Avon Rubber — Update 6 May 2016

Avon Rubber

Robust and well positioned

Interim results

Aerospace & defence

6 May 2016

Price	820p
Market cap	£254m

Net debt (£m) at 31 March 2016		8.4

Shares in issue	31.0m
Free float	96%
Code	AVON

Primary exchange	LSE
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	4.5	1.2	6.5
Rel (local)	4.1	(3.2)	18.7

52-week high/low

1,167p

718p

Business description

Avon Rubber designs, develops and manufactures products in the respiratory protection, defence (74% of 2015 sales) and dairy (26%) sectors. Its major contracts are with national security and safety organisations such as the DoD. 82% of sales are from the US and 18% from Europe.

Next event

Year end results

November 2016

Analyst

Roger Johnston

+44 (0)20 3077 5722

industrials@edisongroup.com

Edison profile page

Avon Rubber is a research client of Edison Investment Research Limited

Avon Rubber’s interim results show the group is able to deliver a robust performance even in a more challenging market environment. Despite the absence of an impact order in Protection & Defence and Dairy markets being cyclically weak, the group has managed to progress on all fronts, gaining market share, and is well positioned to accelerate growth once again as markets normalise.

Year end	Revenue (£m)	PBT* (£m)	EPS* (p)	DPS (p)	P/E (x)	Yield (%)
09/14	124.8	16.6	43.7	5.6	18.8	0.7
09/15	134.3	19.8	56.1	7.3	14.6	0.9
09/16e	150.6	20.5	67.2	9.5	12.2	1.2
09/17e	157.4	21.7	56.5	12.0	14.5	1.5

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

Results demonstrate resilience

Avon’s H116 interims show the strategy has created a robust group that can deliver, even in weak market environments. With revenues up 5% to £66.3m, adjusted operating profit up 6% to £9.0m and adjusted PBT up 5% to £8.8m, both divisions made progress despite the challenge of low milk prices and the lack of an impact order. With an effective tax rate of just 1% (2015: 20%) reflecting anticipated geographic split of taxable profits for FY16, the finalisation of 2015 tax returns and a positive tax outcome of certain enquiries, basic EPS was up 29% to 28.7p (2015: 22.3p). Operating cash conversion was high at 163% of operating profit enabling net debt to decrease to £8.4m (£13.2m at end FY15), after £3.5m spent acquiring Argus in October 2015. The interim dividend (3.2p) continues its trend of increasing by 30% as anticipated.

Group now better positioned than in the past

Despite a more challenging market environment, the group is better positioned to benefit from a normalisation of conditions through its sustained investment and development programme. This has translated into both increased operational flexibility to deliver either DoD or impact export orders in P&D, while improved market share across Dairy positions the group to benefit from a cyclical upswing with an even stronger mix than those seen in 2009 and 2013.

Valuation: Accelerated growth opportunities remain

With results indicating that full-year expectations remain intact, we maintain our current PBT forecasts while our FY16 EPS forecast reflects the lower than expected tax rate, which is anticipated to revert to the norm in FY17. While there may be variations depending on the timing of impact orders, we believe that the accelerated growth opportunities remain into 2017 as a result of improved Dairy market share, the addition and synergies created by InterPuls and with a strong pipeline of both DoD and non-DoD orders in P&D. Our SOTP-derived fair value moves to 1,200p per share (from 1,065p) as a result of improved peer ratings.

Results demonstrate robust performance

The interim results once again show Avon’s business is structured with operational flexibility and has the ability to deliver even when markets soften and without impact orders:

■

Revenue increased by 5% to £66.3m (2015: £62.8m) while adjusted operating profit increased by 6% to £9.0m (2015: £8.5m) at an operating profit margin of 13.6% (2015: 13.5%). EBITDA increased by 9% to £13.2m (2015: £12.2m).

■

Adjusted PBT increased by 5% to £8.8m (2015: £8.4m) and with the tax charge decreased to just £0.1m (2015: £1.7m) at an effective rate of 1% (2015: 20%) due to the anticipated geographic split of profits, finalisation of 2015 tax returns and the positive outcome of certain tax enquiries and the enactment of favourable US legislation post the FY15 period end. As a result, adjusted PAT was £8.7m (2015: £6.7m) with basic adjusted EPS up 29% 28.7p (2015: 22.3p) and fully diluted EPS also up 29% at 28.1p (2015: 21.7p).

