Solid State — Update 29 November 2016

Around two-thirds of the group’s revenues are derived from the Manufacturing division (Steatite). This supplies mission-critical systems including rugged and industrial computers, custom lithium battery packs, secure mobile communication systems, antennae and subsystems for deployment in harsh and demanding environments, where it is imperative that the system does not fail. Around three-quarters of divisional revenues are derived from projects where some level of customisation is needed to fulfil the customer specification. Steatite’s extensive experience of delivering secure, ruggedized systems for harsh environments, backed by a range of aerospace and defence approvals and the ability to provide security-cleared personnel and a secure environment provides significant barriers to entry. Around one-third of revenues are from its value-added distribution division (Solid State Supplies). This specialises in high-reliability components, primarily for defence and aerospace applications. The distribution operation is differentiated from volume component distributors by the level of technical support and range of value-added services it provides, for example device programming, sourcing and obsolescence solutions.

Group revenues declined by 9% to £20.1m during H117 as c £3.5m revenues from the mobilisation phase of the MoJ contract in H116 were partly offset by four months of revenues (£1.7m) from Creasefield in H117. Reported pre-tax profit grew by 10% to £1.6m reflecting the contribution from Creasefield and the beneficial impact of the precautionary cost-cutting programme that took place during H116 in recognition of a general weakening in markets. The first half progress supports the assumptions underpinning our estimates, which we leave unchanged. We note that the group’s order backlog has reduced from £17.8m at end May 2016 to £14.8m at end September 2016. This reflects the sterling weakness caused by the Brexit referendum. Customers of the Distribution business are continuing to purchase the same volume of components each month, but are now placing orders for a six- or nine-month period rather than 12 months as they did previously.

A comparison of Solid State’s prospective share price multiples with its listed peers shows it is trading at a discount to the mean of our sample of manufacturing companies and the mean of our sample of added-value distribution companies with regards to most metrics. Our sum-of-the-parts analysis, which looks at both specialist manufacturing and value-added distribution companies, gives an indicative valuation range of 445-495p/share based on target EV/EBITDA and P/E multiples derived using sector averages (previously 505p/share based on peer group P/E).

The key risk to Solid State is on the distribution side and its franchisors switching to other distributors or deciding to sell direct. The level of technical expertise required to sell sophisticated products and the time taken to educate distributors and for them to build up customer relationships means that franchisors are reluctant to switch distributors unless their sales performance is unsatisfactory. In addition, Solid State is vulnerable to delays in awarding government contracts, to unforeseen changes in standards such as the AS9120 aerospace distribution and AS9100 aerospace manufacturing standards, and to exchange rate fluctuations. Management does not expect Brexit to have a material impact, although demand on the distribution side will be affected by any potential weakening in UK manufacturing resulting from more expensive imports.

Solid State was established in 1971 as a components distributor and listed on AIM in 1996. It has grown both organically and through acquisition, building up its own design capability and engineering expertise, especially in the creation of ruggedized systems and subsystems for use in harsh environments. Around two-thirds of revenues are derived from the Manufacturing division (Steatite), which supplies mission-critical systems including rugged and industrial computers, custom lithium battery packs, secure mobile communication systems, antennae and subsystems suited to harsh environments. Around one-third of revenues are from its value-added distribution division (Solid State Supplies). Management estimates that over 85% of group business is based on high-margin custom designs that meet demanding customer requirements. Management’s strategy is based on top-line growth through selective acquisitions, the development of new products and entry into new industry verticals, combined with margin improvement through focus on value-added design and assembly capability and development of own-brand products.

The group’s headquarters and operating businesses are located at five sites in the UK. Steatite and Solid State Supplies share a 50,000sqft site in Redditch. The group employs around 200 people.

Steatite has an international customer base that includes Amey, Astrium, Atos, BAE Systems, the BBC, GE, Indra, NASA, QinetiQ, Synectics and Thales. It is a tier 1 supplier to some of the UK’s largest companies in the defence, broadcast, security, transportation and industrial sectors and an approved supplier to the UK MoD and other government authorities. Distribution customers include BAE, Honeywell Aerospace, Rolls-Royce, Thales and Ultra Electronics.

The Steatite Manufacturing division aims to offer a one-stop-shop service for customers requiring specialist computing devices, battery packs and secure communications systems for deployment in harsh and demanding environments where it is imperative that the system does not fail.

