Ultra Electronics — Update 13 September 2016

Ultra Electronics — Update 13 September 2016

Ultra Electronics

Andy Chambers

Written by

Andy Chambers

Director, Industrials

Ultra Electronics

Decoding the messages

Company outlook

Aerospace & defence

13 September 2016

Price

1,690p

Market cap

£1,188m

Net debt (£m) at 1 July 2016

325.4

Shares in issue

70.3m

Free float

99%

Code

ULE

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(2.9)

(2)

(0.0)

Rel (local)

(0.2)

(9.9)

(7.9)

52-week high/low

2,026p

1,595p

Business description

Ultra Electronics is a global aerospace and defence electronics company, with operations across three divisions: Aerospace & Infrastructure (27% of 2015 sales); Communications & Security (33%); and Maritime & Land (40%).

Next event

Trading statement

November 2016

Analysts

Andy Chambers

+44 (0)20 3681 2525

Roger Johnston

+44 (0)20 3077 5722

Ultra Electronics is a research client of Edison Investment Research Limited

Ultra Electronics is in a replenishment phase, investing in new technologies to embed in programmes that should return the company to growth from FY17. In the current year the spending environment remains flat, but FX and M&A contributions will bolster performance, enabling the company to deliver EPS in excess of 2011’s record level. Our fair value of 2,037p indicates decent upside for the shares should improved order intake and continuing investment deliver expected growth.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

12/14

713.7

112.0

123.1

44.3

13.8

2.6

12/15

726.3

112.4

123.9

46.1

13.7

2.7

12/16e

797.3

117.1

128.3

47.6

13.2

2.8

12/17e

821.4

121.8

133.5

49.5

12.7

2.9

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

Continuing to invest for future growth

Ultra continued to invest heavily during the first half of the current year. Around 19% of sales continue to be spent on new product development. While growth in defence spending has yet to manifest itself in the western world, notwithstanding the apparent increase in support, the investment positions Ultra to generate growth from new contract awards and the strengthening of the longer-term pipeline of opportunities. The £100m order intake shortfall apparent in H215 is being unwound and significant additional contracts appear close to signature. Order cover for 2016 stood at 87% at the end of July, which allowed management to tighten the organic revenue guidance for FY16 to +/-1%. With FX and M&A also making positive contributions, Ultra should experience healthy earnings growth in the current year, despite the dilutive disposal of Ultra ID Systems, with organic growth in FY17 expected to progress towards long-term trend levels in excess of 4%.

Cost savings support margins

Clearly the sharp fall in sterling against the US$ is providing a boost to previous expectations, although recent volatility introduces a degree of uncertainty as to where translation benefits in 2017 will settle. The S3 programme should continue to deliver progressive cost benefits, as should the Herley integration. In addition, recent advance payment consumption and the sizable cash outflows that emanated from the Oman airport contract termination should be complete. Cash conversion is expected to return to the through cycle norm of 80-85% in FY17.

Valuation: Resumption of growth

Our estimated fair value for Ultra currently stands at 2,037p, a simple average of our FY17 peer-based sum-of-the-parts and our capped DCF valuation. If Ultra continues to grow EPS in 2017 beyond the range of the last five years, and global defence spending does indeed start to accelerate as western world budgets increase, we feel a moderate rerating is plausible.

Investment summary

Company description: Differentiated, specialised solutions

Ultra Electronics is approaching the twentieth anniversary of its listing on the London Stock Exchange in October 1996, three years after it was subject to a management buy-out from Dowty Group with revenues of £84m. After more than 50 acquisitions, the group has matured into a global specialist defence electronics and software solutions supplier with sales approaching £800m. Following a restructuring to more market facing segments last year, it operates across eight product segments formed into three divisions: Aerospace & Infrastructure (27% of FY15 sales/24% of operating profit); Communications & Security (33%/34%); and Land & Maritime (40%/42%). It is still a predominantly US and UK centric business, which together accounted for 76% of sales in 2015.

Valuation: Investing to drive organic growth

Ultra operates primarily as a Tier 3 or Tier 4 supplier, designing and supplying components and subsystems to larger systems suppliers and systems integrators. This provides a broad customer and application base, as well as greater flexibility to target international opportunities. It also affords a degree of margin sustainability due to the niche technological value and capability its products deliver for those customers’ offerings.

Despite many commentators indicating an improved defence spending environment, it remains far from clear that this is a reality. Pre-election rhetoric in the US is being matched by an apparent improvement in budgetary levels, although actual spending outlays may remain flat into 2017.

Ultra continues to invest to drive growth through the development and introduction of innovative technologies, while driving greater efficiency through the implementation of its shared services programme. Ultra spends 5% of its revenues on private venture R&D, which complements the 15% of sales made up of customer-funded development programmes. The relatively high level of development expenditure should stimulate organic growth and be complemented by a continuing pursuit of bolt-on and bolt-in acquisitions supported by the improving cash conversion and FCF.

