Avon Rubber — Update 17 November 2015

Avon Protection (AVON)

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Avon Rubber — Update 17 November 2015

Avon Rubber

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Avon Rubber

Acquisitions add technology and opportunity

Full year results

Aerospace & defence

18 November 2015

Price

1,090.0p

Market cap

£338m

Net debt (£m) at 30 September 2015

13.2

Shares in issue

31.0m

Free float

96%

Code

AVON

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

2.1

24.2

66.4

Rel (local)

3.3

29.4

72.3

52-week high/low

1,167.0p

659.5p

Business description

Avon Rubber designs, develops and manufactures products in the respiratory protection, defence (74% of 2015 sales) and dairy (26%) sectors. Its major contracts are with national security and safety organisations such as the DoD.82% of sales are from the US and 18% from Europe.

Next events

AGM

26 January 2016

Analysts

Roger Johnston

+44 (0)20 3077 5722

Avon Rubber is a research client of Edison Investment Research Limited

Avon Rubber sits in a clear niche leadership position in its chosen markets of respiratory protection and dairy milking equipment. With the forthcoming appointment of new CEO Rob Rennie, the group maintains continuity through Interim CEO Andrew Lewis, who has been instrumental in the transition of the group over the past seven years as CFO. The group continues its growth trajectory delivered through product innovation, market development and through the acquisition of InterPuls.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

09/14

124.8

16.6

43.7

5.6

24.9

0.5

09/15

134.3

19.8

56.1

7.3

19.6

0.7

09/16e

155.7

21.5

57.2

9.5

19.1

0.9

09/17e

162.0

22.6

58.7

12.0

18.6

1.1

Note: *PBT and EPS are normalised, excluding acquired intangible amortisation, IAS19 (R) charges and exceptional items.

Business delivery highlights strategy

Avon has transformed over the past seven years from two divisions with limited products to a group with growing higher margin businesses with expanded high technology product ranges, market exposures and established and trusted brands. FY15 results have clearly demonstrated the benefits, with revenues up 8%, PBT up 20%, EPS up 28%, backed by a 30% uplift in the dividend. With good cash flow and a strong balance sheet even after the £21m acquisition spend during the year, the group is well positioned to continue its growth trajectory which has seen total shareholder returns of 2,872% since transformation commenced in January 2009.

Growth drivers likely to be supported by new CEO

With new CEO Rob Rennie due to commence his tenure on 1 December, we believe that Avon is well set with growth drivers in the short and medium-term. We would be surprised if there were any substantial alteration of this approach in the short-term with the extended management team remaining in-situ and owning the current plan. With key members bought into the strategy, we believe that focus will be on integrating recent acquisitions and delivering further value to shareholders.

Valuation: Deeper pockets and accelerating growth

Avon is positioned to continue its strategy to expand market reach through new product introductions, increasingly visible service revenues and continued export success. With acquisitions, in particular that of InterPuls, also providing new opportunities, we forecast FY16 PBT could rise by up to 23% from our current forecast as new contracts are won and revenue synergies are delivered. With a consistent track record of beating our conservative approach, this would imply an uplift of our fair value from 1,110p/share to 1,355p/share. While this equates to an FY16e EV/Sales multiple of c 3x, we note that in transaction terms, this level was achieved by Latchways in its takeover by MSA in September 2015, highlighting the attractiveness of the personal protection sector.

Investment summary: The story continues...

Company description: Growth machine

Avon Rubber has transformed itself over the past seven years into a well invested group with a significant new product pipeline and leading niche positions in its chosen markets. This has been achieved through a rigorous focus on product development, operational efficiency and market expansion that has opened up numerous growth opportunities and allowed it to deliver total shareholder return of some 2,872% since 2009. With recent acquisitions adding further technology and markets Avon is well positioned to accelerate its growth trajectory in the coming five years.

Valuation: Base case conservative, upside value apparent

We continue to view Avon Rubber as a strong growth story underpinned by a niche leadership position, core long-term contracts and an accelerating pipeline of new product introductions. Our base case fair value using conservative forecasts is 1,110p/share. Given the group’s many opportunities and track record of outperformance, we feel that the potential value of identified incremental opportunities provides a more realistic view of value, yielding a fair value of 1,355p/share based upon FY16 upside forecasts.

Financials: Results demonstrate success

Avon Rubber’s FY15 results have demonstrated the success of the consistent strategy. Revenue was up 8% to £134.3m, driven by a good performance across both divisions, supported by a US$:£ currency tailwind equivalent to £7.2m while InterPuls contributed £1m. Avon’s focus on higher margin sales and improved operational efficiency helped drive adjusted operating profit up 19% to £20.2m with a currency tailwind of £1.0m. InterPuls did not contribute due to acquisition timing.