At least three-quarters of divisional revenues are derived from projects where some level of customisation is needed to fulfil the customer specification. For a fully customised product, such as a battery pack for downhole drilling, Steatite will design a complete new system right down to individual circuit boards. For a semi-customised solution, such as a military communications system, a touchscreen computer for a nurse’s cart or a PC for use in an explosive environment or a food processing plant, Steatite integrates off-the-shelf product with some customised elements such as ruggedized casings designed in-house. This off-the-shelf product may be sourced from third parties, eg Persistent Systems and ViaSat, or from Steatite’s own branded ranges such as its ndura RUGGED brand ruggedized computing and peripheral products and Qpar antenna positioners. Steatite also offers service and repair contracts over the lifetime of products and design consultancy. For those revenues where no customisation is required, Steatite advises the customer on product choice and integration and may provide support during product deployment. By providing this level of service, Steatite effectively becomes an extension of the client’s own design team, making it difficult for a potential competitor to displace it.

The markets served have particularly onerous regulatory requirements. Steatite advises customers on compliance with CE, UK DEF STAN, American MIL-STD, NATO STANAG and UK, European and American TEMPEST requirements. It is able to provide systems that have been pre-certified for use in rail, marine, medical, sub-station, explosive and in-vehicle applications, thus speeding up product certification and reducing time-to-market for the customer. As part of the offer for bespoke mobile and static communications, it is able to provide enhanced drive encryption, which gives greater security of data. For example, the current range of Secure Communications Equipment used by the UK MoD was designed by Steatite, which continues to maintain the systems. Steatite is able to deploy security-cleared staff where required and has a dedicated secure area for sensitive projects. Since lithium battery cells offer high power densities but are liable to explode when the cell is pierced, their transportation in bulk is highly regulated. Steatite has UN approval for this.

Solid State Supplies is a value-added distributor of electronic components. Its product ranges cover embedded processing and memory, imaging and displays, wireless, LED lighting, sensing and control, power management and analogue devices. It has particular expertise in high-reliability components for defence and aerospace applications, in support of which its Quality Management System meets international aerospace standard AS9120. Solid State Supplies is differentiated from volume component distributors by the level of technical support that it provides. Technical team members provide technical support on products, advising on purchases of individual items and how they will work together. They also provide post-sales support and customer training. The operation provides a local link between component suppliers, who may be based in the Far East or US, giving a single source of components from multiple suppliers that is located in the same time zone as the customer, speaks the same language and trades in the same currency.

As customers’ projects progress from R&D to volume production, the division offers value-added services including programming semiconductor devices, checking that hardware has the correct version of firmware installed, putting individual components on reels of tape for use on automatic assembly lines, transferring components used in smaller volumes from larger to smaller reels of tape, creating kits of components to speed up assembly, and baking components to remove moisture and then sealing them to prevent any further moisture from entering the component. These services are carried out in the division’s secure, bespoke, electrostatic discharge (ESD) facility, which is certified to the AS9100 aerospace manufacturing standard. Other services provided that help customers with procurement issues are scheduling deliveries to help with inventory control, traceability of supply and parts obsolescence management. These services help generate additional margin and also help lock-in customers. Solid State Supplies generates additional margin by developing its own-brand product where there is a gap in the market. For example it has introduced a range of industrial camera modules.

Solid State’s specialist technical capability and compliance with the regulatory standards required to operate in the aerospace and defence sectors, eg AS9100, ISO 9001:2008 accreditation for document control and participation in the SC21 supply chain programme developed by the UK aerospace and defence industry, provide a significant barrier to entry. So do the long-term relationships, which it has built up with both franchisors and customers.

Management continues to pursue the successful strategy adopted in 2002. This is based on growth through selective acquisitions and targeted organic development, specifically the addition of new product lines and entry into new industry verticals such as green energy and security solutions, combined with margin improvement through focus on value-added design and assembly capability and development of own-brand products.

We illustrate the ways in which both divisions add value through discussion of two case studies.

Global broadcaster: The client needed to replace its portfolio of studio PCs, which had reached the end of their useful life. The PCs needed to emit minimal amounts of audible noise and to be backwards compatible with existing hardware peripherals and legacy software that operated in Windows XP as well as capable of being upgraded to newer operating systems in future. Importantly, the computing units needed to fit into the space constraints of the studios, to have an in-service life of seven years and to consume as little power as possible in order to minimise operating costs. Off-the-shelf solutions were not appropriate because they took up too much space and would only be supported by the supplier for six to 12 months. Steatite designed customised replacement units, ensuring that the internal layout effectively promoted airflow across the major heat generating components so that the system could be cooled using compact, low-noise fans. The components were selected to minimise power consumption and to ensure vendor support for at least three years. The custom solution delivered the required features and future flexibility within a budget comparable with an “off-the-shelf” solution.

