Avon Rubber — New CEO marches on

Avon Protection (AVON)

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Avon Rubber — New CEO marches on

Avon Rubber’s strong first half results allayed any concerns that the change in management team might have distracted this growth company from the task in hand. In fact, H117 numbers proved quite the opposite. Top-line growth has marched on apace and the CEO has shown ruthless focus in ensuring that R&D is concentrated on financially viable projects to stimulate further growth. A major new contract win announced yesterday should assuage any concerns about the M50 programme.

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Written by

Avon Rubber

New CEO marches on

H117 results

Aerospace & defence

24 May 2017

Price

1,118.00p

Market cap

£347m

$1.29/£

Net cash (£m) at 31 March 2017

12.6

Shares in issue

31.0m

Free float

96%

Code

AVON

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

9.6

14.6

23.5

Rel (local)

4.6

10.5

2.0

52-week high/low

1,119.0p

812.0p

Business description

Avon Rubber designs, develops and manufactures products in the respiratory protection, defence (71% of 2016 sales) and dairy (29%) sectors. Its major contracts are with national security and safety organisations such as the DoD. 86% of sales are from the US and 14% are from Europe.

Next events

FY17 results

5 December 2017

Analysts

Alexandra West

+44 (0)20 3077 5700

Roger Johnston

+44 (0)20 3077 5722

Avon Rubber is a research client of Edison Investment Research Limited

Avon Rubber’s strong first half results allayed any concerns that the change in management team might have distracted this growth company from the task in hand. In fact, H117 numbers proved quite the opposite. Top-line growth has marched on apace and the CEO has shown ruthless focus in ensuring that R&D is concentrated on financially viable projects to stimulate further growth. A major new contract win announced yesterday should assuage any concerns about the M50 programme.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

09/15

134.3

19.8

56.1

7.3

19.9

0.7

09/16

142.9

21.6

74.2

9.5

15.1

0.8

09/17e

168.9

25.0

66.6

11.0

16.8

1.0

09/18e

178.7

26.9

71.4

13.0

15.7

1.2

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

Strong top-line growth and order intake

H117 results demonstrated that Avon Rubber is successfully delivering on its strategy of growing organically through good execution and strategic acquisitions. Revenue was up 7% organically, with flat margins despite slightly higher costs. EPS was flat year-on-year, but this is purely a function of an anomalously low tax charge in FY16 of 1%. The tax rate for FY17 is expected to normalise at 19%. Orders were up 9% y-o-y and we expect further contract wins in the second half.

Shift in mix at Protection & Defence as Dairy rebounds

There is a subtle shift in mix of customers and products in Protection & Defence. The sole-source M50 respirator contract with the US Department of Defense (DoD) is due to end in 2019 and volumes were lower this year, as expected. The proportion of the division’s revenues from the DoD has therefore fallen from 56% in H116 to 50% in H117. Sales to EMEA and North America have increased, as, importantly, have sales of fire products following the acquisition of Argus. Avon is increasingly focused on more sophisticated mask systems, which have a higher selling price. In addition, the FY18 US defence budget, which was released yesterday, looks promising for Avon as it raises troop numbers. Dairy has benefited from a rebound in the milk price, which is leading to farmers investing in their facilities again. The Farm Services model is progressing well and the roll-out of the tag exchange has been brought forward to the second half of the year.

Valuation: At a justified premium to its peers

Avon Rubber is trading on 19.1x FY18e EPS compared to its aerospace and defence peers, which are trading on an average of 17.7x. However, we believe, this 8% premium is justified due to Avon’s higher levels of growth (6% EPS CAGR over the next four years) and significant exposure to US defence and commercial markets. The M50 contract announcement yesterday is tangible evidence of future growth potential in new markets.

