Diversified platform gives resilience

Solid State 24 November 2015 Update

Solid State

Diversified platform gives resilience

Interims

Electronic equipment

24 November 2015

Price

432.50p

Market cap

£36m

Net debt (£m) at end September 2015

4.0

Shares in issue

8.4m

Free float

73%

Code

SOLI

Primary exchange

AIM

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(40.6)

(50.6)

(36.2)

Rel (local)

(39.4)

(51.4)

(33.6)

52-week high/low

922.5

390.0

Business description

Solid State is a high value-add manufacturer and specialist design-in distributor to the electronics industry. It has expertise in industrial/ruggedised computers, electronic components, antennas, microwave systems, secure communications systems and battery power solutions.

Next events

Prelims

July 2016

Analysts

Anne Margaret Crow

+44 (0)20 3077 5700

Roger Johnston

+44 (0)20 3077 5722

Solid State is a research client of Edison Investment Research Limited

The narrative of Solid State’s interims describes how the diversified platform that management has created should be able to deliver another year of results at FY15’s record profit levels, despite delays in deliveries under a major contract with the Ministry of Justice (MoJ) for offender tagging and weakening markets. We leave our estimates unchanged and see fair value at 513p, based on our FY16e estimates.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

03/14

32.1

2.4

28.5

8.5

15.2

2.0

03/15

36.6

3.2

37.4

12.0

11.6

2.8

03/16e

44.0

3.2

35.4

12.0

12.2

2.8

03/17e

N/A

N/A

N/A

N/A

N/A

N/A

Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments.

Solid first half

H116 revenues grew by £4.9m (29%) year-on-year to £22.0m. This strong growth was attributable to the deliveries under the mobilisation phase of the MoJ contract and revenues from Ginsbury Electronics, which was acquired in April 2015. The antennae business was adversely affected by delays in a major airborne programme, and the distribution business by a shift to shorter-term ordering patterns. Reported PBT fell by 4% to £1.5m, reflecting substantially higher administrative costs and only modest margins relating to the first phase of the MoJ contract.

Recovery in non-MoJ activity during H216

Historically, group sales have been weighted towards the second half. Additionally, sales of next-generation ticketing equipment, a resumption in antennae deliveries for the major airborne programme and initial sales of product from Luminus are expected to benefit H216. This supports our (unchanged) estimates, which model H216 revenues at H116 levels, despite substantially reduced deliveries under the MoJ contract (half-on-half). This gives adjusted profit before tax for FY16e of £3.2m, matching the record levels reached in FY15. We are not publishing estimates for FY17, as there is no visibility of when the balance of MoJ deliveries will occur. Noting that management intends to realise c £0.5m annualised cost savings across the group, we calculate that the group would be able to maintain profits at FY15 record levels in the absence of any deliveries under the MoJ contract and up to £2.1m incremental profit if deliveries resume in a timely fashion.

Valuation: Undervalued even if MoJ delays persist

The share price has fallen from 725p since the announcement of delays to the MoJ contract. It is now 16% lower than our indicative value of 513p, which is based on our FY16 estimates. Given the uncertainty regarding the time when deliveries under the MoJ contract will resume and the consequent impact on performance, our valuation section also explores several scenarios based on a range of delivery schedules for the MoJ contract.

Execution of strategy

In our initiation note published in September 2015, we described the successful strategy that management has been pursuing since 2002. This delivered five consecutive years of profits growth between FY10 and FY15. It is based on top-line growth through selective acquisitions, the addition of new product lines and entry into new industry verticals such as green energy and security solutions, combined with margin improvement through focus on value-added design and assembly capability and development of own-brand products. This diversification is providing resilience in softening markets globally and reduces the impact of delays in individual major programmes such as the MoJ contract or airborne antennae programme. We expect this strategy to enable the group to deliver a further year of profits at the record levels experienced in FY15 during FY16, despite weakening markets and a delay in deliveries under the MoJ contract. We highlight recent examples of this strategy in action in the following paragraphs.