Underlying PBT increased by 20% to £19.8m while the adjusted effective tax rate declined to 15% as a result of a more beneficial mix and the recognition of a deferred tax asset in the UK following utilisation of UK tax losses. As a result, adjusted EPS increased by 28% to 56.1p. The group again generated strong operating cash flow of £24.1m, equivalent to 119% of operating profit. Following £21.3m spent on the acquisitions of Hudstar and InterPuls, net debt stood at £13.2m.

With good EPS growth, cash generation and visibility, the dividend was increased by 30% for the second year running.

Sensitivities: Broadened reach reducing risks

Given the global nature of the business there are both economic and performance factors:

Cannibalisation of OEM sales: Avon’s focus on driving Milkrite could frustrate OEM customers, cannibalising OE sales, leading to slowing top-line revenues. As 72% of pre-InterPuls Dairy revenues are derived from non-OEMs, we see the downside risk as low.

Defence budgets: defence budgets have remained under pressure over the past few years. Avon has long-term DoD contracts and an increasing awareness of CBRN is improving on the back of recent chemical weapons use in Syria and Iraq, and this could be positive for Avon.

Filter second source: the DOD is now able to dual source from Avon and 3M and the first delivery order awarded in 2015 under this new arrangement was split between the two sources, two thirds Avon, one third 3M. We expect future awards to be split between the two sources.

Acquisition integration: with the pace of acquisitions having increased, management’s ability to successfully integrate purchases will become an increasing area of focus. This has already been demonstrated by the benefits achieved from the smaller acquisitions to date however integration of an acquisition of the scale of InterPuls will provide further evidence.

Company description: Seven years that changed Avon

During the seven years under the leadership of former CEO Peter Slabbert and CFO Andrew Lewis, Avon Rubber has been transformed to emerge a strong, global leader in its chosen niches in respiratory protection and dairy milking markets. With new CEO Rob Rennie due to embark on the next stage of development for the group, we review the progress and positioning as it continues to accelerate growth. This strategy has delivered total shareholder returns of 2,872% since 2009. Development can be summarised as follows:

Phase 1 – Turnaround (2009-11): initial focus was on transformation, outsourcing European dairy manufacturing to the Czech Republic and establishing the Cadillac manufacturing facility while the pension deficit and long-term debt facilities were also addressed.

Phase 2 – Investment (2012-14): Avon entered an investment phase with additional R&D and business development resource to develop new products and market expansion. This phase is ongoing with new international markets being addressed and Project Fusion in Protection and Impulse Air and Cluster Exchange in Dairy having been delivered to date.

Phase 3 – Growth Opportunities (2013-16+): Avon has demonstrated rapid growth in targeted new products and markets such as the Impulse Air vented liner, Cluster Exchange Service, CS PAPR combination system and Deltair SCBA. Organic developments have been supplemented by acquisitions, funded by the strong cash generation resulting from successful execution of the investment phase. With substantial new product introductions and opening of geographic markets, further top-line growth and margin progression should be witnessed.

Avon has demonstrated that it has been able to identify, execute and deliver opportunities to enhance shareholder value through consistent and reliable management. It is indicative of the group that CFO Andrew Lewis stepped into the Interim CEO position until Rob Rennie’s arrival on 1 December, supported by a senior management team that have been instrumental in the strategy.

High performance products that are leaders in their field

Avon Rubber provides respiratory protection equipment for military and other markets. In addition, it is the market-leading manufacturer of consumable milk liners and a broadening range of associated products for the dairy market. Avon’s expertise lies in product design, materials specification and manufacturing efficiency while it is also introducing innovative new service solutions.

Protection & Defence (74% of FY15 revenue)

Avon’s respiratory protection products are sold direct to military markets where their primary customer is the DOD (Army, Navy, Marines, Coastguard and Air Force) as well as approved governments globally. Other significant markets are first responders including the police and other emergency services, addressed either directly or through distribution channels. SCBA and thermal-imaging equipment is targeted at fire services and other industrial users, primarily through a US distribution network. All products are safety-critical and markets are consequently highly regulated with approval standards creating significant barriers to entry with long product cycles.

Avon’s P&D business consists of a growing range of respiratory products. The main products are respirators or gas masks (M50, C50, ST53, M53 and FM12) together with a range of spares and accessories; the NIOSH-approved emergency hood (NH15); rebreathers for escape and underwater use; and SCBA (primarily the Deltair product range). Consumable filters used by these products are manufactured along with the recently acquired thermal-imaging camera equipment. The respirators and escape hoods offer breathing protection to varying degrees against CBRN threats while the SCBA offers protection in oxygen depleted environments. Avon also has a flexible fabrications business, AEF, which manufactures fuel and water storage tanks and hovercraft skirts.