Financials: FY16 a year of consolidation

We are maintaining our underlying forecasts following the interim results in August. We continue to expect a flat year in organic sales terms, reflecting the lack of increase in defence spending in the UK and the US. This will be boosted by full year contributions from Herley and Furnace Parts, although we have adjusted for the dilutive disposal of the ID business (see our note, Sharpening the Focus). We have also already adjusted for the sharp fall in sterling post Brexit, with our assumption for average US$/£ now $1.38/£1 for FY16 and $1.33/£ for FY17 (previously $1.50/£). We estimate this adds around £36m to FY16 sales and £4.8m to operating profit on translation. The longer-term outlook looks encouraging. We believe organic growth in 2017 will trend closer to the long-term expectation of more than 4%, as a confluence of solid commercial growth and still constrained western world defence spend, with export growth also expected to resume,.

Sensitivities: Defence budgets still not cleared for take-off

The market has, in our view, correctly assumed that defence as a segment remains largely unaffected by the proposed withdrawal of the UK from the EU. However, there is a risk that it may affect global growth and thus once again constrain budget growth. The change of administration in the US also adds a degree of uncertainty with the threat of sequestration still in place for the DOD’s FY18 budget which is due to be proposed in February. In addition, the volatility of FX could reverse limiting the benefits currently being imputed into models.


Company description: Enabling defence technologies

Ultra has developed a core of critical technology expertise that supports strategically important programmes within the defence and security markets. It operates as a predominantly Tier 3/4 supplier, although capable of systems integration as a Tier 2 supplier primarily for its own solutions. Its major markets are in North America and the UK, with its two largest customers being the US Department of Defence (DOD – 19% of FY15 group sales) and the UK Ministry of Defence (MOD - 11% of FY15 group sales). Development of innovative solutions addressing customer needs has been key to this positioning. Common threads run through its businesses: stealth, cyber, security, power management, communications and control.

Growth strategy targets niche specialities

Ultra’s strategy is aiming to provide above average growth in revenues in order to create long-term shareholder value higher than other companies in the market. There are four principal elements to Ultra’s long-term growth strategy:

Increasing the portfolio of specialist capabilities, both organically and by selective M&A.

Increasing the number of long-term platform applications for its technologies.

Extending the customer base.

Broadening the geographic footprint, capitalising on the core transatlantic capability and controlled expansion into newer markets; eg Australia, the Middle East, India and Asia Pacific.

The implementation of a market facing strategy in 2015 is aimed at more effective targeting of growth opportunities, exploiting the core capabilities and utilising synergies across its businesses facing the same end markets. It retains the flexibility afforded by the responsibility devolved to the businesses that has resulted in Ultra holding world leading positions in many of its chosen niches.

Exhibit 1: Ultra Electronics’s businesses mapped to core capabilities

Source: Ultra Electronics

Ultra provides for critical applications and missions

As with many defence electronics companies Ultra remains a difficult company to readily describe. It has a range of sensor, electronic and software enabled technologies and expertise that enable a variety of systems predominantly for the defence and security markets. Its initial expertise in antisubmarine warfare (ASW) markets has been broadened extensively by the raft of acquisitions made over the period since it was quoted.

The company now addresses eight different markets segments through three market-facing operating divisions as discussed in our previous note (Facing up to the market). Following the recently completed disposal of the ID Systems business, the group operates through twenty three businesses spread across the three divisions. The core domain capabilities by business are shown in Exhibit 2, with cyber expertise sitting predominantly in the C2ISR and Communications segments but running across all of the group companies. Ultra now markets its own internal sophisticated cyber security defence capabilities developed over the last three years to commercial customers through its subsidiary CORVID.

Investing to drive growth

In stock market terms the defence sector has continued to prove resilient in recent months, while various market uncertainties have led to sharp declines elsewhere, for example civil aerospace. It seems far from clear that geopolitical tensions are likely to diminish, even if Britain’s decision to leave the EU avoids David Cameron’s Armageddon scenarios.

Global defence markets on the up

The generally perceived wisdom is that global defence spending is returning to growth. However, for various reasons this may be slightly premature. We would prefer to regard the western world defence spending environment as having bottomed out, with little hard evidence that defence contractors are going to benefit from an upswing just yet. The situation is further complicated by political considerations, notably in the US with a presidential election later this year but also due to the fallout that may follow the recent Brexit decision.

US defence budget outlook

However, while there is always significant discussion of the US defence budget, the monies actually flowing down to defence contractors are the subsequent expenditure of those already budgeted and authorised amounts, known as outlays in the US. This is the actual defence spending by the US DOD and normally reflects the budgetary trends developed one to two years previously. In Q1 overall spending was flat on the prior year, in Q2 spending actually fell by 4%. While the prospect of an upturn in budget levels is real, its impact is yet to be reflected in increased actual spending.

Exhibit 2: US DOD spending on procurement and RDT&E

Source: US Department of the Treasury – Monthly Treasury Statements

The outlays can be further broken down into sub-categories, with procurement and RDT&E (Research Development Test & Evaluation), known as the investment budgets (Exhibit 3), the most significant for Ultra. While Ultra noted a more positive trend in its recent trading statement, the basis of this was spending through April. Unfortunately, May and June were rather more depressed in actual spending levels. So, while procurement spend was up 5% in calendar Q1 year-on-year, it fell 9% in Q2. Similarly, RDT&E having been up 1% in Q1 fell by 5% in Q2. Overall, the investment budgets fell by 2% in H116 and remain 20% below the level seen in FY11 (to September 2011). While this should ease as recent budget agreements and an incoming administration of either hue appear likely to regard national security as a priority, it remains to be seen whether the current strategies and focus of investment spending are maintained or altered significantly.