Acquisitions

Management completed a further acquisition, of Ginsbury Electronics, in the first month of the current financial year. Ginsbury made a material contribution to group profit during H116. Turnover was behind plan because weakening in the market caused delays in several key programmes. However, cross-selling opportunities, where Ginsbury’s displays are combined with computing devices, have progressed well, with several projects currently at the design phase. Management continues to evaluate acquisition opportunities, particularly in the battery and added-value sectors.

New products

The distribution division, Solid State Supplies, secured two important new franchise contracts during H116. One is with Luminus, which offers a comprehensive range of LED solutions for general lighting markets, as well as high-output speciality lighting solutions for performance-driven markets including consumer displays, entertainment lighting and medical applications. Management expects this to start contributing revenue during Q416. The other is with Silicon Labs, a global supplier of low-energy microprocessors and radio devices with annual revenues of $620m. Management expects this to start contributing revenue in FY17. We note that the Silicon Labs agreement epitomises management’s strategy of gaining franchises with mid-tier companies that have annual revenues of between $250m and $1,000m globally, thus enabling potentially faster ramp-up in sales volumes with each new franchise.

The Genie own-brand single board computer platform developed by Ginsbury has been well received. Several potential customers of both Ginsbury and Solid State Supplies are currently evaluating the product.

Additional industry verticals

The group entered the rail sector via the acquisition of Blazepoint in 2011. It has designed a compact and rugged printer terminal used by 13 train operators in the UK to print tickets on trains. The first sales of a new-generation model that is more compact and has Bluetooth connectivity are expected to take place during H216. Solid State Supplies has begun to sell embedded modules used in the powertrain control systems of electric vehicles and sensors for use in vehicle monitoring systems and roadside charging stations.

Margin improvement

The margin improvement programme instigated at Ginsbury post-acquisition has delivered a 2pp rise in gross margin compared with budget, partly offsetting lower than expected revenues from this activity. As a result, gross margin for the Distribution division increased by 1pp year-on-year. The new facility currently under construction for the antennae business will reduce new equipment costing for pre-compliance testing, bringing this service in house and thus improving margins.

Adding value

Ginsbury continues to enhance its value-added element through the introduction of its own-brand product as discussed above, and by offering displays as part of a kit with related components. In addition to selling individual computers, Steatite has begun to offer multiple computers rack-mounted in a dedicated cabinet with a complete wiring chassis. The availability of value-added design and assembly capability is a key acquisition criterion.

Financials

We revised our FY16 estimates in our last note at the time of the trading update at the end of October. Management stated its expectations for group revenues and profit before tax for the six months ended September 2015 and advised that it had encountered delays in the delivery schedule for the three-year, £34m contract to supply offender tagging technology to the UK Ministry of Justice (MoJ). There is still no clarity on when the balance of revenues (estimated at £29m) will be received during the three-year period. Also, production timescales mean that even if further orders under the contract are received soon, it will not be possible for Steatite to fulfil them by the end of the current financial year. We therefore leave our FY16 estimates unchanged as these already assume no MoJ deliveries during H216, and keep our FY17 estimates under review.

Earnings

Solid State made a satisfactory start to the year despite some softening in its target markets, as reported by industry peers, and despite revenues from the MoJ contract being lower than originally expected because the programme has stalled after the initial mobilisation phase. H116 revenues grew by £4.9m (29%) year-on-year to £22.0m. This strong growth was primarily attributable to the deliveries for the mobilisation phase of the MoJ contract (estimated at £3.5m), with additional contribution from Ginsbury Electronics (estimated at £1.6m), acquired in April 2015. Revenues from the Q-par antennae business were adversely affected by delays to an airborne programme, while revenues from the distribution operation (excluding Ginsbury) were lower, reflecting a shift to customers placing short-term orders.

The deliveries for the mobilisation phase of the MoJ contract were at relatively low margins (this will not be the case for deliveries of product), which were balanced against the increased operating costs associated with this new activity. This contributed to a 4.4pp decline in group gross margin to 27.7% and a 4% reduction in reported profit before tax to £1.5m. The interim dividend was maintained at 4.0p, supporting our estimates, which show the FY16 dividend held at FY15 levels.

