Another profit warning from Chemring (LON:CHG) caused its shares to plunge by some 17% this week, and although trying to catch a falling knife is usually as dangerous as the products made by the company, its growth over the last decade makes it worth a closer look.
Chemring is a defence company with a market capitalisation of £536m, placing it in the FTSE250. The group specialises in the manufacture of energetic material products and countermeasures and provides solutions in defence, security and safety markets. They are involved in advanced development programmes in the UK, USA, Europe and Australia and operate in four market sectors: Counter-IED, Countermeasures, Pyrotechnics and Munitions. As a result of the growth in threat detection systems, electronics now represents 40% of their revenues and the long-term strategy is to maintain a balance between high technology electronics and energetic products.
Over the 10 years from 2002 to 2011 the company appears to have gone from strength to strength with compounded annual growth rates as follows: revenue 25%; adjusted EPS 37%; basic EPS at 33%; and dividends per share at 31%.
Had £1,000 been invested in the company at the start of the period it would have been worth £11,873 at the end of the 10 years with dividends reinvested: an annualised total return of 28% (source: Chemring).
But good things don’t last forever…
Despite the excellent long term record of the company, 2011/12 has been much more difficult and the defence sector generally has struggled with government budget cuts which has either seen orders cancelled or delayed. But it appears that Chemring’s management have failed to adequately forecast the disruption to its business and have continued to reduce profit expectations as the financial year progressed. The market was therefore taken by surprise by the end of year trading statement on Thursday which delivered the knock out blow:
…the Group has reduced its expectations for its earnings per share for the financial year ended 31 October 2012 by 13 pence.”
The announcement cited 3 principal reasons for the reduction: (1) delays in the granting of some export licences regarding a contract to supply a Middle Eastern customer with vehicle based mortar systems; (2) delay in the receipt of a multi-year contract for the supply of aircraft countermeasures to a customer in the Middle East; and (3) a product not being accepted by a customer due to technical problems.
Delays, delays and excuses, and all this following the week after the company announced the resignation of its CEO, David Price, to be replaced by Mark Papworth, formerly of Wood Group plc and Rolls Royce. Hardly surprising then that the market hammered the share price by 17% on the day, falling to a year low of 260p, around a half of the share price a year before and well down from a high of around 720p in early 2011. The price bounced back 6% on Friday, but the fall will have woken up any sleeping bargain hunters from their slumber. The question is: does Chemring present a good buying opportunity or is it a value trap?
At a current price of 277.3p CHG sits on a historic P/E based on adjusted EPS of only 5.3 (and 7.0 on basic EPS) which is oviously at a large discount to the market. In terms of the forecast for 2012, it is difficult to establish exactly which estimate to deduct management’s 13p reduction from, but the analysts estimates as per the company’s website are showing a forecast EPS of 54p and so if we assume a forecast of around 40p the P/E estimate is approximately 7.0 for 2012. As for 2013, it remains to be seen whether those forecasts will now be cut, although one would hope not by much bearing in mind the delays referred to above should largely defer the profit from one period to the next; and the cynic in me also wonders whether the incoming CEO saw an opportunity to throw the kitchen sink at the numbers to flatter future comparatives. This is of course the optimistic view: the pessimist on the other shoulder will say that the trading problems and delays will persist and the company will continue to struggle with orders at least until government spending improves, causing a knock on effect through the coming periods as well. But the job of valuation is to ensure that such pessimism is already factored in and with a P/E of barely over 5 that seems to be the case.
The value credentials are further underpinned by the dividend yield which will no doubt also appeal to income seekers. The interim dividend for 2012 was lifted by 33% to 5.3p after the company stated in last year’s annual report that its dividend policy going forward would be to reduce dividend cover to 3 times. This gives a trailing twelve month dividend of 16.1p and a yield of 5.8%, again significantly cheaper than the market average and double the FTSE250. Given the high yield it is therefore paramount to consider dividend sustainability. We have already seen the impressive historic growth rate over the last 10 years during which period the adjusted dividend cover was high, reducing to 3.5 times on adjusted EPS in 2011 as part of its change in dividend policy and even on basic EPS the dividend was still covered 2.7 times which provides a good margin of safety.
In fact, Chemring’s largest shareholder is Invesco, via the king of income fund managers himself, Neil Woodford. Invesco hold almost 30% of the company and last year very nearly got themselves into a right pickle whereby they accidentally breached the 30% holding level which is the trigger point for a mandatory bid. Luckily for them the Takeover Panel recognised it as a mistake on the basis that Invesco undertook to immediately reduce their holding to beneath 30%.
It is also instructive to look at several years’ cash flows, not only to see how well dividends have been covered by free cash flow, but also to understand other aspects of the business which can’t be gleaned from the income statement or balance sheet. Below is a table showing a summary of cash flows for the last 7 years showing both the free cash flow analysis and how it was utilised.
Since 2006 free cash flow cover has steadily declined and in 2011 the declared dividend was uncovered – something which should ring alarm bells for dividend seekers. Given the company’s growth rate it is perhaps not surprising that free cash flow is lower than earnings given the additional investment required in capital expenditure and working capital that it is usually required, but nevertheless it warrants further investigation. In the 2011 annual report it makes reference to capital investment of £24.4m in new countermeasures facilities in Salisbury (UK) and Lara (Australia), as well as new energetics facilities in Scotland. Given that this is clearly defined investment in future growth as opposed to maintenance capital expenditure, if we allowed for this then the adjusted free cash flow cover would be over 1.4 times. It is however important to keep an eye on the capex levels going forward. The other item to point out is the large increase in “intangible” expenditure which has arisen as a result of the group’s increased spend on research and development which again should bode well for future growth.
The other obvious point of note from the cash flow is how acquisitions have been a major part of Chemring’s expansion which is shown by the below acquisition timeline from the Company’s website:
The net amount spent on acquisitions over the 7 years was £456m which was almost 3 times the company’s free cash flow for the same period. It is hardly surprising then that the company’s gearing has been relatively high, at times approaching 100%, with the occasional need to place further shares to fund the cost of the acquisitions. In 2011 however the gearing reduced to 55% given that only part of the proceeds from a share placement was spent on acquiring GD Detection Systems.
At the 2012 half year net debt had increased to £311m, or 2 times EBITDA. At over 3 times last year’s underlying net profit this is manageable, although I would feel uncomfortable to see any material increase from here without an improvement in trading. At the time of the interim report the directors believed that the debt would be lower at the year end, but this needs keeping an eye on from a dividend sustainability point of view. Dividend investors do not want to see that free cash flow being directed towards debt reduction.
Lastly, it is relevant to note that in recent weeks Chemring has been subject to a potential takeover bid by the Carlyle Group, the US private equity firm. This was announced on 17 August 2012 and the Takeover Panel has given them a deadline of 9 November 2012, only a few days away, to decide whether they will proceed with a formal offer. The share price jumped some 33% to 415p after the August announcement, although fall in share price since then is probably also due to increasing doubts that the takeover will proceed. Nevertheless, the potential of a takeover bid can sometimes be a further sign that a company is undervalued.
Overall, it is clear that Chemring is facing difficulties at present which have resulted in a further profits warning and the resignation of their CEO in the last two weeks. That presents some risk to the valuation until trading improves, but the low price relative to earnings appears to reflect this risk and the yield provides the potential of a decent income return in the meantime. Given the excellent track of the company up to 2011 this may well be an opportunity to pick up a quality company at a bargain price.
Disclosure: the author holds shares in Chemring.