UK smoke and mirrors may be undone by Brexit

It would seem logical to suggest that if there is indeed a reduction in GDP growth arising from Brexit, of which there may already be some signs, then the new Prime Minister and her ministerial team could launch an interim Strategic Defence & Security Review to respond to the change in circumstance. Such a move may call into question strategic priorities in the UK, and would need to be set against the revised economic projections. Lower growth could once again rein in spending, even maintaining the commitment to NATO of spending 2% of GDP on defence and security which in any event was met only by including intelligence budgets in the overall total. Procurement spending in the UK remains further constrained by an increasing proportion of an overall flat total of c £16bn going to submarine programmes including the Successor programme for Trident submarines. Submarine spending rises by over £1.5bn over the ten-year plan (Exhibit 3).

Exhibit 3: UK defence equipment procurement plan by operating centre

Source: UK MOD “The Defence Equipment Plan 2015”

With regard to Ultra, its focus on strategically important and critical applications (eg submarines, ASW, cryptography, secure communications etc), may well provide significant protection against renewed budgetary constraints. It also benefits from its portfolio effect as any one platform does not unduly influence overall performance.

Brexit would seemingly offer little to reduce European inertia in defence spending. It seems unlikely that the focus on defence would intensify within the European Union in the absence of Britain. Greater integration of forces may occur, but we would continue to regard NATO as the primary institution for regional defence and security and as such, we do not expect to see defence spending increase substantially in the German or French markets other than to fulfil the 2% obligation.

Ultra FY16 organic growth guidance unsurprisingly flat

Such a combination would place the emphasis on export market potential to drive organic growth for Ultra. To a degree this would be realised by export sales programmes from the US and the UK, although where independent capability has been developed, Ultra can address local programmes. Development spending to drive all of these remains high at around 20% of sales, including Ultra’s own commitment of around 5%.

Given this background it is not a surprise that current year guidance for organic growth ranging from +/-1% has been given, expected to improve from 2017. We do not expect a major acceleration next year, more of a gradual increase to around 2%, with the long-term trend still over 4%.

Longer-term opportunities developing positively

The recovery of c 40% of the £100m of orders deferred from 2015 together with new opportunities helped Ultra to improve its book to bill ratio to a healthy 1.0x during H1 FY16. The order backlog of £785.7m at the period end provided order cover for the year of 84%, consistent with the prior year. The company also stated that initial indications in July left cover at the end of the month at 87%, following signature of several major contracts and with other major potential prospects progressing well. In addition to the firm order backlog, the company also has substantial “off order-book” potential in the form of multi–year indefinite delivery indefinite quantity (IDIQ) contracts for the US DOD, framework contracts for various platforms and options. This includes substantial revenue build across civil and military aircraft programmes, especially the JSF. The level of off order-book potential business has increased to £2.4bn from £1.5bn previously indicated.

In our view this expansion reflects the investment that Ultra continues to make in its technology and capabilities. It is also reflected in the broad range of current long-term opportunities

Exhibit 4: Ultra Electronics – long-term key programme opportunities

Division

Segment

Key Programmes

Value

Award

Comment

Aerospace & Infrastructure

Aerospace

XAC MA700 propeller electronic controller

£2m

won

Agreed IP licence to GE Dowty

Indicative value £165m

 

Cessna Hemisphere control systems

£40m

2017

New programme launched 2015

 

WheelTug on Boeing 737 (uses Ultra controls)

£35m

2018

Certification commences 2016

 

 

Saab Gripen E/F NG HiPPAG integration

£7m

2017

 

Infrastructure

London Underground & Manchester Metro DC systems

£9m

2017

Recast as new programmes

 

 

Baggage Systems upgrades (Heathrow & South Africa)

£13m

2018

Ultra is incumbent

 

Nuclear

Small Modular Reactor I&C (Instrumentation & Control) development with NuScale

£20m

won

First contracts awarded

 

 

US Plant Life Extension expanded sensors & safety I&C

£30m

2017

Delayed

 

 

Chinese CPR-1000/ACC-1000 new build reactors

£9m

2017

Continuing Business

Communications & Security

C2ISR

Middle East Land Border Security

£90m

2017

Selected as single source

Indicative value £410m

 

NATO JEWCS (Joint Electronic Warfare Core Staff) - Land & Maritime Scope 4th Gen

£120m

2017

Slipped

 

Targeting pod for RAF

£50m

2017

 

 

 

Airborne EQ Systems for a NATO country

£65m

2017

Awaiting selection of prime

 

Communications

Typhoon 1, Watchkeeper, A400M crypto

£42m

won

Development contracts

 

 

Project MARSHALL MOD military air traffic management

£11m

won

Development underway

 

 

US Army WIN-T ORION radio production

£32m

2017/18

 

Maritime & Land

Maritime

UK Successor - power & control

£25m

2017

Development underway

Indicative value £312m

UK Successor - signature management

£27m

2017

Development contract awarded

 

Fatahillah 2 - Indonesian Corvette refit

£15m

2017

Following delivery of Fatahillah 1

 

Underwater Warfare

India Naval Torpedo Defence System (NTDS)

£30m

2016

Awaiting ministerial approval

 

TB-34 Towed Array for US Navy

£30m

lost

Debrief awaited, LMT/L3 selected

 

TB-29X Towed Array for US Navy

£83m

2017

Awaiting bid assessment

 

India IADS (integrated anti-submarine defensive suite) & ASW

£72m

2017/18

 

 

Land

UK VIRTUS soldier worn power system

£30m

2017

 

Source: Ultra Electronics

Divisional analysis

Ultra operates in three divisions that encompass its 24 subsidiaries operating across eight segments. With such a portfolio of capabilities, products and expertise there will be both positive and negative aspects of development and manufacturing phases at any point in time. These drive both revenues and margins dependent on specific mix, with more mature delivery cycles normally generating better returns than development contracts and new product introductions, although this can be dependent on the development risk undertaken and the value proposition offered.