Dairy (26% of FY15 sales)

The Dairy business designs, manufactures and sells products and services used in the automated milking process, primarily rubberware such as liners and tubing. These consumable products come into direct contact with the cow and the milk and are replaced regularly to ensure product hygiene, animal welfare and to maximise milk quality. The €30m acquisition in 2015 of InterPuls, a milking components specialist in electromechanical components, such as pulsators, milk meters, automatic cluster removers, milking clusters, washing systems, vacuum pumps, bucket milkers and pipeline system components has added significantly to the product range, making Avon the complete milking point solution provider. Avon’s products are sold through distributors under the Milkrite and InterPuls brands while they also manufacture a decreasing proportion for major OEMs.

The global market is concentrated in high consumption automated milking markets in North America and Western Europe where Avon has significant market shares. Potential exists outside these traditional markets, in particular in China, India, Russia, Eastern Europe and South America, all of which are currently experiencing rapidly increasing demand for dairy products which is being satisfied through mechanised milking. The acquisition of InterPuls will broaden Avon’s geographic reach, while the addition of InterPuls’s established distribution relationships in emerging markets should accelerate growth in these regions.

Strategy delivering broadened range and higher margins

Avon’s strategy is to target its core market niches, expanding its product offering, developing its own trusted and recognised brands, securing routes to market and delivering an increasing proportion of higher value, higher margin products and solutions to its customers as shown in Exhibit 1 below highlighting the stepped approach to expansion pursued by management.

Exhibit 1: Avon Rubber’s strategic roadmap

Source: Edison Investment Research

In addition to organic growth, the group has demonstrated its ability to identify, pursue and close value-enhancing acquisitions addressing specific technology gaps in the portfolio. With a strong balance sheet, a clear strategic vision and further systems and service based growth opportunities, we believe that the strategy will continue to deliver shareholder value for the foreseeable future.

Targeted acquisitions playing an increasing part

Avon has trailed that it is seeking value enhancing acquisitions to support technology development and market positioning and a number of such targeted acquisitions have recently been completed:

VR Technology: Re-breather technology opened new opportunities

Avon acquired VR Technology in 2013 to accelerate rebreather technology. Originally focused on personal dive computers (a device to monitor divers’ air consumption and ensures correct decompression stops during a dive), VR subsequently developed rebreather designs of their own.

The underlying technology for both products is a suite of control electronics, gas sensors and control valves that manage the diver’s breathing air and maintains oxygen and carbon dioxide levels within the correct range. Now rebranded Avon Underwater Systems, it is designing a product range for military use, developing a multi-capability mine counter-measures rebreather.

Hudstar Systems: Software control brought in-house

Hudstar Systems purchased for $5.1m in 2015, designs and manufactures electronics hardware and software for the fire service industry, including head-up displays, wireless communication systems, personal alert safety systems, pressure transducers, telemetry systems and remote air management systems. It manufactures electronics equipment for Avon’s Deltair product, principally the console unit.

The acquisition reduces supply chain risk due to the vertical integration of this key supplier for the Deltair, safeguarding production capability and reducing production costs. It also provides a route to in-source other components purchased across the rest of the product range, for example circuit boards for dive computers and rebreathers further improving margins.

As well as reducing costs, Hudstar also provides access to a number of different technologies (some of which are patented) that could be used across the rest of the product range and in future product development, for example, in telemetry and more complex in-mask heads up displays. The added electronics capability also providing added electronics expertise within Avon’s engineering skill base that can be used to improve existing products and services.

e2v’s thermal imaging business: Enhancing the systems based approach

After the year end the Group announced the acquisition of Argus, the thermal imaging camera business of e2v for £3.5m. This further strengthens Avon’s product range in the fire and first responder markets and has several benefits, reflecting the group’s strategic approach:

Complementary product addition to Avon’s current NFPA compliant first responder offering; Deltair SCBA, providing the ability to leverage and expand current fire distribution network within the Americas through a broader product portfolio.

Immediate access to the first responder market that demands a NFPA 1801 compliant thermal imaging camera allowing increased penetration with Avon’s current strategic Law Enforcement distributors/agents and installed customer base.

InterPuls: Moving up the food chain

In August 2015 Avon made the significant strategic acquisition of InterPuls for a total consideration of €29.75m. This acquisition, combined with existing activities, makes Dairy a leading international provider of milking point technology, providing complete teat to pipeline solutions for the sector:

InterPuls adds high technology products providing the farmer with a range of high margin technical solutions including pulsators, milk meters, automatic cluster removers and vacuum pumps, enabling customers throughout the world to configure state of the art milking systems.

InterPuls is expanding beyond traditional milking components into high technology sensors and devices to monitor the life cycle of a cow, analysing milk production, reproduction and health data to provide critical management information to increase operational efficiency of the farm.

The combination of the largely non-overlapping sales force of InterPuls with Milkrite should drive higher sales growth than either company could have achieved alone by extending international reach and cross fertilising product ranges. The larger business combination will also increase Avon’s market profile in the higher margin market sectors targeted for expansion.