■

Operating cash conversion remained strong during the period at 163% of operating profit, allowing the group to continue to invest for future growth with capex of £3.8m. As a result of the strong cash conversion, net debt decreased by £4.8m since the FY15 year end to £8.4m even after the £3.5m cash paid to acquire the Argus thermal detection business in October 2015.

■

With the robust performance and sustained growth opportunities, the board increased the interim dividend by 30% to 3.16p (2015: 2.43p) continuing the trend witnessed over the past three years.

Divisionally, the group continued to demonstrate its leadership position in each of its chosen fields:

Protection & Defence: Operational flexibility key

Protection & Defence continued to benefit from recent investments in product development, underpinned by the M50 DoD mask programme while providing operational flexibility to meet export orders. While there were no such impact orders during the period, the division managed to marginally increase revenue to £45.7m (2015: £45.3m) while operating profit increased to £6.6m (2015: £6.4m) arising from a positive mix of product shipped, an improvement in DoD pricing and continued operational efficiency improvement. The differing areas all contributed to the result while overall order intake in H1 totalled £55m (2015: £47m) with £22m of the £30m closing order book due for delivery in H2 providing good visibility at this stage:

■

M50 mask sales to the DoD were 107,000 systems (2015: 112,000) while a further order was received towards the end of the period for 167,000 systems, which underpins order coverage until well into 2017 and allowing the group visibility and delivery flexibility.

■

M61 filter pairs returned to the mix with 36,000 sets delivered during the period (2015: zero) and an order was secured for a further 85,000 pairs expected to be delivered during H2. While this has been a more volatile area, the consumable nature of these means that as M50 masks are used in increasing numbers then demand for filters is set to grow although the current budget environment means that orders are more piecemeal at this stage.

■

Overall sales to foreign military, law enforcement and first responder customers increased year on year, although no single large impact order was received or delivered during the period. Management has indicated that international enquiries continue to be encouraging, but as ever specific timing for receipt and delivery of large orders is historically difficult to predict although the group tends to average one or two per annum and we note that management has stated that the timeline for such an order is shortening.

■

The fire market saw growth following the acquisition of Argus in October. The new thermal imaging range was added to the stable with further developments such as the new Mi-TIC Storm gaining certification.

■

DoD spares sales increased while AEF had a softer first half, having performed very well over each of the last three years, reflecting the variability in timing of certain DoD procurement programmes for fuel and water storage tanks.

The outlook for the divisions remains strong in our view with the group having shown many times over the past five years that the core DoD programme provides stability while the operational flexibility inherent in the manufacturing setup allows rapid delivery of impact orders as they arise. With the MM53 Joint Service Aircrew Mask (JSAM) funded development and test programme also progressing towards conclusion at the end of FY16 and likely to lead to a production contract from 2017 worth in excess of $70m with funding of $12m allocated in the 2017 US budget, further growth opportunities also exist beyond existing products.

Dairy: Positioned for the cyclical upswing

While the dairy market has remained challenging, as previously flagged by management, the group increased revenue by 18% to £20.6m (2015: £17.5m) as a result of the acquisition of InterPuls which offset the cyclical weakness caused by soft milk prices leading to extended use of consumables. EBITDA increased by 17% to £4.5m (2015: £3.9m) and operating profit increased to £3.4m (2015: £3.3m). Operationally, there were a number of further developments which position the group well when a cyclical upswing occurs in the dairy market as witnessed previously after the down cycles in 2009 and 2013:

■

Milkrite market share continued to increase. In both the US and European markets, Avon’s own brand Milkrite product market share increased to 50% in the US, of which 28% was the higher margin Impulse Air mouthpiece (31 March 2015: 22%, 30 September 2015: 25%), and to 23% in Europe of which Impulse Air accounted for 4.0% (31 March 2015: 3.0%, 30 September 2015: 3.5%). This continues to reduce reliance on OEM sales and highlights the benefits of the Milkrite strategy even in these softer markets.