Robust first half with strong order intake

The interim results for FY17 showed that Avon Rubber has not suffered during this period of management transition, and that new CEO Paul McDonald has hit the ground running:

Revenue increased 7% at constant currency year-on-year to £81.1m (2016: £66.3m), while adjusted operating profit increased 6% to £10.9m (2016: £9.0m) at an operating profit margin of 13.4% (2016: 13.6%). The 20bp decrease is attributable to the group absorbing £0.3m of additional amortisation, £0.3m of additional impairment charges and a £0.2m increase in corporate costs.

Adjusted PBT increased 7% to £10.7m (2016: £8.8m). The basic adjusted EPS was flat year-on-year at 28.7p due to a tax rate of 19% compared to 1% last year. Last year’s rate was anomalous due to a one-off tax credit and management has guided that 19% is a more normalised level.

Operating cash conversion remained strong for the period at 103% of EBITDA (2016: 111%). Net cash was £12.6m, which is £10.6m higher than at the end of FY16 partly because capex has been slightly lower this half at £2.7m (H116: £3.8m). This is due to the new CEO taking a more focused approach to R&D spending, targeting opportunities with the highest returns and halting a number of programmes that he felt were too risky and/or commoditised, for example the tank pad.

With the robust performance and sustained growth opportunities, the board increased the interim dividend by 30% again to 4.11p (2016: 3.16p), continuing the trend witnessed over the past four years. The payout ratio of 7.0x is more than comfortable, but the board is showing no inclination to increase it at this moment in time. This implies that the company wants to retain its firepower to make acquisitions.

Order intake was strong, increasing 9% to £90.7m (2016: £73.4m) In Protection & Defence, 60% of the closing order book is for delivery in the second half of FY17, giving good visibility.

Protection & Defence: Diversification of the customer base

Revenue was 6% higher at £55.9m (2016: £45.7m) and underlying operating profit was £8.0m at an operating margin of 14.3% (2016: 14.3%). Interestingly, the shift in mix we saw last year continued, with only 50% of the division’s sales going to the DoD compared to 56% in H116. This is partly due to lower DoD sales. However, it is mainly attributable to strong growth in Fire, where the acquisition of Argus appears to have been a success, and higher sales to EMEA and North American markets (see Exhibits 1 and 2).

Exhibit 1: Protection & Defence revenue split by market H117

Exhibit 2: Protection & Defence revenue split by market H116

Source: Avon Rubber H117 results presentation

Source: Avon Rubber H117 results presentation

Exhibit 1: Protection & Defence revenue split by market H117

Source: Avon Rubber H117 results presentation

Exhibit 2: Protection & Defence revenue split by market H116

Source: Avon Rubber H117 results presentation

M50 respirator: sales of the JSMPG M50 were lower as expected at 93,000 mask systems (2016: 107,000). This long-term, sole-source contract continues to underpin the division and a further order for 131,000 units provides management with good visibility for the next 12 months. The contract states a total service requirement of between 2-3m mask systems. We estimate that Avon has supplied approximately 1.8m to date. However, this contract comes to an end in 2019, and the DoD has stated it could potentially look to dual-source its gas masks in the future. Management believes that in the future it will receive a contract to sustain stocks of the FM50 at the required levels, and while this will mean volumes will be lower, the price per unit is expected to be higher. President Trump’s FY18 defence budget released yesterday proposed a 4% increase (38,000 troops) in the US Army’s end strength to 1.018 million. This raises the possibility that Avon may also receive some additional orders as respirators are personal issue kit.

Move towards higher price products: Avon is increasingly focusing on premium respirators. It sees significant opportunities materialising for the M53A1, which retails at $1,500-2,000 per mask, and the ST53, which retails at up to $7,000 per system. Management seems confident that these higher-end products will help offset the reduction in the M50 programme.