We note that, historically, group sales have been weighted towards the second half. Additionally, sales of the new ticketing equipment, a resumption in antennae deliveries for the airborne programme and initial sales of product from Luminus are expected to benefit H216. The order book at end October 2015 was £18.1m, £3.1m less than at end October 2014. The difference is less than the value of orders attributable to the MoJ contract at end October 2014. These pointers support our estimates (which are unchanged), which model H216 group revenues at similar levels to H116. In effect, improvement in sales elsewhere in the group is expected to offset substantially lower revenues from the MoJ contract (still from the mobilisation phase). H216 operating profit (not adjusted for share-based payments) is expected to be at similar levels to H116. We model a 20% year-on-year growth in revenues to £44.0m for FY16, while profit before tax (adjusted for share-based payments) remains at FY15 levels (£3.2m). We note that sales of secure communication systems are likely to benefit from increased budgets for special forces to combat terrorism, although this effect may not manifest until FY17. FY17 performance should also benefit from a cost reduction programme across the group, which management expects will realise an annualised saving of around £0.5m. This programme, which focuses on duplications arising from the rapid sequence of acquisitions, should be regarded as precautionary in nature. Although the distribution order backlog has fallen, billings are holding, indicating that overall demand is steady, but clients are placing shorter-term orders, as has happened in previous periods of market weakness.

Balance sheet and cash flow

H116 operating cash flow was distorted by the timing of contract deliveries. The £0.9m increase in receivables relates partly to a major contract that will reverse during H216 and partly to the Ginsbury acquisition. The £0.4m inventory increase is only partly attributable to the Ginsbury acquisition. Management is currently taking action to reduce inventory levels. Capex was higher than in H115, with investment at several sites, including the dedicated electronic monitoring facility. £2.1m was spent on acquiring Ginsbury. Net debt increased by £1.5m to £4.0m at end September 2015, gearing from 19.9% to 30.2%.

We expect further significant capital expenditure during H216 as a new facility for the antennae and subsystems activity is constructed and equipped. This facility is expected to open in Q117. It will permit the construction of larger antennae for specialist applications and enable pre-compliance testing to be carried out in house. An estimated £0.7m is allocated for this new equipment.

Valuation

Sum-of-the-parts valuation

Exhibit 1: Listed peers

Company

Market
cap (£m)

Current
EV/Sales (x)

Next
EV/Sales (x)

Current EV/
EBITDA (x)

Next EV/
EBITDA

Current
P/E (x)

Next P/E
(x)

Arotech Corp

25

0.5

0.4

15.6

4.7

30.2

5.4

Cobham

3,248

2.1

2.0

10.5

10.1

14.2

13.5

Cohort

163

1.2

1.1

11.1

9.6

17.5

14.9

Concurrent Technologies

46

-

-

-

-

17.6

16.7

Cubic Corp

779

0.8

0.7

9.6

8.4

29.4

17.0

Elbit Systems

2,452

1.3

-

11.4

-

18.5

15.6

Rockwell Collins

7,737

0.4

0.4

1.6

1.4

16.9

15.2

Saft Groupe

519

1.1

1.0

7.5

6.8

14.8

12.8

Ultra Electronics Holdings

1,326

2.0

1.8

10.9

10.0

15.7

14.8

Vislink

45

-

-

-

-

7.5

6.9

Mean manufacturing companies

1.2

1.1

8.9

7.3

16.4

15.1

Acal

177

-

-

-

-

17.3

15.8

Brammer

211

-

-

-

-

9.9

9.1

Diploma

793

-

-

-

-

17.5

16.5

Mean value-added distributors

14.9

13.8

Source: Bloomberg. Prices at 18 November 2015. Note: Grey shading indicates exclusion from mean.

We continue to use a sum-of-the parts analysis to value this stock. This gives an indicative value of 513p/share, based on our estimates for FY16.