The result has been a period of consolidation with group sales and profitability little changed over the five years from 2011 to 2015. This is despite divergent performances of the three divisions over that period, which are themselves subject to variable performances of the individual business units.

Exhibit 5: Ultra electronics - divisional breakdown

Year to Dec (£m)

2011

2012

2013

2014

2015

2016E

2017E

Aerospace & Infrastructure

229.3

226.6

230.4

198.6

193.2

219.1

230.0

Communications & Security

228.7

268.9

237.7

224.4

239.3

267.7

271.5

Maritime & Land

273.7

265.3

277.1

290.7

293.8

310.5

319.8

Group Revenues

731.7

760.8

745.2

713.7

726.3

797.3

821.4

Aerospace & Infrastructure

37.2

45.1

46.2

29.6

28.6

33.5

35.2

Communications & Security

41.7

32.9

27.5

37.0

40.4

42.8

43.4

Maritime & Land

42.8

43.8

48.0

51.5

50.9

54.3

56.0

Group EBIT

121.7

121.8

121.7

118.1

120.0

130.7

134.6

Aerospace & Infrastructure

16.2%

19.9%

20.1%

14.9%

14.8%

15.3%

15.3%

Communications & Security

18.2%

12.2%

11.6%

16.5%

16.9%

16.0%

16.0%

Maritime & Land

15.6%

16.5%

17.3%

17.7%

17.3%

17.5%

17.5%

Group EBIT margin

16.6%

16.0%

16.3%

16.5%

16.5%

16.4%

16.4%

Source: Ultra Electronics, Edison Investment Research estimates

Aerospace & Infrastructure

As Exhibit 6 demonstrates, the variety of activities encompassed by a simple divisional title is extensive. The complexity within each division arises as a result of the chosen status of Ultra as predominantly a Tier 3/Tier 4 supplier to over 350 platforms. However, hopefully the graphic enables a quick overview of the principal exposures and products of the business units.

Exhibit 6: Aerospace & Infrastructure - business activities

Source: Ultra Electronics. Note: * Advanced Tactical Systems; **Flightline Systems; ***Nuclear Control Systems.

The Aerospace domain, which accounted for 18% of Ultra’s group sales last year, has established strengths in a variety of mission critical electronic systems, control and instrumentation solutions, as well as more niche aviation technologies such as ice protection. It operates across both civil and military aircraft programmes, establishing long-term positions by providing innovative, low cost and safety compliant solutions to platform manufacturers. Civil output is set to continue to ramp up in the large commercial aircraft market and Ultra has gained positions on new regional jet and turboprop programmes such as the Mitsubishi Regional Jet and the Chinese MA700. It has gained business in the large business jet market with Gulfstream and Cessna. Commercial sales growth is thus expected to continue through the rest of the decade. In the military market, exposure to the F-35 programme combined with growth in new transport programmes such as the KC390 and A400M should also drive sales. However, declines in legacy programmes continue with the Typhoon production rate also now set to reduce as the programme is elongated.

Infrastructure accounts for 4% of group sales with Ultra providing critical systems and software for the safe operation and security of transport and energy infrastructure. Transport investment remains in a growth phase with tier 2 airport systems experiencing growth in South America, the Middle East and Asia. Rail investment is also expected to grow, although pricing is becoming increasingly competitive in export markets for Ultra’s range of power management solutions. Smart grid technologies also look set to benefit from the continuing constraint of energy networks, combined with increasing power demand.

Ultra also has strong positions in the Nuclear domain, which accounts for 6% of group sales. Its qualified sensors and safety systems support the growing market in reactor licensing, delivery, security and safe operation of reactors. With equipment on more than 190 reactors in 16 countries as well as on 32 new build reactors worldwide, Ultra has well established presence. While nuclear is a notoriously long cycle business, Ultra should be able to access an increasing demand for plant life extensions and upgrades, as well as exploiting opportunities for new build growth on Generation 3 and NuScale’s Small Modular Reactor (SMR). Cyber protection and physical security of infrastructure is also now an increasing requirement.

Communications & Security

Communications accounts for 14% of group sales and provides advanced, interoperable secure communications and systems for voice, video and data transfer. This includes the provision of scalable and low-risk radio, encryption, satellite and specialist systems to military government, law enforcement, industry and commercial customers around the globe.

Exhibit 7: Communications & Security - business activities

Source: Ultra Electronics. Note: *Command & Control Systems

The demand for faster, lower cost, more mobile yet secure links are increasingly in demand in the command and control environment to improve situational awareness through efficient transfer of voice, data and video. In turn this should drive increased bandwidth demand and higher capacity requirements on High Throughput Satellites (HTS) operating on the higher frequency Ka-band over the next five years. Demand for secure key management and increasingly IP-based encrypted system continues to drive demand in the military market, and Ultra has presence in both the UK and the US encryption programmes.

