit of the doubt is due, given the “Circular Economy” is still in its infancy and undergoing rapid evolution.
Either way, there do appear to be certain genuine synergies available such as within distribution. Close the Loop currently operates 60,000 recycling collection points across Australia and a further 200,000 in the US. If it can expand the variety of products which it can collect for recycling from these locations, then it has the basis for a scale advantage. To some extent this is already playing out, given Close the Loop collects batteries, soft plastics, cosmetics and print cartridges.
There is also a risk that Close the Loop is attempting to “boil the ocean” by expanding so broadly geographically. Global packaging peers count their revenue in the tens of billions of dollars versus roughly $200 million for Close the Loop, post completion of the ISP Tek/Captive Trade deal.
However, given the pre-existing Close the Loop business already had extensive operations in the United States, perhaps it does make sense to try and extract further value from this network, via international expansion, even at this early stage.
The group’s international footprint is poised to grow further still, having won a pilot contract in China with HP for its print cartridge recycling services at the end of last year. In this way, Close the Loop’s existing multinational OEM customers pull it into new markets.
Close the Loop delivered a strong set of results for the first half of 2023. Revenue increased 44% to $58.6 million, underlying net profit before tax was up 32% to $6.6 million and free cash flow was $3.7 million. Underlying figures are adjusted for acquired amortisation which is reasonable.
At 31 December 2022 the group balance sheet was fairly solid with $13.2 million cash offsetting borrowings of $14 million and current assets of $51.5 million covering total liabilities of $49 million. Post the ISP Tek deal, borrowings will jump to $92.6 million versus $56 million cash giving a net debt position of $36.6 million. This is 0.85 times pro-forma historical earnings before interest, tax, depreciation and amortisation (EBITDA) of $43.2 million which is not high assuming there is no dramatic drop-off in performance due to the unwinding of chip shortages.
There are very few good listed businesses which are helping to solve our vast environmental challenges. The rewards on offer to such businesses are substantial and so I think Close the Loop is worth keeping an eye on. This is despite my nagging doubts regarding the handling of The Pouch Shop transaction and the rapid pace of strategy execution. The fact remains that the business outperformed its prospectus forecast for financial year 2022 and delivered significant further improvement in the first half of 2023. It also has defensive characteristics (with the exception of a potential covid boost at ISP Tek) and so could well continue to outperform for investors.
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Disclosure: neither the editor (Claude Walker) nor the author (Matt Brazier) of this article own shares in CLG, and neither will trade shares in CLG for at least 2 days following the publication of this article. This article is not intended to form the basis of an investment decision and is not a recommendation. Any statements that are advice under the law are general advice only. The author has not considered your investment objectives or personal situation. Any advice is authorised by Claude Walker (AR 1297632), Authorised Representative of Equity Story Pty Ltd (ABN 94 127 714 998) (AFSL 343937).
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