CEO transition supported by strong core team

With new CEO Rob Rennie due to begin on 1 December, the transition has been overseen by CFO Andrew Lewis acting as Interim CEO, supported by a strong senior management team that has created and delivered the growth strategy together. These include: Sarah Matthews-DeMers, Associate Group Finance Director; John Kime, President of Avon Protection Systems; and Paul McDonald, MD of Dairy. We have met each of the team on numerous occasions and have been impressed with the collective clarity of vision. It is this depth that suggests to us that the strategy is likely to be maintained and evolved rather than completely re-written.

Financials demonstrate success – strong FY15

Avon Rubber’s FY15 results have demonstrated the success of the consistent strategy:

Revenue: Avon reported an 8% growth in revenues to £134.3m (2014: £124.8m), driven by a good performance across both divisions with P&D up 7% and Dairy up 11% supported by an 11 cent US$:£ currency tailwind equivalent to £7.2m. The organic growth was achieved despite a tough comparator in FY14 in P&D following two large non-DoD sales and some softening of European Dairy markets in H2 while InterPuls contributed £1m since August 2015.

Adjusted operating profit: Avon’s continued focus on higher margin sales and improved operational efficiency helped drive adjusted operating profit up 19% to £20.2m (2014: £17.0m). Currency supplied a tailwind of £1.0m while InterPuls did not contribute due to the acquisition timing. Consequently, operating margins increased by a further 150bp to 15.1% (2014: 13.6%).

EPS up 29%: underlying net interest costs reduced slightly to £0.2m (2014: £0.3m) and other non-cash finance expenses were broadly flat at £0.2m. Underlying PBT therefore increased by 20% to £19.8m (2014: £16.6m). The adjusted effective tax rate declined to 15% (2014: 21%) as a result of a more beneficial mix and the recognition of a deferred tax asset in the UK following utilisation of UK tax losses. As a result, adjusted EPS increased by 28% to 56.1p (2013: 43.7p).

Cash generation strong, net debt following acquisitions: the group again generated strong pre-exceptional operating cash flow of £24.1m (2014: £26.5m), equivalent to 119% of operating profit, through sound operational management. Investment in 2015 was £6.2m (2014: £6.8m) as new product development in Project Fusion continued and investment in the roll out of Cluster Exchange continued in Dairy. Following £21.3m spent on the acquisitions of Hudstar and InterPuls, net debt stood at £13.2m with bank facilities of £26.4m committed to November 2018.

Dividend increased strongly: with good EPS growth, cash generation and visibility, the final dividend was increased by 30% to 4.86p which, added to the interim dividend of 2.43p, results in a 30% increase in the full year dividend, for the second year running, to 7.29p (2013: 5.61p).

Avon’s results came in marginally ahead of our previously upgraded forecasts by 1% at the PBT level but a significant 8.5% at the EPS level due to lower than forecast tax rate. We are increasing our FY16 PBT forecast by 4% and initiate FY17e PBT growth of 5% to £22.6M. We raise our FY16 EPS forecast by 8% to 57.2p and initiate FY17e growth of 3% to 58.7p as tax rates normalise and the impact of the higher effective Italian tax rate comes into full effect.

Protection & Defence – demonstrating business balance

FY15 results demonstrated the benefits of the numerous opportunities being pursued in P&D. With a good performance across all parts of the division, reported revenue increased by 7% to £98.8m (0.3% at constant currency). Core DoD, Fire and AEF business all grew, offsetting a decline in non-DoD revenues (£27.7m versus £31.0m) following two large impact orders delivered in 2014. Margins improved despite higher DoD sales as operational efficiencies were achieved following closure of Lawrenceville and increased prices were achieved in the DoD contract. This allowed operating profit to grow by 17% to £15.9m. 50k DoD mask orders remained in hand at year end, providing cover into Q216 before which a further release is anticipated. Avon also received an award for 124k filter pairs in H215 under the new dual sourced contract. Other developments included:

Joint Aircrew Service Mask (JSAM): design, development and testing progressed well while the DoD extended its testing programme and funded Avon for a further 12 months, at which point a follow-on production worth up to $74m is anticipated.

Non-DoD sales: commercial sales to non-DoD markets eased in 2015 to £27.7m due to the strong comparator in FY14 from two large impact orders versus one in FY15. The industrial portfolio progressed in oil & gas markets, while the fire market grew following release of the NFPA-approved Deltair SCBA, one of only four units to have achieved this standard.

AEF delivered a third strong year of contribution having secured orders for hovercraft skirt and fuel & water storage tanks with an increasing non-DoD focus while DoD spares remain volatile.