A growing requirement to secure and protect critical national infrastructure (CNI) and national borders should help to drive growth in the C2ISR (Command & Control, Intelligence, Surveillance & Reconnaissance - 23% of FY15 sales) domain. Increasing precision targeting and range of strikes continues to be a key demand in the military market, requiring improved and secure intelligence and surveillance data capture and analysis, increasingly in a real-time environment. ISTAR is being developed for both manned and unmanned air platforms.

Growth in 2017 is expected to largely arise from the full year contribution of Herley, which was acquired on 21 August 2015 for £164.7m and only contributed £24.4m of sales and £4.3m of profit in just over four months. Herley extended Ultra’s electronic warfare EW capabilities, increasing market share and exposure to this growing global budget line.

However, divisional performance will be held back by the sale to private equity of Ultra Electronics’s ID Systems business, which manufactures and supplies Magicard ID card printers and related software globally (see our recent note, Sharpening the focus). ID had FY15 sales of £19.3m and generated an operating profit of £4.0m. It will reduce full year sales and operating profit contribution from the Communications & Security division by 7% and 8% respectively, or by c 3% at the group level, with half of the impact occurring in the current year and the balance in FY17.

Land & Maritime

The historical core of Ultra, Underwater Warfare, remains the largest of the eight domains representing 24% of group sales. Ultra’s products are benefiting from preferential budget allocations in the US to underwater systems as part of the “pivot to the Pacific”. Submarine combat systems, torpedo production and countermeasures are all being prioritised by the US Navy.

Exhibit 8: Land & Maritime - business activities

Source: Ultra Electronics

The leading positions in the US are also translating into more opportunities in the Asia Pacific market as submarine numbers continue to increase, and where the spend on ASW is expected to increase to £0.5bn. India in particular is expected to award three ASW contracts in the near future totalling a potential spend of £100m. Ultra’s continuing spend on sophisticated innovative systems continues to enable it to win significant new opportunities in both air and sea ASW markets.

Maritime systems account for 6% of group sales, providing advanced warfighting systems and power management equipment to naval surface ships, submarines and unmanned vehicles. The segment continues to face budgetary constraint in the new build segment, but this is serving to drive capability and cost effective upgrades on existing platforms where service lives are being extended. Ultra also provides signature management and degaussing products where growth is likely to increase due to more sophisticated threat developments such as influenced mines.

Ultra provides power systems and electronic solutions in the Land systems market (5% of FY15 sales). As spending has transitioned away from land forces in recent years the number of new vehicle platforms has reduced and new build quantities have fallen sharply. Whilet this has been offset to some extent by life extensions, support and upgrades it remains an area with reduced growth prospects although the declines appear to have bottomed out. A more integrated battlespace, with unmanned, manned and infantry assets requiring system connectivity and power, provides Ultra with several development opportunities such as for the UK VIRTUS programme.

Management

Despite the recent change in CFO, we would describe the management situation as stable and strong. The continuity provided by Rakesh Sharma’s stewardship as CEO is allowing the current repositioning of the business to develop. The incoming CFO, Amitabh (Ami) Sharma is an Ultra old boy, returning to the fold after 16 years honing his financial management in both private and public entities. Unrelated to the CEO, Ami thus comes to the position with experience of the company, but with a new external perspective that should enable him to further challenge the operations. For the present, we do not expect any major change to the strategic and efficiency initiatives put in place last year. Significant portfolio adjustment does not appear to be on the cards at present, although the sale of ID does indicate a desire to focus capital allocation in order to pursue growth.

Sensitivities

Brexit impact: We see the Brexit vote as having little impact on Ultra. There is certainly some medium-term risk to UK defence spending should GDP fall against previous expectations, as this would allow the 2% of GDP spending commitment to NATO to be met at lower levels. However, most major equipment programmes are long term and committed.

US defence spending: an election year introduces an element of uncertainty about future spending priorities, especially in the current year. The outcome could affect the defence investment budgets (procurement & RDTE). However, Ultra continues to supply critical technologies for various programmes.

Export market growth: European markets are a relatively small proportion of sales (10%). As geopolitical tensions in the world remain high and widespread, we expect global defence spending to continue to grow, although the fall in the oil price since 2014 is certainly pressurising budgets in many traditional UK defence export markets.

FX movements: The fall in the value of sterling should have a beneficial effect on translation and global competitiveness. Similarly, any reversal would be detrimental to revised expectations. Translation sensitivity of revenues to a 1 cent movement in the $/£ rate is £3m, and £0.4m for adjusted operating profit. We have now adopted $1.38/£ in FY16 in our model (previously $1.50/£), which has increased revenue and profit forecasts by around 6%. Ultra has fully hedged its transactional exposure for this year and for most of 2017.

Business model risk: largely revolves around technology development and contract win and execution, although acquisition risk is also a clear factor arising from the strategy. The governmental customers, and associated regulatory and legislative environments also provide challenges, although Ultra appears to have backed off contracting prime/Tier1 ambitions following the adverse outcome of the Omani contract that terminated in 2015.