Export orders: Avon Rubber has been involved in protracted discussions with Middle Eastern customers over the past couple of years and last week stated that it expected to receive orders from Middle Eastern customers in H217. Yesterday, the company announced a contract to supply 37,000 FM50 respirators and associated spares and accessories to an unnamed customer, which equates to c £8m of revenue expected in H118. This shows positive order momentum in defence export markets and the statement from last week suggests we can expect to see more contract wins in the second half of FY17. The company is also pursuing selling lower-tech masks to customers such as India where ‘in-country’ production and price are more important than cutting-edge technology. This could potentially lead to upselling opportunities to Special Forces.

Growth in Fire market sales: the acquisition of Argus has been a success. Fire sales are now being led with the Thermal Imaging camera product range (Mi-TIC). There has also been organic growth in sales of the Deltair self-contained breathing apparatus.

Dairy: Higher milk price drives higher sales

Trading conditions have markedly improved for the Dairy division in H117 following the improvement in the milk price. Revenue was up 7% at £25.2m (2016: £20.6m) and operating profit was £4.0m (2016: £3.4m) at an operating margin of 15.9% (2016: 16.5%). The 60bp decline in the margin is attributable to higher depreciation of the cluster equipment and some overhead growth as sales increase. Dairy farmers have increased their capital expenditure, which has led to further growth from the range of InterPuls products.

Less dependence on OEMs: the acquisition of InterPuls has reduced Avon’s reliance on OEMs. Own brand sales are higher margin and give the business strategic independence.

Accelerated expansion in Farm Services: the Cluster Exchange Service business is growing well in North America and Europe. The Pulsator Exchange pilot was successful in North America in H117 and so the decision has been taken to accelerate its launch, which will now take place in the second half of the year. The Farm Services model should lead to a more robust and sustainable business model that is less susceptible to fluctuations in the milk price.

Potential remains in emerging markets: the number of cows being milked using automated processes is growing in emerging markets. A portion of the higher central costs is attributable to the sales and marketing efforts in these areas, where business is relationship based and so having the best teams in place is crucial.

A strengthened management team

New CEO Paul McDonald has been busy during his first three months. He immediately appointed new divisional heads, with Leon Klapwijk assuming responsibility for Protection & Defence and Craig Sage heading up Dairy (Mr McDonald’s previous role). These internal promotions left a void in the tier two management, which has now been strengthened by external hires from competitors. The new head of EMEA sales & marketing for Protection & Defence comes from Scott Safety, the sole-source provider of gas masks to the UK MoD. The new head of Farm Services comes from a competitor, which should help Avon plan how to best exploit its position in a competitive market. The newly appointed finance director, Nick Keveth, starts on 1 June and will have a two-month handover period with Paul Rayner, the interim FD.

It is to Mr McDonald’s and Mr Rayner’s credit that they have managed to deliver such a strong set of results during this transition period for the company. While the CEO is new to the role, he has been at Avon Rubber for 15 years. He gave the impression at the results meeting that he is clear about where the company should be focusing and that he is relishing his new-found responsibilities.

Positive US defence budget with troop uplift

President Trump released his FY18 defence budget yesterday. It confirmed that US defence spending is on an upward trajectory, which is positive for the defence industry as a whole, and of course for Avon Rubber; the DoD is Avon’s key customer, providing 37% of FY17 revenue. President Trump has requested an FY18 base budget of $574bn, which is 3% higher than Obama’s previous request, and he has requested $65bn of Overseas Contingency Operations (OCO) funding. The request for 38,000 additional Army personnel is positive for Avon because, as noted earlier, this may lead to the requirement for more FM50 respirators.

It is important to note though that for the president to set a defence budget at these levels, he needs to repeal the 2011 Budget Control Act, which enforces spending caps. The level of compromise shown by the House and Senate to pass the recent omnibus spending bill for 2017 suggests that Congress may be in a mindset that could see it finally reaching an end to sequestration.