Dairy – transitioning to higher value position

Dairy continued to increase its position up the value chain through a broadening Milkrite product portfolio and greater recurring revenue streams. FY15 showed the benefits of this strategy with revenue up 11% to £35.5m (6% at constant currency) driven by the successful roll-out of the Cluster Exchange Service and increased Milkrite market share, while InterPuls added £1m of revenue following completion in August. Operating profit increased by 12% to £6.4m, reflecting existing business only as InterPuls did not contribute in FY15 due to the seasonal effects of acquisition timing. While some softening of the market was seen in Europe during H2 this appeared to be turning again at year end, while other developments continue to support growth:

Milkrite penetration: the group’s own brand Milkrite products continue to represent an increasing proportion of revenues accounting for 72% of sales in FY15. Impulse Air sales in North America increased market share to 25% (2014: 21%) from launch just four years ago. Impulse Air also increased European market share to 3.5% following launch in late FY13 showing that the increased sales force in Europe, previously an overhead, is now delivering increased profits. With InterPuls providing new technologies and services as well as complementary regional sales channels, significant cross-selling opportunities exist.

Cluster exchange growth: following launch in the US and Europe in 2013, the group’s Cluster Exchange Service has rapidly grown to service 430,000 cows across 1,262 farms. This allows greater value capture by Avon with a more robust service model improving visibility and consistency of performance. While we assumed early converts would be existing Milkrite customers, management has indicated take up is 50:50 with non-Milkrite customers.

New international markets: new international markets have been targeted as long-term growth drivers with launches in China and Brazil. Chinese growth resumed and moved into a small profit in FY15, while the sales and distribution centre in Brazil was opened during H115.

Future growth opportunities strong

Management has demonstrated a clear strategic thought process, trailed intentions with investors and then successfully executed on its plans. We identified several opportunities in our July 2014 update note, some of which have contributed to FY15’s performance, however further upside remains as highlighted in Exhibit 2 below, while recent acquisitions provide new growth drivers:

Exhibit 2: Further opportunities and potential financial impact

Opportunity

Assumptions

Comment

FY16e incremental
revenue/op profit

FY17e incremental
revenue/op profit

FY18e incremental
revenue/op profit

Probability
(H/M/L)

JSAM (DoD)

$74m, five year programme, 15% margin.

Production moved to right: additional development funding secured

-

-

$14m (£8.8m)

$2m (£1.3m)

$14m (£8.8m)

$2m (£1.3m)

High

JSAM (International)

Revenues half DoD programme, 40% margin

Subsequent international opportunities

-

-

-

-

$7m (£4.4m)

$2.8m (£1.8m)

Medium

EEBD (DoD)

$140m, 10 year programme, 15% margin

Bid process not finalised

-

-

$14m (£8.8m)

$2m (£1.3m)

$14m (£8.8m)

$2m (£1.3m)

Low

EEBD (International)

Revenues half DoD programme, 40% margin

Subsequent international opportunities

-

-

$7m (£4.4m)

$2.8m (£1.8m)

$7m (£4.4m)

$2.8m (£1.8m)

Medium

Navy Rebreather (DoD)

$15-20m opportunity, 15% margin

White Paper Stage

-

-

$3m (£1.9m)

$0.5m (£0.3m)

$3m (£1.9m)

$0.5m (£0.3m)

Medium

Navy Rebreather (International)

Revenues half DoD programme, 40% margin

Subsequent international opportunities

-

-

-

-

$1.5m (£0.9m)

$0.6m (£0.4m)

Medium

Fire

$300m market

FY15 3.5% share ($12m), 5% FY16e, 10% FY18e, 30% margin

Fire penetration increasing and set to benefit from Argus

$14m (£8.8m)

$4.2m (£2.6m)

$22m (£13.8m)

$6.6m (£4.1m)

$28m (£17.5m)

$8.4m (£5.3m)

High

Other Fusion

Target markets of NA law enforcement, first responder, industrial, oil & gas with expanded product set. Assume initial penetration and 30% margin.

Enhanced through acquisitions and Project Fusion

£1m

£0.3m

£2m

£0.6m

£3m

£0.9m

High

North America (Impulse Air)

FY15 25% share (c£6m),

+1% share pa.

40% margin

Penetration continues to grow

£1.5m

£0.6m

£2m

£0.8m

£2.5m

£1.0m

High

North America (Cluster Exchange)

Gain c 2% market share pa but half from Impulse Air customers.

Twice the sales of Impulse Air.

30% margin

Cluster Exchange wins 50:50 Impulse Air:new customers

£1.5m

£0.45m

£2m

£0.6m

£2.5m

£0.75m

High

Europe Milkrite (Impulse Air + Cluster Exchange)

Slower penetration rate than Impulse Air launch in North America due to market +2% pa.

Split half and half with ClusterExchange as launched at same time.

Combined margin 35%.

Has become more likely following previous addition of salesforce + InterPuls

£1.2m

£0.42

£1.6m

£0.56m

£2.0m

£0.7m

High

BRIC (China)

Initial growth shown $3m in FY15.

Assume growth to $6m by FY18.

Dairy margins achieved by five-year timescale.

FY15 successfully moved to profit

$1.5m (£0.9m)

$0.26m (£0.16m)

$2m (£1.3m)

$0.35m (£0.22m)

$3m (£1.9m)

$0.52m (£0.32m)

High

BRIC (Brazil)

Investment stage in early years, followed by a similar growth trajectory as seen in China.