Ferranti: In 2012, Solid State Supplies was awarded a contract worth £1.2m over 18 months to supply programmed semiconductor devices. Ferranti helped Solid State Supplies set up its secure AS9100 certified in-house programming department, where it uploads software onto components. Customers such as Ferranti can take the devices directly from this facility to their manufacturing lines without having to programme the devices themselves. The initial contract from Ferranti has been renewed several times.

The availability of value-added design and assembly capability is a key acquisition criterion, as clearly demonstrated by the Creasefield purchase. The appointment during H117 of two specialists in the fields of obsolescent component sourcing, anti-counterfeit testing solutions, component up-screening and high-reliability applications in the military, aerospace, rail and oil and gas markets opens up relatively high-margin activities where Solid State Supplies can add value. Several existing customers have already added the group to their list of approved obsolete component suppliers.

Solid State has completed nine transactions in 14 years (see Exhibit 3). The first, Steatite in 2002, was a pivotal point in the group’s evolution, marking management’s decision to concentrate on building up the computing, communications and batteries activities. Our analysis of the two most recent acquisitions further illustrates how the group is enhancing its value-added capability. Management continues to evaluate acquisition opportunities and has stated its intention of completing on average one transaction each year.

Creasefield specialises in the design and manufacture of custom battery packs. This transaction extends the technologies offered and takes the group into new sectors. Solid State’s solutions are based primarily on lithium-ion technology while Creasefield is also expert in alkaline battery technology. Solid State’s existing batteries activity is primarily focused on the oil and gas and sub-sea sectors. Investment in this sector has been subdued for several years because of low global oil prices, though sales activity is beginning to show signs of recovery. Creasefield is also involved in the aerospace, medical, security and water industries. The combination enhances the group’s existing engineering and production capabilities for batteries – there is substantially more manufacturing space at Creasefield’s site in Crewkerne than that allocated for battery activity in Redditch – and creates further opportunities for cross-selling. Creasefield was acquired for a total consideration of £1.6m. The consideration was paid in cash, supported by proceeds from settlement of the MoJ contract. For the 12 months ended March 2016, Creasefield recorded a £60k operating loss on £4.8m turnover. Management expects that Creasefield will make a modest positive profit contribution (after integration costs) during FY17 and a more significant profit contribution during FY18.

Ginsbury Electronics was established in 1979 and offers display components, monitors, panels, signage and associated power components from OEMs including Kyocera, Astrodesign, Klein, Pico and Digital View. Ginsbury exemplifies the group’s value-added approach. It has a dedicated team of qualified engineering sales specialists and technical support who are able to create fully integrated monitor or digital signage systems for customers. In response to customer demand for a more highly integrated product offering, the team developed the Ginsbury Genie, a high-reliability, low-power embedded computing platform with fully integrated TFT display for use in industrial and embedded applications. Ginsbury’s display panels, monitors and components are deployed in fighter jets, bomb disposal vehicle systems, helicopters, industrial control systems and broadcast units. The Ginsbury acquisition has enhanced the group’s offering in the display area by extending the ruggedized solutions it can offer, widened the range of higher priced products and created further opportunities for value-added services in the distribution division. Post-acquisition, the business has remained at its site in Rochester and operates as an autonomous unit within Distribution. Cross-selling initiatives have been successful, with many customers now developing products utilising expertise from both entities, for example systems deploying both displays (Ginsbury) and embedded computing devices (Solid State Supplies) for electric vehicle charging and on-food printing.

The group is expanding its product portfolio through a combination of acquisitions (as discussed previously), the addition of new franchises and development of its own products. For example, over the last year Solid State Supplies has won the franchises from Kemet (capacitors for use in remote power applications) and from Silicon Labs (low energy microprocessors and radio devices for internet-of-things applications). We note that Kemet chose to work with Solid State Supplies rather than competitors because of its superior design-in capability. We note that the Silicon Labs agreement epitomises management’s strategy of gaining franchises with mid-tier companies that have annual revenues of between $250m and $1bn globally, thus enabling potentially faster ramp-up in sales volumes with each new franchise.