Valuation

With the Omani airport contract issues now effectively behind the company, focus can return to a more normal composition of technology development and production cycles. While the current mix of ongoing contracts is less favourable than it has been in recent years, a transition back to a greater proportion of production revenues should occur over the remainder of the decade, expanding margins, boosting cash flows and enhancing returns. An increase in export activity, bolstered by more favourable FX should also enhance margins in the medium term. Set against this is a continued pressure on government budgets and a constant search for value for money propositions from suppliers, inevitably including downward pressure on pricing, which the S3 programme and other efficiency savings are designed to counter. Our medium-term forecasts assume below target organic revenue growth of 3.5% and flat adjusted operating margins of 16.4%.

Discounted cash flow (DCF)

Our cash-based capped DCF valuation basis is in our view a conservative basis for estimating cash flow values as it does not assume any growth in the terminal value. While we do normalise working capital to zero and capex to equal depreciation, it still eliminates some element of the potential tail value. The DCF on a calculated WACC of 7.1% currently delivers a value of 2,026p. A 10bp change in the WACC affects the value by c1.7%.

Exhibit 9: Ultra Electronics capped DCF sensitivity analysis to WACC and terminal growth

WACC

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

Terminal growth rate

0%

3081

2481

2054

1734

1486

1288

1%

3108

2504

2072

1749

1499

1298

2%

3136

2526

2090

1764

1511

1309

3%

3164

2548

2108

1779

1524

1320

Source: Edison Investment Research estimates

Sum of the parts (SOP) valuation

Our SOP valuation uses domestic and international peer comparators whose principal activities service the defence and security markets. Year to date performances have varied significantly within this group as company specific travails for some contrasts with a generally positive view of the sustainability of returns as defence spending prospects have improved. In both cases valuation multiples have tended to expand during the first half of 2016.We base our SOP assumptions on FY17 and the results are presented in Exhibit 10 below. It returns a value per share of 2,048p.

Exhibit 10: Ultra Electronics sum of the parts (FY17 basis)

 

2017 EBITA

Tax rate

2017 NOPAT

P/E

Value (£m)

Basis

Aerospace & Infrastructure

35.2

23.0%

27.1

16.2

438

US peers (Raytheon, Rockwell Collins) + premium to Thales & BAE - Civil Aviation

Communications & Security

56.0

23.0%

43.1

15.9

686

Premium rating to US peers (Rockwell Collins, L-3 Communications), enhanced commercial exposure

Maritime & Land

43.4

23.0%

33.5

17.9

599

20% premium to UK sector (15.5x) – “Pivot to the Pacific” opportunity and underwater/ASW growth

Enterprise value

1,724

Net debt

-284

Forecast December 2016 net debt

Equity value

1,440

Shares in issue (m)

70

Implied fair value per share (p)

2,048

 

Source: Bloomberg and Edison Investment Research estimates


Financials

Our operating assumption and estimates remain as revised following the interim results (see our recent note, Strategically positioned for growth). Thus, despite the dilutive disposal of Ultra ID that completed on 24 August, full year earnings expectations remain largely as expected at the time of the FY15 results.

Revenues contracted organically in H116 by 2%, but the underlying performance allowed management to tighten the guidance range to +/-1% for the full year, implying a second half improvement. In addition, the full-year contributions of Herley and FP are expected to add around 5% to sales, and FX translation for the full year should be around a 6% benefit year-on-year (FY16 average US$1.38/£ versus FY15 $1.53/£).

H2 will be adversely affected by the dilutive disposal of Ultra ID Systems for £22m which in FY15 had annual sales of £19.3m generating around £4m of adjusted operating profit.

Ultra has two ongoing integration and efficiency programmes in process. The group’s S3 (standardisation and share services) programme remains on track to deliver £20m of cost savings by 2018. At the end of H116 Ultra had spent £7.6m out of the budgeted £30m, with £3.4m of savings already realised and another £4.5m identified, £2m of which are expected to be achieved in H216. The balance of the savings should be identified as the company continues to optimise areas such as procurement processes, IT platforms and finance. Ultra are keen to ensure that the entrepreneurial culture of the group is maintained despite the process, rather than centralising control, in order to maintain innovation and flexibility.

In addition, the integration of Herley remains in line with the acquisition case, and in fact $1.8m of cost synergies are already identified at this stage compared to an anticipated $0.8m. Ultra is thus well on the way to achieving the expected total of $8m of benefits to be realised by the end of 2018, and indeed expect to remain ahead of the plan through next year.

Operating cash conversion for the full year is expected to be in excess of 70%, implying some unwinding of first half working capital outflows with a slowing H2 consumption of advance payments. At the net debt level the FX impact is expected to be similar to the half year, with the £8.2m performance bond call, pension payments and transaction costs only adjusted for the £22m proceeds from the disposal of Ultra ID Systems. Cash conversion is expected to improve to around 85% in 2017, with no further Oman related outflows expected.

The main variables remain FX and the level of advances which is contingent on order success during H2, but for which no upside has been incorporated in our model. The rate of attrition of advances is nevertheless stabilising following the significant utilisation on the ECU RP contract over the last couple of years which has now completed.

The pension fund was closed to future benefit accrual on 5 April 2016, which led to a £15.5m curtailment gain. This was the primary reason for a reduction in the balance sheet liabilities from £84.8m at the start of the year to £66.9m at the half year. A triennial actuarial review is currently underway, the outcome of which will become clear by the prelims early next year.