■

Cluster Exchange progress. Take up of the Cluster Exchange Service was encouraging both in North America and Europe with 446,000 cows serviced across 1,411 farms, up from 342,000 cows at 1,100 farms at H115. The service provides a more robust, repeatable and predictable revenue stream which again insulates the business against more volatile ordering patterns and positions it well to further increase revenue potential as more farms professionalise and sign up.

■

InterPuls integration. The integration of InterPuls has progressed well. While the current market environment has a greater effect on the more capital-intensive spend of its customer base, the acquisition has provided both improved relationships with European distributors for Milkrite and also provides substantial North American upside opportunities for InterPuls products that have not been present in the market as yet. Preparations are underway with dealers being trained, samples being distributed and products launched to the market.

In addition to these drivers, the group continues to pursue opportunities in emerging markets and the sales and distribution operations opened in China and Brazil are progressing to plan. Overall, we view the division as even better placed to benefit from the cyclical upswing once markets improve than it was following the 2009 and 2013 lulls seen previously. As a result, Avon continues to invest in sales capacity to capture further market share as it has done in the past.

Operating forecasts remain unchanged

Following the interim results and the continued progress across the group even in more difficult markets, we are maintaining our operating forecasts for FY16 and FY17 respectively. Our FY16 EPS forecast has increased to 67.2p/share (previously 54.7p/share) due to the lower than forecast tax rate. We anticipate this to return to a more normalised level in FY17.

Valuation uplift potential intact

We continue to view Avon as having a core underlying valuation supported by the existing business which has demonstrated its capacity to deliver even in a more challenging market environment and in the absence of impact orders. We therefore continue to value the group based on the methodology as laid out in our November 2015 Outlook note. This yields a core fair value of 1,200p/share as shown in Exhibit 1 below, up from 1,065p/share due to increased peer ratings and a lower net debt position:

Exhibit 1: Edison sum-of-the-parts fair value

	CY16e EBITA (£m)	Tax rate	CY16e NOPAT (core) (£m)	P/E	Value (£m)	Notes
Protection & Defence	15.1	22%	11.8	20.4	241.0	10% premium to MSA (17.5x), Tyco (17.8x) and 3M (20.4x)
Dairy	8.2	22%	6.4	21.0	135.0	50% premium to Skellerup/in-line with Genus
Net debt					(4.0)	Sep 16 year end estimate
Equity value					372
Shares in issue					31.0
Implied fair value per share (p)					1,200

Source: Edison Investment Research. Note: P/Es taken as at 3 May 2016.

Adding the incremental opportunities which we believe continue to exist as before, our potential upside scenario generates a fair value of 1,470p/share as shown in Exhibit 2 below:

Exhibit 2: Edison sum-of-the-parts fair value including upside opportunities

	CY16e NOPAT (core) (£m)	CY16e NOPAT (increment)	CY16e NOPAT	P/E	Value (£m)	Notes
Protection & Defence	11.8	2.3	14.1	20.4	286.6	10% premium to MSA (17.5x), Tyco (17.8x) and 3M (20.4x)
Dairy	6.4	1.6	8.0	21.0	168.9	50% premium to Skellerup/in-line with Genus
Net debt					0.0	Sep 16 year end estimate + £5.0m incremental operating profit converted at 80%
Equity value					456
Shares in issue					31.0
Implied fair value per share (p)					1,470

Source: Edison Investment Research. Note: P/Es taken as at 3 May 2016.

Given the positive positioning and success in delivering even in the currently more challenged market, we believe that Avon deserves a premium over its peers. Clear identifiable catalysts to drive a re-rating include the receipt of an impact order, an improvement in Dairy market conditions and the transition from development to a production contract for the M53 JSAM aircrew mask.