Exhibit 3: US defence budget

Source: US FY18 budget and FY17 DoD Green Book

Small upgrades due to order momentum despite higher costs

Management does not give quantitative guidance, but said yesterday that it is confident in meeting its expectations for the full year. We have adjusted our FY17 revenue expectations to reflect better than expected growth in Protection & Defence, and tempered our expectations in Dairy slightly, resulting in a 0.8% increased at the group level. We have raised our FY18 revenue estimate by 1.3% to reflect the order momentum in Protection & Defence. In both years our margin expectations have remained broadly unchanged, although central costs are slightly higher as guided by management due to a higher spend on sales and marketing.

Our net cash figure is slightly lower due to the newly agreed payment scheme to service the pension following the triennial valuation. The group has agreed to increase its contributions to £1.5m per year from £0.7m, starting from 1 April 2017.

Exhibit 4: Estimate revisions

Year to September (£m)

 

2017e

2017e

 

2018e

2018e

 

Prior

New

% change

Prior

New

% change

Protection & Defence

113,027

118,073

4.5%

116,418

122,796

5.5%

Dairy

54,557

50,780

-6.9%

60,013

55,858

-6.9%

Total sales

167,584

168,853

0.8%

176,431

178,654

1.3%

 

 

 

 

 

 

Protection & Defence

17,632

18,656

5.8%

18,627

19,647

5.5%

Dairy

9,380

8,734

-6.9%

10,317

9,608

-6.9%

Other

(2,000)

(2,200)

-10.0%

(2,000)

(2,200)

-10.0%

Total operating profit

25,012

25,190

0.7%

26,944

27,055

0.4%

 

 

 

 

 

 

EPS normalised (p)

66.2

66.6

0.6%

71.1

71.4

0.4%

DPS (p)

11.0

11.0

0.0%

13.0

13.0

0.0%

Net cash/(debt)

19,529

19,080

-2.3%

36,564

35,216

-3.7%

Source: Edison Investment Research

Valuation

Trading at a justified premium to its peers

Avon Rubber is currently trading on 19.1x FY18e EPS, which places it at an 8% premium to its peers in the aerospace and defence sector, where the average is 17.1x. However, the company has higher than average growth due to its high levels of exposure to the US DoD and growing commercial markets. It also has excellent order momentum, as demonstrated by the defence contract announcement yesterday.

Exhibit 5: Financial summary

Year end 30 September

£000s

2013

2014

2015

2016

2017e

2018e

PROFIT & LOSS

IFRS

IFRS

IFRS

IFRS

IFRS

IFRS

Revenue

 

 

124,851

124,779

134,318

142,884

168,853

178,654

Cost of Sales

(91,140)

(83,264)

(88,618)

(90,159)

(106,545)

(112,730)

Gross Profit

33,711

41,515

45,700

52,725

62,308

65,924

EBITDA

 

 

20,440

23,164

26,586

30,808

35,718

36,873

Operating Profit (before amort. and except.)

 

 

14,223

17,003

20,215

21,763

25,190

27,055

Amortisation of Intangibles

(417)

(261)

(1,043)

(3,307)

(3,000)

(3,024)

Exceptionals

(383)

(2,017)

(604)

(506)

0

0

Other

(420)

(400)

318

(320)

(400)

(400)

Operating Profit

 

 

13,003

14,325

18,886

17,630

21,790

23,631

Net Interest

(347)

(274)

(147)

(154)

(150)

(150)

Other finance costs

(253)

(187)

(247)

(33)

0

0

Profit Before Tax (norm)

 

 

13,656

16,554

19,821

21,576

25,040

26,905

Profit Before Tax (FRS 3)

12,403

13,864

17,838

16,801

21,640

23,481

Tax

(3,566)

(3,053)

(2,672)

1,824

(4,869)

(5,283)

Tax adjustment

(122)

(450)

(253)

(924)

0

0

Profit After Tax (norm)

 

 

9,968

13,051

16,896

22,476

20,171

21,622

Profit After Tax (FRS 3)

8,837

10,811

15,166

18,625

16,771

18,198

Average Number of Shares Outstanding (m)

29.5

29.9

30.1

30.3

30.3

30.3

EPS - normalised (p)