FY15 profit headwinds from investment

$1m (£0.6m)

-$0.1m (-£0.06m)

$2m (£1.3m)

$0m (£0m)

$3m (£1.9m)

$0.3m (£0.19m)

Medium

Cross-sell of InterPuls / Milkrite

Opportunity to cross-sell into respective markets (Europe / North America)

Additional revenue synergies not yet baked into forecast

£1m

£0.5m

£2m

£1m

£3m

£1.5m

High

TOTAL incremental

Revenue

Op profit

£16.5m

£5.0m

£49.9m

£12.0m

£66.0m

£17.6m

Source: Edison Investment Research

As can be seen, the wide range of opportunities available to the group continues to provide the potential for significant growth over the next five years. While specific timing and ramp up rates may vary, as highlighted by the move to the right of the JSAM production programme, this balance of opportunity allows other areas to outperform. One such area was the further uptick in US Impulse Air market share (+4%) in FY15 for example.

Importantly, as the group has already established sales and marketing routes to non-DoD and commercial markets, the structure is already in place to take new products to them. This should show in achievable margins and provide operational leverage potential as contracts are won, new business is developed and a broadened portfolio enters sales channels. Existing business can also be rejuvenated such non-DoD opportunities for AEF to offset more volatile DoD spares revenues.

Forecasts conservative as management delivers

The successful approach to identifying upside growth opportunities is demonstrated in Exhibit 3 below, which highlights the progressive PBT since management took charge in 2009. Exhibit 4 highlights the changes to our year two forecasts from introduction to actual results since FY10:

Exhibit 3: PBT results since FY10 (£m)

Exhibit 4: Original yr 2 forecasts vs actual results (£m)

Source: Avon, Edison Investment Research

Source: Avon, Edison Investment Research

Exhibit 3: PBT results since FY10 (£m)

Source: Avon, Edison Investment Research

Exhibit 4: Original yr 2 forecasts vs actual results (£m)

Source: Avon, Edison Investment Research

The group has outperformed our original expectations in each of the last four years by between 3% and 16% despite our initial forecasts calling for an average annual 17% PBT increase each year during that period. We believe management has created a culture of delivery and outperformance which shows through in technology development, operational efficiency and ultimately results.

Sensitivities being managed through strategy

Given the global nature of the business there are both economic and performance factors, as well as those related to the exposure to the US DoD as the largest customer:

Cannibalisation of OEM sales: Avon’s focus on driving Milkrite could frustrate OEM customers, cannibalising OE sales, leading to slowing top-line revenues. Given the higher margins achieved by Avon on Milkrite, this should be offset at the operating profit level. With the acquisition of InterPuls providing Avon with critical mass to compete with OEMs, a further reduction could well occur, however with 72% of pre-InterPuls Dairy revenues derived from non-OEMs, we see the downside risk of this having less of an impact than in previous years.

Defence budgets: defence budgets have remained under pressure over the past few years. Given that the M50 mask is a 10-year sole source contract and that Avon has an IDIQ contract for M61 filters, both of which have rising budget allocations, we feel confident that the personal protective equipment budget will be maintained. Awareness of CBRN is also improving on the back of recent chemical weapons usage in Syria and Iraq and this could be positive for Avon.

Filter second source: the DOD is now able to dual source from Avon and 3M and the first delivery order awarded in 2015 under this new arrangement was split between the two sources, two thirds Avon, one third 3M. We expect future awards to be split between the two sources.

Acquisition integration: with the pace of acquisitions having increased, the ability of management to successfully integrate purchases will become an increasing area of focus. This has already been demonstrated by the benefits achieved from the smaller acquisitions to date; however integration of an acquisition of the scale of InterPuls will provide further evidence.

Valuation: Fair on base forecast, upside value apparent

We continue to view Avon Rubber as a strong growth story underpinned by a niche leadership position, core long-term contracts and an accelerating pipeline of new product introductions. When combined with a culture that fosters innovation as witnessed by the Cluster Exchange Service approach, incremental contract and cross-sell opportunities created by recent acquisitions, we believe that it deserves a premium to peers.

Our conservative forecasts provide a base fair value of 1,110p/share as shown in Exhibit 5 below:

Exhibit 5: Edison sum-of-the-parts fair value

 

CY16 EBITA (£m)

Tax rate

CY16 NOPAT (core) (£m)

P/E
CY16

Value (£m)

Notes

Protection & Defence

15.1

22%

11.8

18.0

212.0

10% premium to MSA (14.8x), Tyco (15.7x) and 3M (18.5x).

Dairy

9.2

22%

7.2

19.5

139.5

50% premium to Skellerup/in line with Genus.

Net debt

(7.4)

Sept 2016 year end estimate.