Exhibit 4: Financial summary

Year end 30 September	£'000s	2013	2014	2015	2016e	2017e
PROFIT & LOSS		IFRS	IFRS	IFRS	IFRS	IFRS
Revenue		124,851	124,779	134,318	150,556	157,433
Cost of Sales		(91,140)	(83,264)	(89,629)	(100,464)	(105,054)
Gross Profit		33,711	41,515	44,689	50,091	52,379
EBITDA (before amort. and except.)		20,443	23,303	25,225	28,065	31,033
Operating Profit (before amort. and except.)		14,223	17,003	20,215	20,956	22,041
Amortisation of Intangibles		(417)	(261)	(1,043)	(2,500)	(2,500)
Exceptionals		(383)	(2,017)	(604)	0	0
Other		(420)	(400)	318	(400)	(400)
Operating Profit		13,003	14,325	18,886	18,056	19,141
Net Interest		(347)	(274)	(147)	(300)	(150)
Other finance costs		(253)	(187)	(247)	(180)	(200)
Profit Before Tax (norm)		13,656	16,554	19,821	20,476	21,691
Profit Before Tax (FRS 3)		12,403	13,864	17,838	17,576	18,791
Tax		(3,566)	(3,053)	(2,672)	(176)	(4,228)
Tax adjustment		(122)	(450)	(253)	0	0
Profit After Tax (norm)		9,968	13,051	16,896	20,300	17,063
Profit After Tax (FRS 3)		8,837	10,811	15,166	17,400	14,563

Average Number of Shares Outstanding (m)		29.5	29.9	30.1	30.2	30.2
EPS - continuing, normalised (p)		33.8	43.7	56.1	67.2	56.5
EPS - continuing, FRS 3 (p)		30.0	36.2	50.4	57.6	48.2
DPS (p)		4.3	5.6	7.3	9.5	12.0

Gross Margin (%)		27%	33%	33%	33%	33%
EBITDA Margin (%)		16%	19%	19%	19%	20%
Operating Margin (before amort. and except.) (%)		11%	14%	15%	14%	14%

BALANCE SHEET
Fixed Assets		36,928	36,815	74,095	79,177	73,791
Intangible Assets		16,541	17,240	41,309	45,476	43,250
Tangible Assets		20,387	19,575	28,212	29,094	25,933
Other		0	0	4,574	4,607	4,607
Current Assets		34,449	34,971	34,481	36,747	40,735
Stocks		13,374	12,887	17,123	20,813	18,899
Debtors		20,891	19,159	17,026	15,111	19,522
Cash		184	2,925	332	823	2,314
Assets held for sale		0	0	0	0	0
Current Liabilities		(23,369)	(26,453)	(27,178)	(28,578)	(30,521)
Creditors		(17,296)	(19,601)	(18,005)	(19,408)	(21,789)
Short term borrowings		0	0	(2,350)	(438)	0
Tax		(6,073)	(6,852)	(6,823)	(8,732)	(8,732)
Liabilities for assets held for sale		0	0	0	0	0
Long Term Liabilities		(27,312)	(20,317)	(39,194)	(39,160)	(33,709)
Long term borrowings		(11,059)	0	(11,143)	(8,801)	(3,350)
Deferred Tax		(2,977)	(2,315)	(9,734)	(9,996)	(9,996)
Retirement benefit obligations		(11,279)	(16,029)	(16,605)	(18,732)	(18,732)
Provisions		(1,997)	(1,973)	(1,712)	(1,631)	(1,631)
Other		0	0	0	0	0
Net Assets		20,696	25,016	42,204	48,186	50,296

CASH FLOW
Operating Cash Flow		14,708	25,004	20,446	26,893	28,017
Net Interest		(364)	(314)	(147)	(300)	(150)
Tax		(2,229)	(2,903)	(3,270)	(176)	(4,228)
Capex		(11,054)	(6,815)	(6,183)	(8,732)	(9,131)
Acquisitions/disposals		(437)	(31)	(21,228)	(3,500)	0
Equity financing		(1,765)	0	(1,152)	(1,500)	(2,000)
Dividends		(1,132)	(1,422)	(1,859)	(2,198)	(2,870)
Net Cash Flow		(2,273)	13,519	(13,393)	10,487	9,638
Opening net (debt)/cash		(8,725)	(15,937)	2,925	(13,161)	(3,974)
Cash FX effect		123	281	97	0	0
Discontinued operations / relocation		0	0	0	(1,300)	0
Debt FX and Other		(5,062)	5,062	(2,790)	0	0
Closing net (debt)/cash		(15,937)	2,925	(13,161)	(3,974)	5,664

Source: Edison Investment Research

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