Chemring Group (CHG)

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Stockwatch: A steady turnaround play

Is defence technology group Chemring (CHG) returning to useful profits if not revenue growth, and able to re-energise shareholder returns?

Its latest prelims to end-October 2017 are bolstered by margin improvements and lumpy revenue from ammunition supplies to the Middle East, which may put the stock off ethical limits to some. Nor do near-term dynamics of Chemring's order book excite, if mainly due to a lumpy aspect and currency translation.

At 185p, the stock is on a price/earnings (PE) multiple of about 15 times, yielding 2%, albeit with strong projected earnings cover of 3.6 times. Net tangible assets are at a 58% discount to market value (given accounting goodwill on acquisitions). Thus, at first sight it's "high enough" until revenue growth proves more consistent and cash flow can justify more hikes in the dividend.

US has declared a major increase in defence spending

Yet, in long-term context, Chemring's markets are declared "emerging from a long period of decline" and US markets look promising after the Senate last September passed a defence bill that backed President Trump's call for a steep increase in military spending - the US constitutes about half of Chemring's revenues, followed by the Middle East, the UK, Asia Pacific and Continental Europe.

It's a cynical view, but apart from the UK and Europe perhaps, some three quarters of Chemring's geographic areas look to offer robust if sometimes lumpy prospects.

Most stock charts only cover the last five years, hence the impression of a volatile-sideways range from 115p to 250p. But going back over 10 years, Chemring soared from 100p in mid-2005, reaching 500p in 2008, then plunged to 300p in the financial crisis, but re-rated sharply again over 700p by 2010.

This resulted in a major head & shoulders chart reversal pattern which, indeed, was followed by a retracing nearly all the way back to 100p in 2016. Such sentiment swings reflected excesses both ways, as defence procurement went from a booming business to one under the cosh for government spending cuts; but the industry trend is indicated improving again.

Building on an established turnaround

I laid out a 'buy' case at 143p in September 2016 after a quarterly update cited a 20%-plus improvement in revenue, and a 12.6% rise in the order book (if helped by currency translation given sterling revenues are sub-20% of total).

A rights issue also cut debt and helped management rationalise sites and implement cost-savings. Insiders also bought £112,690 worthy of equity at prices from 115p to 133p that June to August.

Indeed, it all helped a re-rating to 204p by early 2017, but the price then drifted to 164p by late 2017 despite strong building on 2016 performance - with materially better revenues and margins under an "operational excellence programme" underway.

An update last September then cited particularly strong orders from the US government, like I'd anticipated a year before, if Trump was elected. Yet the shares continued to drift until a financial year-end update cited progress slightly ahead of internal expectations and 15% annual revenue growth. However, the order book was down 19% to £478 million as a major Middle East ammunition order completed and a previous currency benefit had turned headwind.

Margin improvements significantly helping

Prelims to end-October 2017 now clarify the progress as mainly margin improvements, the chief aspect of group revenue growth (15%, or 11% at constant exchange rates) deriving from a Middle East ammunitions' boost to the "energetic sub systems" side, which encompasses space & satellite launch, safety systems, components, and more.

Its operating profit is up 9.8% to £34.8 million on revenue up 31.5%, while the countermeasures division has seen operating profit up 30.5% to £16.7 million on revenue 2.5% lower. Sensors & electronics' operating profit is up 25.4% to £14.3 million on revenue 2.5% lower.

While margin improvement is welcome, slightly lower revenues in two divisions, and a temporary boost to the principal one, explain why the stock has shrugged at the results - remaining unchanged. After an improvement programme has achieved efficiencies, investors next want to see broader and more consistent revenue growth.

Narrative is overall quite optimistic

Chemring's end-markets are declared: "emerging from a long period of decline...indications of global growth in our markets will be around 3% per annum, although in certain niches growth is likely to be stronger."

Within segmental reviews, the countermeasures side "is looking much stronger in both conventional and flare variants; our focus continues on strengthening our market-leading position..." although its order book is only 1% ahead at £178.6 million, with significant US/UK orders offset by changes in Australian ordering.

The "critical US market" is still emphasised as "looking much stronger after years of declining markets." Sensors' order book is 12.4% ahead at £55.4 million, with performance expected to show an improvement this year. However, on the energetics' side it's down 33.4% to £244 million, due to lower volumes of 40mm ammunition, which is material in a group context

The only exception to strength in the areas/segments where Chemring operates, is said to be the UK, but "the Ministry of Defence represents less than 5% of group revenues." The Middle East is stronger, albeit with "lower oil prices reducing some aspects of demand and incurring delays" though recent oil price rises ought to improve this.

Reduction in total debt, but lower cash flow

Repayment of facilities helps explain longer-term borrowings nearly halving to £61.9 million as of end-October 2017, while short-term debt is up 75% to £61.6 million. Despite a 25% reduction in total debt, it's not clear whether this will mitigate interest costs (which clipped 20.4% of operating profit).

Cash at bank has nearly halved to £33.6 million with the cash flow statement showing a 42.1% deduction in cash generated from operations, to £47.1 million, as a £30 million investment in working capital was needed to fulfil energetics' contracts. Trade receivables also increased.

This "investment" seems quite onerous, but "improved relations with suppliers" is expected to improve it. So, it's unsurprising the dividend hasn't re-rated further than to 3p, with some 4 times earnings cover, in the meantime.

Chemring Group - financial summary             Estimates
year ended 31 Oct 2012 2013 2014 2015 2016 2017 2018
Turnover (£ million) 740 472 403 377 477 548  
IFRS3 pre-tax profit (£m) 18.8 -66.5 -5.2 -9.1 8.0    
Normalised pre-tax profit (£m) 53.1 15.8 12.5 -1.9 13.3 44.1 46.0
Operating margin (%) 9.3 6.8 9.8 4.8 5.9 10.1  
IFRS3 earnings/share (p) 5.9 -25.2 -0.6 -2.1 2.4 12.9  
Normalised earnings/share (p) 21.2 12.1 7.4 4.2 4.3 12.9 12.7
Earnings per share growth (%) -45.5 -43.1 -38.6 -43.7 3.6 200  
Price/earnings multiple (x)           14.3 14.6
Historic annual average P/E (x)     19.5 29.0 33.4 37.8 15.1
Cash flow/share (p) 33.0 15.9 6.2 5.5 19.0    
Capex/share (p) 18.6 8.9 10.2 6.8 6.5    
Dividends per share (p) 14.1 6.7 5.4 3.6 1.3 3.0 3.5
Yield (%)           1.6 1.9
Covered by earnings (x) 1.5 1.8 1.4 0.2 3.3 3.8 3.6
Net tangible assets per share (p) 9.1 21.4 27.9 26.8 58.2 78.4  
Source: Company REFS              

Target 250p/share helped by investment and acquisitions

Mind, some of the numbers quoted in the REFS' table vary from the company's presentation of results, and a forecast 12.7p normalised earnings per share (EPS) forecast for the current year looks to need upgrading. Still, a PE in the mid-teens versus a circa 2% yield is a fair summary.

This is unlikely to tempt buyers who will probably also wait for a more promising group order book, which may take until later this year. But, in a long-term context, Chemring is positioned to take advantage of stronger US demand, and I suggest this current quiet period will prove useful for long-term buyers.

The stock won't quintuple like it did from 2005 to 2008, but, with medium-term profit potential over £50 million I suggest a return to at least 250p.

Management says investment has been constrained in recent years, but its "manufacturing base is a priority that will increase in importance in future years". Acquisitions are also indicated, with a priority on sensors where the group seeks to expand its technological and market reach. Accumulate.

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