It has always been that selling weapons or related gear has been a profit generating business, and in this article I am talking strictly legal arms trade. Those investors who have no qualms investing in this particular sector must consider the Hampshire-based Chemring Group Plc (CHG). The £750m-Cap, London-listed company has come to my attention because it seems to have quite a fan base on the Web; most of these fans seem future-optimistic. Having put the company under my dusty microscope I could see the attraction of the stock, as well as some uncertain spots the enthusiasts seem to have brushed under the carpet.
The market leading Chemring occupies two market segments of the defence sector: that of energetics (battlefield simulation, vehicle-mounted mine detection etc.) and that of countermeasures (flares, decoys etc). Although the revenues are fairly evenly split between the two segments, countermeasures £158m and energetics £197m, the growth potential seems to be much heavier in energetics (last year revenues grew by 86%), compared to a still noteworthy uplift of 22% in countermeasures.
The 3000 employee-strong company has a geographic spread many firms of its size would envy. The products are distributed in the USA (40%), Europe (43% incl. UK) and Australia/Asia (the rest), with the main customers being predominantly the armed forces and the governments. The production facilities are in the USA for the products being sold there, with the UK production facilities servicing European and other markets. The marketing role is carried out by the worldwide sales network Chemring have built up over the years (company started operating in 1905).
The company gets its capital from both debt and equity with a roughly equal split, Debt to Equity Ratio is 47% and the average cost of this capital is 6.7%. Interest expense is covered 5.4 times giving Chemring a solid “A-“ rating.
This capital was put to hard work last year when the company made multiple strategic acquisitions to solidify its market leading position. Total assets have been augmented in the last financial year by acquisition of Non-Intrusive Inspection Technology, Inc. (manufacturer of robot and vehicle-mounted mine detection systems) for $30m plus another $10m in contingent pay outs. Another £12m of cash and £61m of equity was invested in Scot Inc. (manufacturer of devices used in aircraft emergency), Martin Electronics (specialist manufacturer of ammunition devices), Titan Dynamic Systems Inc. (manufacturer of battlefield simulators) and the UK-based Electronics and Engineering Ltd.
Chemring have comparatively low volatility (beta), because the leverage is sustainable, but also for the reason that the company’s assets are generating steady revenue growth while increasing net income margin. In half year to 30th Apr ’09 the revenues stood at £234m, 56% increase over previous reporting period. The income margin reached 12.4%, an improvement of one percentage point over previous reporting period. A margin like this gives us a ROE of 23.9% and ROC of 15%. Considering the above-mentioned cost of capital of 6.7% Chemring are working its assets very well.
Over on the Balance Sheet we have an increase in Total Assets at year end from £364.5 to £581.4m. The increase has come from additions to property, plant and equipment, doubling of intangible assets due to earlier-mentioned acquisitions, and uplift in goodwill by some £34m also due to acquired companies during the year. Inventories and receivables are also piling up due to increase in business volume and cash makes up the remaining £30m increase in assets.
Balance sheet liquidity is good with current ratio being 1.7; only £20m of the company’s debt pile of £197.3m is current.
The cash flow from operations in 2Q2009 has been £24m (£6.4m in 2Q2008). Re-investment, however, remains high and is likely to become higher. For example, growth in CapEx in 2008 has been 113% due to the investments in automation, manufacturing facilities and safety improvements. Going forward, extra capital investments are planned in the UK and Australia where the company is obliged to build a manufacturing facility near Melbourne costing in the region of A$18m.
In the financial 2008 Chemring paid out a dividend of £9.3m or 26 pence a share (40% increase over last reporting period), yielding 1.8%. The dividend is solid at coverage of 4.6 times.
All in all, is there an upside to the current share price? Based on Chemring’s re-investment rate of 73% and ROC of 15% the EPS growth for 2010 is unlikely to exceed 11% (current growth rate forecast of 14.5% is not justified by the fundamentals). Given this rate of growth and the current profit margins, the intrinsic company value hovers in a range of £18.4 a share when valued using Discounted Cash Flow and £23.5 a share when valued using Price Earnings Model. Current share price is £21.20.
Chemring’s strong points would firstly include a solid order book, currently totalling some £630m. What I also like is that the vital R&D funding is being shared between customers and Chemring. Company’s own R&D expenditure grew 7% last year, while customer-funded R&D jumped 39%. The expansion into pyrotechnics market (explosions, flashes, smoke, flames, fireworks) is seemingly on the cards and the management feels there is potential there (current company market share is only 3.5% of total market). Geographic expansion into Japan, India and Korea must occur in the medium-term future; existing customers there are expanding (tempering this, however, is the fact that production facilities and marketing presence in these regions would have to be installed requiring more capital outlay).
Chemring’s weak points must include the fact that the US Department of Defense is the largest customer. And despite the company’s optimistic statements concerning future US Army demand for its gear, the involvement of the US Army across major world theatres is forecast to be on the wane in the coming years. What also deserves careful reflection is that Chemring has been making, and will likely continue to be making, multiple acquisitions; these always carry risks of over-payment, inability to profitably integrate into existing assets or inability to extract sufficient value. Another area for consideration is the company’s capital-intensity; it is challenging to predict CapEx trends in medium term future, and by extension precise cash flows. Finally what sticks out, is that the inside company ownership is 1%. The management have comparatively little skin in the game, so to speak.
Having considered all of the above, its Internet fans have a point when they describe Chemring as “solid” and “well managed”. Numis Securities even figured that “Chemring is currently the fastest growth stock in the sector”. One could certainly argue that the company is an attractive candidate for a long term portfolio.
Alec Hajinoff is the founder of www.onlyprofitable.co.uk
www.proactiveinvestors.co.uk
No comments:
Post a Comment