Capital allocation is expected to remain as before, with investment for high return organic growth continuing and generating a progressive dividend improvement, with both bolt-in M&A and some modest portfolio optimisation continuing.

Exhibit 11: Financial summary

£m

2014

2015

2016e

2017e

Year end 31 December

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

 

713.7

726.3

797.3

821.4

Cost of Sales

(494.3)

(514.1)

(580.9)

(609.9)

Gross Profit

219.4

212.2

216.4

211.4

EBITDA

 

128.9

130.9

142.5

146.5

Operating Profit (before amort. and except.)

 

118.1

120.0

130.7

134.6

Intangible Amortisation

(3.4)

(3.8)

(3.5)

(3.4)

Exceptionals

(97.8)

(81.7)

(58.5)

(44.3)

Other

0.0

0.0

0.0

0.0

Operating Profit

16.8

34.5

68.7

86.9

Net Interest

(6.0)

(7.5)

(13.6)

(12.8)

Profit Before Tax (norm)

 

112.0

112.4

117.1

121.8

Profit Before Tax (FRS 3)

 

10.8

27.0

55.1

74.1

Tax

(15.0)

(9.8)

(16.8)

(17.8)

Profit After Tax (norm)

86.0

86.8

90.2

93.8

Profit After Tax (FRS 3)

(4.2)

17.2

38.3

56.3

Average Number of Shares Outstanding (m)

69.9

70.1

70.3

70.3

EPS - normalised (p)

 

123.1

123.9

128.3

133.5

EPS - normalised and fully diluted (p)

 

122.8

123.8

128.1

133.3

EPS - (IFRS) (p)

 

14.5

24.5

54.5

80.1

Dividend per share (p)

44.3

46.1

47.6

49.5

Gross Margin (%)

30.7

29.2

27.1

25.7

EBITDA Margin (%)

18.1

18.0

17.9

17.8

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

16.5

16.5

16.4

16.4

BALANCE SHEET

Fixed Assets

 

532.1

639.1

584.5

556.9

Intangible Assets

461.5

570.9

524.9

492.7

Tangible Assets

62.6

68.2

59.7

64.2

Investments

8.1

0.0

0.0

0.0

Current Assets

 

250.6

308.5

346.1

356.3

Stocks

73.7

81.8

91.7

97.3

Debtors

101.5

117.0

143.5

146.8

Cash

41.3

45.5

45.5

45.5

Other

34.1

64.2

65.5

66.8

Current Liabilities

 

(199.8)

(181.4)

(187.2)

(192.1)

Creditors

(199.8)

(181.4)

(187.2)

(192.1)

Short term borrowings

0.0

0.0

0.0

0.0

Long Term Liabilities

 

(279.6)

(447.5)

(423.5)

(376.2)

Long term borrowings

(170.8)

(341.0)

(329.7)

(282.0)

Other long term liabilities

(108.8)

(106.5)

(93.8)

(94.2)

Net Assets

 

303.4

318.7

319.9

344.9

CASH FLOW

Operating Cash Flow

 

97.8

85.4

85.4

131.0

Net Interest

(4.5)

(6.0)

(7.5)

(13.6)

Tax

(22.9)

(26.0)

(17.3)

(17.8)

Capex

(17.7)

(6.4)

(11.8)

(18.2)

Acquisitions/disposals

(104.5)

(171.8)

22.0

0.0

Financing

2.2

4.9

0.0

0.0

Dividends

(29.7)

(31.3)

(32.6)

(33.7)

Other

(5.6)

(13.9)

(26.9)

0.0

Net Cash Flow

(84.9)

(165.2)

11.4

47.7

Opening net debt/(cash)

 

42.2

129.5

295.6

284.2

HP finance leases initiated

0.0

0.0

0.0

0.0

Other

(2.5)

(0.9)

0.0

0.0

Closing net debt/(cash)

 

129.5

295.6

284.2

236.5

Source: Company reports, Edison Investment Research estimates

Contact details

Revenue by geography

417 Bridport Road
Greenford
Middlesex. UB6 8UA.
United Kingdom
+44 (0) 20 8813 4321
www.ultra electronics.com

Contact details

417 Bridport Road
Greenford
Middlesex. UB6 8UA.
United Kingdom
+44 (0) 20 8813 4321
www.ultra electronics.com

Revenue by geography

Management team

Chairman: Douglas Caster CBE

CEO: Rakesh Sharma

Having previously worked for Racal and Schlumberger, he joined Dowty in 1988. In 1992, he became MD of Sonar & Comms and after participating in the Ultra MBO, joined the board in October 1993. In April 2000, was promoted to MD of I&PS division. In April 2004 appointed COO, becoming CEO in April 2005. Appointed deputy chairman in Apr 2010 and became chairman in April 2011. He is also Chairman of Metalysis Limited since 2015 and a NED at Morgan Advanced Materials.

Began his career at Marconi in 1983 before moving to Dowty as chief engineer of Sonar & Comms in 1989. Appointed marketing director in 1993 when Ultra was formed. From 1997 to 1999 worked in the US as Ultra's operations director, NA. After returning to the UK he was MD of PMES and then Sonar & Comms before becoming MD, Tactical & Sonar in 2005. In 2008 he ran the Group's I&PS Div before being appointed COO in January 2010. Appointed to the board in April 2010 and CEO in April 2011.

