CHG.L - Chemring

[petec]

• Several different defence divisions, all lumpy, not sure on worth of too much detail.  Counter-IED (6% global share but 25% in the main bit, detection systems), Countermeasures (60% share in expendables?!), Pyrotechnics (light and smoke flares, 9% global share), Munitions (large calibre, 6% global share).  Lots is expendable and therefore repeat business and/or related to big on-going projects like Eurofighter and JSF, neither of which is in full production yet but they will run for 10-15 years plus.  Customer needs are fast changing but materials knowhow is key, manufacturing standards are high, and safety is paramount, which probably confer an advantage.  R&D/sales 8%.

• LT I don't like government budgets cuts impacts but sadly I think we'll keep fighting and defence spending is growing ex-NATO.  There is operational gearing though, so volume falls are not good.  And the last 10 years were boosted by Iraq, Afghan.  That said, they say orders have already fallen due to the wind-downs there and stockpiles are therefore dwindling.  Also most contracts are competed so pricing pressure is always there, not new.

• 42% US by revenue, 30% non-Nato in 1H, from 24% last year, going to 40% target.  Non-NATO is lower margin and slower payment but nice diversification.  Sequestration would be a 10% budget cut but people are focussing on the uncertainty rather than the scale.

• Current poor half due to delayed order which came on last day, WC outflow for same reason as they prepared for the order.  Meant debt up to £315m = 2x EBITDA but £70m fcf forecast for full year, plus selling a division for £17m, so should reverse.  Much of the debt is in dollars but then so are revenues; at year end 260/354 total debt was >5y maturity.  Covenants are breached at 4x d/ebitda and 10x finance costs/ebitda.  £25m pension deficit (£65m total liability).

• Even so, revenues +4% in 1H, y/y.  Record order book £1bn up 7% y/y, deliverable 2012 and 2013.  Confirmed orders cover 94% of guided revs for 2H and dividend raised 33% signals confidence.  May was a strong month, last of 1H.

• Market does not like history of missing guidance, nor the uncertainty in the US, nor the cash flow timing issues.  Far less focus on intrinsic value than there is on these issues, e.g. CS worrying about 'Middle East religious festival timing issues' affecting cash flows and 2H guidance.  CS dropped PT by 21% while dropping estimates 7%.  I don't really care that management are bad at guidance unless their optimism causes them to layer in un-necessary costs.

• 1.1xBV vs. 5y average on BB of 3.4x, although BV is ~90% made up of GW and other acquired intangibles.  £70m FCF would be a 13% free cash yield; 6% comes in dividend and there is scope for a buyback though I would rather see debt paydown.  1H came in at 16.8p eps vs. consensus 19p; even if 2H is the same, the stock is on 7.9x.  Even if estimates get cut by half it is cheap based on historic multiples.  Takeout candidate?

 

Averages

10y avg

5y avg

3y est avg

Sales growth incl acquis

28.6%

32.1%

4.6%

Gross margin

33.4%

34.3%

34.5%

Operating margin

17.1%

22.1%

17.9%

Net margin

9.3%

11.8%

13.0%

Net income growth

40.4%

47.4%

16.5%

FCF conversion pre acquis

21%

62%

69%

RoE

17%

21%

19%

High PE

22.2x

19.7x

Low PE

13.0x

12.5x

PE now

5x