 

 

33.8

43.7

56.1

74.2

66.6

71.4

EPS - continuing, FRS 3 (p)

 

 

30.0

36.2

50.4

61.5

55.4

60.1

DPS (p)

4.3

5.6

7.3

9.5

11.0

13.0

Gross Margin (%)

27%

33%

34%

37%

37%

37%

EBITDA Margin (%)

16%

19%

20%

22%

21%

21%

Operating Margin (before amort. and except.) (%)

11%

14%

15%

15%

15%

15%

BALANCE SHEET

Fixed Assets

 

 

36,928

36,815

74,095

85,244

81,639

79,146

Intangible Assets

16,541

17,240

41,309

47,357

47,734

48,283

Tangible Assets

20,387

19,575

28,212

30,112

26,130

23,088

Other

0

0

4,574

7,775

7,775

7,775

Current Assets

 

 

34,449

34,971

34,481

45,111

59,828

78,330

Stocks

13,374

12,887

17,123

20,648

19,811

20,960

Debtors

20,891

19,159

17,026

19,968

20,938

22,153

Cash

184

2,925

332

4,495

19,080

35,216

Assets held for sale

0

0

0

0

0

0

Current Liabilities

 

 

(23,369)

(26,453)

(27,178)

(36,641)

(32,652)

(33,970)

Creditors

(17,296)

(19,601)

(18,005)

(24,185)

(22,695)

(24,013)

Short term borrowings

0

0

(2,350)

(2,499)

0

0

Tax

(6,073)

(6,852)

(6,823)

(9,212)

(9,212)

(9,212)

Other

0

0

0

(745)

(745)

(745)

Long Term Liabilities

 

 

(27,312)

(20,317)

(39,194)

(51,713)

(51,713)

(51,713)

Long term borrowings

(11,059)

0

(11,143)

0

0

0

Deferred Tax

(2,977)

(2,315)

(9,734)

(10,007)

(10,007)

(10,007)

Retirement benefit obligations

(11,279)

(16,029)

(16,605)

(39,951)

(39,951)

(39,951)

Provisions

(1,997)

(1,973)

(1,712)

(1,755)

(1,755)

(1,755)

Other

0

0

0

0

0

0

Net Assets

 

 

20,696

25,016

42,204

42,001

57,102

71,793

CASH FLOW

Operating Cash Flow

14,708

25,004

20,446

31,680

32,896

34,225

Net Interest

(364)

(314)

(147)

(309)

(150)

(150)

Tax

(2,229)

(2,903)

(3,270)

(1,031)

(4,869)

(5,283)

Capex

(11,054)

(6,815)

(6,183)

(6,838)

(6,923)

(7,325)

Acquisitions/disposals

(437)

(31)

(21,228)

(3,250)

0

0

Equity financing

(1,765)

0

(1,152)

(1,812)

(1,000)

(2,000)

Dividends

(1,132)

(1,422)

(1,859)

(2,430)

(2,870)

(3,330)

Net Cash Flow

(2,273)

13,519

(13,393)

16,010

17,084

16,136

Opening net (debt)/cash

 

 

(8,725)

(15,937)

2,925

(13,161)

1,996

19,080

Cash FX effect

123

281

97

(853)

0

0

Discontinued operations / relocation

0

0

0

0

0

0

Debt FX and Other

(5,062)

5,062

(2,790)

0

0

0

Closing net (debt)/cash

 

 

(15,937)

2,925

(13,161)

1,996

19,080

35,216

Source: Edison, company accounts

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US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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RedHill’s Q117 business update described steady progress on both fronts: the R&D pipeline and planned commercialisation of the two products for gastrointestinal (GI) diseases via co-promotion or in-licensing deals. The initiation of promotional activities is expected in Q217 and data readouts from two mid- to late-stage clinical trials in Q2/Q317 will provide inflection points this year. Our valuation is slightly higher at NIS1.40bn ($378m).

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