CFO: Amitabh Sharma

Qualified as a Chartered Accountant in 1993 and worked at KPMG until he joined Ultra Electronics in 1999, where he spent six years as Group Financial Controller. In 2005 he was appointed Group Finance Director at Gibbs and Dandy and became a Divisional Finance Director at St Gobain following its purchase of Gibbs in 2008. In 2014 he became Group Financial Controller at Senior, before taking up an FD role at a start-up. He re-joined Ultra in Jan 2016, becoming Group Finance Director and joining the Board in May 2016.

Management team

Chairman: Douglas Caster CBE

Having previously worked for Racal and Schlumberger, he joined Dowty in 1988. In 1992, he became MD of Sonar & Comms and after participating in the Ultra MBO, joined the board in October 1993. In April 2000, was promoted to MD of I&PS division. In April 2004 appointed COO, becoming CEO in April 2005. Appointed deputy chairman in Apr 2010 and became chairman in April 2011. He is also Chairman of Metalysis Limited since 2015 and a NED at Morgan Advanced Materials.

CEO: Rakesh Sharma

Began his career at Marconi in 1983 before moving to Dowty as chief engineer of Sonar & Comms in 1989. Appointed marketing director in 1993 when Ultra was formed. From 1997 to 1999 worked in the US as Ultra's operations director, NA. After returning to the UK he was MD of PMES and then Sonar & Comms before becoming MD, Tactical & Sonar in 2005. In 2008 he ran the Group's I&PS Div before being appointed COO in January 2010. Appointed to the board in April 2010 and CEO in April 2011.

CFO: Amitabh Sharma

Qualified as a Chartered Accountant in 1993 and worked at KPMG until he joined Ultra Electronics in 1999, where he spent six years as Group Financial Controller. In 2005 he was appointed Group Finance Director at Gibbs and Dandy and became a Divisional Finance Director at St Gobain following its purchase of Gibbs in 2008. In 2014 he became Group Financial Controller at Senior, before taking up an FD role at a start-up. He re-joined Ultra in Jan 2016, becoming Group Finance Director and joining the Board in May 2016.

Principal shareholders

(%)

Aberdeen Asset Managers

11.07

Fidelity Worldwide Investments

9.49

Artemis Investment Management

5.03

JO Hambro Capital Management

5.02

Schroder Investment Management

4.65

Columbia Threadneedle Investments

4.54

Blackrock Investment Management

4.14

Companies named in this report

BAE Systems (BA/ LN) Thales (HO FP) Raytheon (RTN) Rockwell Collins (COL) L-3 Communications (LLL)

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London +44 (0)20 3077 5700

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New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

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 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

Edison, the investment intelligence firm, is the future of investor interaction with corporates. Our team of over 100 analysts and investment professionals work with leading companies, fund managers and investment banks worldwide to support their capital markets activity. We provide services to more than 400 retained corporate and investor clients from our offices in London, New York, Frankfurt, Sydney and Wellington. Edison is authorised and regulated by the Financial Conduct Authority. Edison Investment Research (NZ) Limited (Edison NZ) is the New Zealand subsidiary of Edison. Edison NZ is registered on the New Zealand Financial Service Providers Register (FSP number 247505) and is registered to provide wholesale and/or generic financial adviser services only. Edison Investment Research Inc (Edison US) is the US subsidiary of Edison and is regulated by the Securities and Exchange Commission. Edison Investment Research Limited (Edison Aus) [46085869] is the Australian subsidiary of Edison and is not regulated by the Australian Securities and Investment Commission. Edison Germany is a branch entity of Edison Investment Research Limited [4794244]. www.edisongroup.com

DISCLAIMER
Copyright 2016 Edison Investment Research Limited. All rights reserved. This report has been commissioned by Ultra Electronics and prepared and issued by Edison for publication globally. All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report. Opinions contained in this report represent those of the research department of Edison at the time of publication. The securities described in the Investment Research may not be eligible for sale in all jurisdictions or to certain categories of investors. This research is issued in Australia by Edison Aus and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. The Investment Research is distributed in the United States by Edison US to major US institutional investors only. Edison US is registered as an investment adviser with the Securities and Exchange Commission. Edison US relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. As such, Edison does not offer or provide personalised advice. We publish information about companies in which we believe our readers may be interested and this information reflects our sincere opinions. The information that we provide or that is derived from our website is not intended to be, and should not be construed in any manner whatsoever as, personalised advice. Also, our website and the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. This document is provided for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.
Edison has a restrictive policy relating to personal dealing. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report. Edison or its affiliates may perform services or solicit business from any of the companies mentioned in this report. The value of securities mentioned in this report can fall as well as rise and are subject to large and sudden swings. In addition it may be difficult or not possible to buy, sell or obtain accurate information about the value of securities mentioned in this report. Past performance is not necessarily a guide to future performance. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (ie without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision. To the maximum extent permitted by law, Edison, its affiliates and contractors, and their respective directors, officers and employees will not be liable for any loss or damage arising as a result of reliance being placed on any of the information contained in this report and do not guarantee the returns on investments in the products discussed in this publication. FTSE International Limited (“FTSE”) © FTSE 2016. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under license. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

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 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

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 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

Probiodrug — Update 13 September 2016

Probiodrug

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