New product introductions include next generation portable ticketing equipment for the UK rail industry, antennas for an electronic jamming system intended to combat piracy and fully integrated computer cabinet systems, which have been sold to a global technology leader in the aerospace, transport, defence and security markets for use in air traffic control systems. We note a project with a third-party producing a chemical, biological, nuclear and radiological sensor that brings together teams from Steatite’s battery, computing and rugged communications business units.

The group is also growing by entering new industry verticals. We noted earlier that the Creasefield acquisition takes the batteries activity, which was primarily focused on the oil and gas and sub-sea sectors, into the aerospace, medical, security and water industries .The batteries business has also begun to apply this technology to designing battery packs for use with wind turbines and solar power generation systems. Energy storage is key to increasing the adoption of renewable energy as it helps match power output with demand. In another example of applications related to green technology, Solid State Supplies has begun to sell embedded modules used in the powertrain control systems of electric vehicles and sensors for use in vehicle monitoring systems and roadside charging stations.

Management’s drive to improve margins appears to be working. Group gross profit margin increased by 3.5pp year-on-year to 31.2% (though some of this improvement related to one-off currency gains). The cost-reduction programme instigated by management in H116 as a precautionary measure in response to a general weakness in the market delivered £0.25m net savings during FY16 and enabled management to hold operating costs at H116 levels during H117 despite four months of additional costs associated with Creasefield. The new facility currently under construction in Leominster for the antennae business will reduce new equipment costing for pre-compliance testing, bringing this service in house and thus potentially improving margins.

The seasonally adjusted Markit/CIPS Purchasing Manager’s Index (PMI) for Manufacturing rose to 55.4 in September 2016 from 53.4 in August, beating market expectations of 52.1. It was the highest reading since June 2014, as growth of output, new orders and employment all strengthened. The domestic market remained a prime driver of new business wins, while the weaker pound drove up new orders from abroad. The rebound in the PMI level since its EU-referendum related low in July was sufficient to make the third quarter average (52.3) the best during the year-to-date. While encouraging, import costs rose further and output price inflation remained well above the series average, so this favourable environment may not continue. (Note that 50 marks the transition between market expansion and contraction.) However, Steatite’s growth trajectory is decoupled from the manufacturing sector as a whole, because of its focus on product for harsh environments. Demand is more closely linked to investment in individual niches including defence, homeland security, transportation and the downstream oil and gas sector. Since Steatite offers several distinct product ranges, there is no single company that offers a similar portfolio. Solid State benefits from an increasing trend for OEMs to outsource design and development of sub-systems, preferring to act solely as integrators.

On the distribution side Solid State occupies the middle ground between global behemoths with annual revenues of over £1,000m, such as Arrow Electronics, Avnet, Future Electronics, Ingram Micro and WPG Holdings, and regional minnows with annual revenues of less than £10m. The global giants are not interested in taking on product lines that are not high volume. The small players, of which management estimates there are over 300 in the UK alone, are too small to provide extensive technical support and have insufficient funding to secure multiple franchises. This was Solid State’s situation prior to its admission to AIM in 1996. The group is similar in approach to Acal, which also combines manufacturing and value-added distribution of complex electronic components, but there is limited overlap with regards to product offer.

The industry association AFDEC (Association of Franchised Distributors of Electronic Components) expects UK component market sales to be similar to 2015 levels during 2016. It notes that a recovery in UK demand could be promoted by investment in infrastructure and a shift towards reshoring. It notes “real evidence” of reshoring beginning.

John Lavery retired from his role as managing director of Steatite and executive director of Solid State plc at the end of July 2016, stepping down to a non-executive role. His place has been taken by Matthew Richards, who was previously senior VP and managing director of API Technologies Corp., managing director for Secure Systems & Technologies Ltd. and business unit director at Vislink for the defence and security sectors. Peter James, who is currently financial controller at IQE, will become group finance director in February 2017. This replaces a part-time appointment.

Dependence on individual franchisors – in theory, Solid State is vulnerable to franchisors switching to other distributors. In reality, the level of technical expertise required to sell sophisticated products and the time taken to educate distributors mean that franchisors are reluctant to switch distributors unless their sales performance is unsatisfactory. It is possible that a franchisor may elect to sell direct rather than through Solid State, but this is made less likely given Solid State’s long-term relationships with customers.

Timing of defence and government contracts – in common with any business operating in these sectors, Solid State is vulnerable to delays in awarding government contracts. This risk is reduced by participating in numerous programmes.