Exhibit 2: Sum-of-the parts analysis

% FY16e profits from Manufacturing

61%

% FY16e profits from Distribution

39%

Year 1 P/E Manufacturing

16.4x

Year 1 P/E Distribution

14.9x

Weighted P/E

15.8x

FY16e EPS – FRS 3 (p)

32.4p

Indicative value/share

512.6p

Source: Bloomberg, Edison Investment Research

The problem faced by investors evaluating this stock is the uncertainty posed by the current situation with the MoJ contract. It is reasonable to assume that deliveries under the contract will pick up at some point during FY17 because the contract is a high-profile one for the customer, who is committed to taking £34m of product from Solid State over a three-year period commencing once the mobilisation phase is complete and supply of product has commenced. Moreover, Solid State is confident of being able to fulfil its obligations under the contract. The uncertainty lies in when deliveries will resume. We present a scenario analysis showing a range of outcomes on the restructured cost base.

The analysis models a range of revenues attributable to the MoJ contract, starting with no revenues (base case) and rising to £15m. This higher bound was the level estimated for FY16 and FY17 before the October announcement noting delays to the programme. This higher level could still be achieved in FY17 if orders under the contract are placed sufficiently early in the New Year.

Exhibit 3: Scenario analysis

Base case

MoJ revenues (£m)

0.0

3.0

6.0

9.0

12.0

15.0

MoJ incremental EBIT (£m)

0.0

0.4

0.7

1.0

1.6

2.1

Group reported EBIT (£m)

3.2

3.5

3.9

4.2

4.7

5.3

Group EPS – FRS 3 (p)

32.2

35.6

39.0

41.8

47.4

53.0

% profit manufacturing

59%

62%

65%

67%

70%

73%

Year 2 mean P/E manufacturing companies

15.1x

15.1x

15.1x

15.1x

15.1x

15.1x

% profit Distribution

41%

38%

35%

33%

30%

27%

Year 2 mean P/E value-added distributors

13.8x

13.8x

13.8x

13.8x

13.8x

13.8x

Weighted Year 2 P/E

14.6x

14.6x

14.6x

14.7x

14.7x

14.7x

Indicative value/share

468p

519p

570p

613p

697p

781p

Source: Edison Investment Research. Note: Prices as at 18 November 2015.

The scenario analysis indicates that, taking into consideration the positive impact of the current cost reduction programme, if there are no deliveries under the MoJ contract in the hypothetical year under analysis, group reported operating profit would be £0.2m higher than our FY16 estimate. This is our base case scenario. A modest £3.0m of revenues from the MoJ contract (ie lower than FY16e levels, but at higher gross margins) would deliver an additional £0.3m of operating profit. If MoJ revenues were to reach £15.0m, this would deliver an additional £2.1m operating profit compared with our base case. While noting that this scenario analysis does not constitute a forecast, we apply our sum-of-the-parts valuation methodology to the range of profit outcomes, using the year 2 average multiples from our sample sets of peers to give a discount for present value. This analysis gives an indicative valuation range of 468p-781p/share.

Exhibit 4: Financial summary

£000

2014

2015

2016e

Year end 31 March

PROFIT & LOSS

Revenue

 

 

32,085

36,559

43,989

Cost of Sales

(22,729)

(25,396)

(31,670)

Gross Profit

9,357

11,164

12,318

EBITDA

 

 

2,809

3,766

3,845

Operating Profit (pre amort. of acq intangibles & SBP)

 

2,461

3,273

3,297

Amortisation of acquired intangibles

0

0

0

Share-based payments

(235)

(211)

(250)

Exceptionals

0

0

0

Operating Profit

2,226

3,062

3,047

Net Interest

(72)

(48)

(75)

Profit Before Tax (norm)

 

 

2,389

3,224

3,222

Profit Before Tax (FRS 3)

 

 

2,154

3,014

2,972

Tax

(278)

(122)

(268)

Profit After Tax (norm)

2,111

3,102

2,955

Profit After Tax (FRS 3)

1,876

2,892

2,705

Average Number of Shares Outstanding (m)

7.4

8.3

8.4

EPS - normalised (p)

 

 

28.5

37.4

35.4

EPS - normalised fully diluted (p)

 

 

28.4

36.3

34.7

EPS - FRS 3 (p)

 

 

25.3

34.9

32.4

Dividend per share (p)

8.5

12.0

12.0

Gross Margin (%)

29.2

30.5

28.0

EBITDA Margin (%)

8.8

10.3

8.7

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

7.7

9.0

7.5

BALANCE SHEET

Fixed Assets

 

 