Equity value

344

Shares in issue

31.0

Implied fair value per share (p)

 

 

1,110

 

Source: Edison Investment Research. Note: P/Es taken as at 16 November 2015.

Given the group’s track record of outperformance, this base valuation, close to the current share price, undervalues Avon in our opinion. We rather look at the upside potential generated from the numerous opportunities outlined throughout this note and provide an indication of the indicative value that can be generated if these are delivered over the coming 12 months as in Exhibit 6 below.

Exhibit 6: Edison sum-of-the-parts fair value including upside opportunities

 

CY16 NOPAT (core) (£m)

CY16 NOPAT (increment) (£m)

CY16 NOPAT (£m)

P/E
CY16

Value (£m)

Notes

Protection & Defence

11.8

2.3

14.1

18.0

252.5

10% premium to MSA (14.8x), Tyco (15.7x) and 3M (18.5x).

Dairy

7.2

1.6

8.8

19.5

170.9

50% premium to Skellerup / in-line with Genus.

Net debt

(3.4)

Sep 16 year end estimate + £5.0m incremental operating profit converted at 80%.

Equity value

420

Shares in issue

31.0

Implied fair value per share (p)

 

 

1,355

 

Source: Edison Investment Research. Note: P/Es taken as at 16 November 2015.

The implied fair value of 1,355p/share equates to a FY16 P/E ratio on current forecasts of 23.5x or an EV/Sales multiple of 3.1x. While this appears relatively fully valued, we highlight that acquisition multiples achieved in the sector can easily reach these levels with the takeover of Latchways by MSA equating to a multiple of 3x sales for a business we feel did not have the same IP, contract visibility or growth prospects as Avon.

Exhibit 7: Financial summary

Year end 30 September

£'000s

2013

2014*

2015*

2016e

2017e

PROFIT & LOSS

IFRS

IFRS

IFRS

IFRS

IFRS

Revenue

 

 

124,851

124,779

134,318

155,740

161,970

Cost of Sales

(91,140)

(83,264)

(89,629)

(103,924)

(108,081)

Gross Profit

33,711

41,515

44,689

51,816

53,889

EBITDA (before amort. and except.)

 

 

20,443

23,303

25,225

29,047

31,937

Operating Profit (before amort. and except.)

 

 

14,223

17,003

20,215

21,938

22,901

Amortisation of Intangibles

(417)

(261)

(1,043)

(2,500)

(2,500)

Exceptionals

(383)

(2,017)

(604)

0

0

Other

(420)

(400)

318

(400)

(400)

Operating Profit

 

 

13,003

14,325

18,886

19,038

20,001

Net Interest

(347)

(274)

(147)

(300)

(150)

Other finance costs

(253)

(187)

(247)

(180)

(200)

Profit Before Tax (norm)

 

 

13,656

16,554

19,821

21,458

22,551

Profit Before Tax (FRS 3)

12,403

13,864

17,838

18,558

19,651

Tax

(3,566)

(3,053)

(2,672)

(4,176)

(4,421)

Tax adjustment

(122)

(450)

(253)

0

0

Profit After Tax (norm)

 

 

9,968

13,051

16,896

17,283

17,729

Profit After Tax (FRS 3)

8,837

10,811

15,166

14,383

15,229

Average Number of Shares Outstanding (m)

29.5

29.9

30.1

30.2

30.2

EPS - continuing, normalised (p)

 

 

33.8

43.7

56.1

57.2

58.7

EPS - continuing, FRS 3 (p)

 

 

30.0

36.2

50.4

47.6

50.4

DPS (p)

4.3

5.6

7.3

9.5

12.0

Gross Margin (%)

27%

33%

33%

33%

33%

EBITDA Margin (%)

16%

19%

19%

19%

20%

Operating Margin (before amort. and except.) (%)

11%

14%

15%

14%

14%

BALANCE SHEET

Fixed Assets

 

 

36,928

36,815

74,095

73,919

74,277

Intangible Assets

16,541

17,240

41,309

42,365

43,511

Tangible Assets

20,387

19,575

28,212

26,980

26,192

Other

0

0

4,574

4,574

4,574

Current Assets

 

 

34,449

34,971

34,481

38,496

41,842

Stocks

13,374

12,887

17,123

18,385

19,444

Debtors

20,891

19,159

17,026

19,779

20,084

Cash

184

2,925

332

332

2,314

Assets held for sale

0

0

0

0

0

Current Liabilities

 

 

(23,369)

(26,453)

(27,178)

(28,378)

(29,240)

Creditors

(17,296)

(19,601)

(18,005)

(21,555)

(22,417)

Short term borrowings

0

0

(2,350)

0

0

Tax

(6,073)

(6,852)

(6,823)

(6,823)

(6,823)

Liabilities for assets held for sale

0

0

0

0

0

Long Term Liabilities

 

 

(27,312)

(20,317)

(39,194)

(35,768)

(28,051)

Long term borrowings

(11,059)