Regulatory issues – product supplied for aerospace and defence applications must meet with detailed specifications required for these sectors. Solid State has extensive experience of meeting these requirements and is an MoD-approved supplier. Its operations must continue to be compliant with the AS9120 aerospace distribution and AS9100 aerospace manufacturing standard and ISO 9001:2008 document control protocol. These are both areas that the operation is familiar with.

Brexit – 85% of FY16 group revenues were attributable to customers based in the UK (though the country in which the end-systems are deployed may be very different), 5% North America and 7% mainland Europe, so the relative weakness of sterling against the euro and the dollar is not having a significant impact on demand. The impact with respect to customer relationships in mainland Europe will be mitigated by the added-value design capability and other services that the group can offer, which make it relatively difficult for customers to find alternative suppliers. The impact of changes in foreign exchange rates is limited because most contracts are denominated in sterling, but the supply of components that the group has purchased in US dollars are billed in US dollars. The key risk identified by management is the potential loss of two distribution franchises, where the group has a pan-European remit. Collectively these represent £80k profit per annum, which is hardly material. Demand for the group’s products may be affected by any potential weakening in UK manufacturing resulting from more expensive imports.

A comparison of Solid State’s prospective share price multiples with its listed peers shows it is trading at a discount to the mean of our sample of manufacturing companies and the mean of our sample of added-value distribution companies with regards to most metrics.

Our sum-of-the parts analysis (Exhibit 5), which is based on the target EV/EBITDA and P/E multiples derived using the peer group averages, gives an indicative valuation ranging from 445p (based on FY17 blended EV/EBITDA of 10.1x) to 495p (based on FY17 blended P/E of 15.1x). Our previous analysis, which was based only on P/E ratio multiples, gave an indicative value of 505p. As the market becomes more confident that Solid State is able to grow profits in the absence of the MoJ contract, the share price should move upwards through our indicative valuation range.

Group revenues reduced by 9% year-on-year to £20.1m. The H116 results were flattered by £3.5m from the mobilisation phase of the MoJ contract, while H117 results benefited from £1.7m (four months) sales from the Creasefield acquisition. Underlying revenues (£18.4m in H116) were similar in both periods, in line with our assumptions for the year as a whole. The MoJ revenues received in H116 were at a very low margin, and there was benefit from forward currency hedges (which will not be repeated during H217), raising gross margin by 3.5pp to 31.2%. Operating costs were held at H116 levels as the beneficial impact of the cost-reduction programme undertaken during FY16 offset the additional costs associated with the Creasefield acquisition. Reported pre-tax profit grew by 10% to £1.6m. However, EPS reduced by 8% to 16.6p through a combination of lower R&D tax credits, lower tax relief on share-based charges and the dilutive impact of the exercise of share options issued to directors under a long-term management incentive plan. The interim dividend was maintained at 4.0p, which is prudent at this stage, though we note management’s intention to pursue a progressive dividend policy.

The first half progress supports the assumptions underpinning our estimates, which we leave unchanged. These strip out the c £5m MoJ revenues received in FY16 at very low margin, and model FY17 underlying revenues at similar levels to FY16, with new product introductions offsetting any market weakness. Noting that management’s programme to realise c £0.5m annualised cost-savings completed successfully, we model a £0.2m increase in FY17 underlying operating profit based on our assumption for underlying FY16 performance referred to above, but this is obscured by the lack of share-based payments charges in FY17, which flattered FY16. We then add £4.0m revenues (based on historic levels) and a neutral profit contribution from Creasefield. We model modest underlying revenue growth in both divisions for FY18. We note that the group’s order backlog has reduced from £17.8m at end May 2016 to £14.8m at end September 2016. This reflects the sterling weakness caused by the Brexit referendum. Customers of the Distribution business are continuing to purchase the same volume of components each month, but are now placing orders for a six- or nine-month period rather than 12 months as they did previously.

The anomalous debtor position at end FY16 unwound during H117 following receipt of the MoJ settlement. As part of this settlement was paid out to suppliers involved in the project, the creditors level reduced as well. Net debt reduced by £3.2m to £0.2m at the end of September. The cash received from the MoJ is being used to fund both organic growth and acquisitions.

Capital expenditure is modelled at similar levels to FY16 to cover completion of the antenna facility. £1.9m is allocated for the Creasefield acquisition. We model net debt reducing to £0.1m at end FY17. Our estimates show cash generation resulting in £1.0m net cash by end FY18, though in reality this cash will probably be expended on further acquisitions in line with management’s stated strategy of completing a transaction a year. We are not forecasting any acquisitions in our model unless they are announced.