Chemring recovery gets City excited

Following Chemring has been both a painful and often terrifying experience for investors since early 2011. It's lost shareholders a pot of money, too. But former Aussie military man Michael Flowers, the third chief executive in four years, appears to be leading a recovery at the flares and countermeasures firm, which continued apace in the fourth quarter.

It hasn't been straightforward. Some of Chemring's problems, such as declining defence budgets in the west, have been felt industry-wide; others have been company-specific, including a fatal accident at its Kilgore flares plant in 2014. It's why the share price collapsed from over 700p to a 10-year low of 90p in June.

However, legacy issues overcome, Chemring has just beaten full-year expectations following a decent fourth quarter. Revenue surged 51% to £188 million in the three months ended 31 October, thanks to deliveries on the 40mm ammunition contract and further work at both the countermeasures and the Energetics explosives and propellants division.

Full-year revenue is tipped to grow £100 million to a better than expected £477 millionIt's why annual numbers will "be in line with market expectations, with a slight upside resulting from foreign exchange gains".

Full-year revenue is tipped to grow by around £100 million to a better-than-expected £477 million, or £440 million at constant currency. And the weak pound flatters the order book - up about £23 million year-on-year - to the tune of £103 million. That's because Chemring does lots of work in the US for which it is paid in dollars. At constant currency, the order book fell.

Apart from the revenue beat, City analysts are also going ga-ga over cash. After an £80 million rights issue earlier this year, net debt has shrunk from £154 million, or £147 million at the end of the third quarter, to £88 million, or £65 million at constant currency.

"Cash in fourth-quarter was excellent and net debt lower than we had expected," said Investec Securities analyst Chris Dyett. "Investors had been worried about a miss here."

"The improved financial position, with net debt/earnings before interest, tax, depreciation and amortisation (EBITDA) of 1.2x and falling, provides the company with greater flexibility when deciding on the speed of investment, restructuring and on terms with suppliers. This flexibility is a real advantage."

And Sanjay Jha over at Panmure Gordon is so impressed he's upgraded the shares to 'buy' from 'hold' and raised his price target from 136p to 175p.

"Our main reservation to becoming a buyer has been removed, profit is converting to cash and the balance sheet looks much stronger," says Jha. "We estimate that in fourth-quarter underlying net cash inflow was £71 million after an underlying net cash outflow of £46 million in the first nine months of the year."

On Jha's upgraded earnings per share (EPS) forecasts of 11.5p for 2017, Chemring trades on a forward price/earnings (PE) ratio of 14 times. That new price target is equivalent to the Aerospace & Defence sector PE of 15.

Trump's win in the US presidential election is widely seen as positive for the defence sectorOur resident stockpicker Edmond Jackson gets a pat on the back for this one. In September, he backed the shares at 143p, claiming that "in a 'bombed out' situation like this it only needs bad news to abate for a stock recovery trend to begin". It has.

"An early-stage buy case, therefore, derives from various positives: medium-term scope for improved defence spending; a rights issue having mitigated debt and enabled investment; a stream of bad news ebbing; a five-year chart low and the directors buying.

"Chemring has plenty to prove but that goes with contrarian investing."

Chemring remains a risky play, but things have certainly picked up. Watch for further confirmation at the final results on Thursday 19 January.

That will be too early for any hint as to the impact of a Trump victory on business, but his win in this month's US presidential election is widely seen as positive for the defence sector.

An afternoon interview with Mike Flowers

Mike Flowers was in optimistic mood when I caught up with him this afternoon. He's clearly pleased that the rights issue has got the business away from the day-to-day management of debt.

"We can now focus on the day-to-day essentials of the business," he told me. "It really has been just a consistent approach from all of the businesses. No standouts. That's a real positive."

There's also good news on industry dynamics. "Nothing particularly is changing," says Flowers. "The US budget has been growing a little bit and, with the new [Trump] administration, that will continue.

"Overall, the market will be quite stable or see modest growth, and it's my job to deliver the operational performance that means out of even modest growth in macro, we can seek to grow a little more than that."

I asked about contract delays, too, so often a bugbear for Chemring. "We have got better at predicting when orders are going to come in," I'm told. "It's very difficult, but we don’t want to be reliant on one order to do the numbers. We need to be more robust than that. It's pleasing in these results that I've got no one to blame! Nothing of significance has been delayed."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.