0

(11,143)

(7,717)

0

Deferred Tax

(2,977)

(2,315)

(9,734)

(9,734)

(9,734)

Retirement benefit obligations

(11,279)

(16,029)

(16,605)

(16,605)

(16,605)

Provisions

(1,997)

(1,973)

(1,712)

(1,712)

(1,712)

Other

0

0

0

0

0

Net Assets

 

 

20,696

25,016

42,204

48,269

58,829

CASH FLOW

Operating Cash Flow

14,708

25,004

20,446

27,782

28,534

Net Interest

(364)

(314)

(147)

(300)

(150)

Tax

(2,229)

(2,903)

(3,270)

(4,176)

(4,421)

Capex

(11,054)

(6,815)

(6,183)

(9,033)

(9,394)

Acquisitions/disposals

(437)

(31)

(21,228)

(3,500)

0

Equity financing

(1,765)

0

(1,152)

(1,500)

(2,000)

Dividends

(1,132)

(1,422)

(1,859)

(2,198)

(2,870)

Net Cash Flow

(2,273)

13,519

(13,393)

7,076

9,699

Opening net (debt)/cash

 

 

(8,725)

(15,937)

2,925

(13,161)

(7,385)

Cash FX effect

123

281

97

0

0

Discontinued operations / relocation

0

0

0

(1,300)

0

Debt FX and Other

(5,062)

5,062

(2,790)

0

0

Closing net (debt)/cash

 

 

(15,937)

2,925

(13,161)

(7,385)

2,314

Source: Company accounts, Edison Investment Research. Note: *Continuing operations.

Contact details

Revenue by geography

Hampton Park West
Melksham
Wiltshire, SN12 6NB
UK
01225 896899
www.avon-rubber.com

Contact details

Hampton Park West
Melksham
Wiltshire, SN12 6NB
UK
01225 896899
www.avon-rubber.com

Revenue by geography

Management team

CEO designate (joining 1 December 2015): Rob Rennie

Interim CEO / CFO: Andrew Lewis

Rob Rennie held a number of senior positions at Invensys, most recently as President of Energy Controls, a division with annual sales of >$400m. This group included Eurotherm, the global supplier of industrial and process control, measurement and data management solutions, where Rob started his career and was ultimately appointed MD. He was the driving force behind the evolution of Eurotherm and, as a member of the Invensys Executive Committee, was part of the team that successfully sold Invensys to Schneider Electric in 2014.

Andrew Lewis joined Avon as group financial director in September 2008. He was previously a director at PwC and Group Financial Controller at Rotork. He holds a first-class joint honour’s degree in mathematics and accounting from the University College of North Wales.

Chairman: David Evans

Associate Group Finance Director: Sarah Matthews-DeMers

David Evans took over as chairman in February 2012, having joined the board in 2007. He has over 30 years’ experience in the UK and US defence market having spent 17 years with GEC-Marconi before joining Chemring Group in 1987 and being appointed CEO in 1999. He remained as an NED following his retirement in April 2005 and was previously a NED of Whitman.

Sarah Matthews-DeMers joined Avon in 2011 as group financial controller. She began her career at PwC where she gained extensive experience of working with a wide range of companies, specialising in advising FTSE 350 clients and later, corporate treasury.

Management team

CEO designate (joining 1 December 2015): Rob Rennie

Rob Rennie held a number of senior positions at Invensys, most recently as President of Energy Controls, a division with annual sales of >$400m. This group included Eurotherm, the global supplier of industrial and process control, measurement and data management solutions, where Rob started his career and was ultimately appointed MD. He was the driving force behind the evolution of Eurotherm and, as a member of the Invensys Executive Committee, was part of the team that successfully sold Invensys to Schneider Electric in 2014.

Interim CEO / CFO: Andrew Lewis

Andrew Lewis joined Avon as group financial director in September 2008. He was previously a director at PwC and Group Financial Controller at Rotork. He holds a first-class joint honour’s degree in mathematics and accounting from the University College of North Wales.

Chairman: David Evans

David Evans took over as chairman in February 2012, having joined the board in 2007. He has over 30 years’ experience in the UK and US defence market having spent 17 years with GEC-Marconi before joining Chemring Group in 1987 and being appointed CEO in 1999. He remained as an NED following his retirement in April 2005 and was previously a NED of Whitman.

Associate Group Finance Director: Sarah Matthews-DeMers

Sarah Matthews-DeMers joined Avon in 2011 as group financial controller. She began her career at PwC where she gained extensive experience of working with a wide range of companies, specialising in advising FTSE 350 clients and later, corporate treasury.

Principal shareholders

(%)

Schroders

14.0

Franklin Resources

10.2

Blackrock

9.9

JP Morgan Chase

5.2

Henderson Global Investors

3.4

Companies named in this report

3M, Honeywell, Tyco, Mine Safety Applications (MSA), Draeger, Skellerup, Genus

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

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