5,995

6,643

8,174

Intangible Assets

4,936

5,400

5,845

Tangible Assets

1,059

1,243

2,328

Current Assets

 

 

15,744

16,142

17,464

Stocks

4,575

5,402

6,207

Debtors

10,484

9,003

10,072

Cash

685

1,738

1,185

Current Liabilities

 

 

(10,926)

(10,039)

(10,795)

Creditors including tax, social security and provisions

(7,888)

(5,838)

(6,995)

Short term borrowings

(3,038)

(4,201)

(3,800)

Long Term Liabilities

 

 

(405)

(355)

(355)

Long term borrowings

0

0

0

Other long term liabilities

(405)

(355)

(355)

Net Assets

 

 

10,407

12,391

14,487

CASH FLOW

Operating Cash Flow

 

 

2,214

2,680

3,401

Net Interest

(72)

(48)

(75)

Tax

(161)

(476)

(476)

Capital expenditure

(305)

(487)

(1,000)

Capitalised product development

(8)

(661)

(270)

Acquisitions/disposals

(2,323)

0

(731)*

Financing

2,618

(308)

0

Dividends

(603)

(810)

(1,000)

Net Cash Flow

1,359

(110)

(152)

Opening net debt/(cash)

 

 

2,304

2,353

2,463

HP finance leases initiated

0

0

0

Other

1,408

0

0

Closing net debt/(cash)

 

 

2,353

2,463

2,615

Source: Company accounts, Edison Investment Research. Note: *Net of cash.

Edison, the investment intelligence firm, is the future of investor interaction with corporates. Our team of over 100 analysts and investment professionals work with leading companies, fund managers and investment banks worldwide to support their capital markets activity. We provide services to more than 400 retained corporate and investor clients from our offices in London, New York, Frankfurt, Sydney and Wellington. Edison is authorised and regulated by the Financial Conduct Authority (www.fsa.gov.uk/register/firmBasicDetails.do?sid=181584). Edison Investment Research (NZ) Limited (Edison NZ) is the New Zealand subsidiary of Edison. Edison NZ is registered on the New Zealand Financial Service Providers Register (FSP number 247505) and is registered to provide wholesale and/or generic financial adviser services only. Edison Investment Research Inc (Edison US) is the US subsidiary of Edison and is regulated by the Securities and Exchange Commission. Edison Investment Research Limited (Edison Aus) [46085869] is the Australian subsidiary of Edison and is not regulated by the Australian Securities and Investment Commission. Edison Germany is a branch entity of Edison Investment Research Limited [4794244]. www.edisongroup.com

DISCLAIMER
Copyright 2015 Edison Investment Research Limited. All rights reserved. This report has been commissioned by Solid State and prepared and issued by Edison for publication globally. All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report. Opinions contained in this report represent those of the research department of Edison at the time of publication. The securities described in the Investment Research may not be eligible for sale in all jurisdictions or to certain categories of investors. This research is issued in Australia by Edison Aus and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. The Investment Research is distributed in the United States by Edison US to major US institutional investors only. Edison US is registered as an investment adviser with the Securities and Exchange Commission. Edison US relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. As such, Edison does not offer or provide personalised advice. We publish information about companies in which we believe our readers may be interested and this information reflects our sincere opinions. The information that we provide or that is derived from our website is not intended to be, and should not be construed in any manner whatsoever as, personalised advice. Also, our website and the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. This document is provided for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.
Edison has a restrictive policy relating to personal dealing. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report. Edison or its affiliates may perform services or solicit business from any of the companies mentioned in this report. The value of securities mentioned in this report can fall as well as rise and are subject to large and sudden swings. In addition it may be difficult or not possible to buy, sell or obtain accurate information about the value of securities mentioned in this report. Past performance is not necessarily a guide to future performance. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (ie without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision. To the maximum extent permitted by law, Edison, its affiliates and contractors, and their respective directors, officers and employees will not be liable for any loss or damage arising as a result of reliance being placed on any of the information contained in this report and do not guarantee the returns on investments in the products discussed in this publication. FTSE International Limited (“FTSE”) © FTSE 2015. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under license. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

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

Share this with friends and colleagues