Avon Rubber — Update 18 November 2016

Avon Rubber has transformed itself over the past eight years from a troubled group to one with a strong base around niche leadership positions and a significant platform to accelerate growth. With a well invested business, both in terms of manufacturing and product development, the key now for CEO Rob Rennie is making the most of the platform that has been created. With a strong balance sheet and available firepower, options exist both for organic and increased acquisition-led catalysts.

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 is 1,330p/share (previously 1,200p/share), reflecting a 15% upgrade to our FY17 forecasts. Given the group’s many opportunities and track record of outperformance, we feel that the potential value of identified incremental opportunities provides an upper range of value, yielding a fair value of 2,000p/share based on FY17 upside forecasts.

Avon Rubber’s FY16 results have demonstrated the success of the consistent strategy despite challenging market conditions and the lack of an impact order in the year. Revenue was 6% up from £134.3m to £142.9m, supported by a £/US$ currency tailwind equivalent to £9.4m. Avon’s focus on higher-margin sales, improved operational efficiency and cost management helped drive adjusted operating profit up 8% to £21.8m with a currency tailwind of £1.4m.

Underlying PBT increased by 9% to £21.6m, while a tax credit of £0.9m resulted in adjusted EPS increasing by 33% to 74.2p. The group generated strong operating cash flow of £33.1m, equivalent to 152% of operating profit. The group ended the period with net cash of £2.0m despite the £3.3m acquisition of Argus. With good EPS growth, cash generation and visibility, the dividend was increased by 30%, making good on the target to double the dividend over the last three years.

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

Over the past eight years, Avon Rubber has transformed from a group in transition and turnaround to an efficient operation with two leading businesses primed to continue the significant growth path achieved during that period. The announced departure of CFO Andrew Lewis brings to an end the involvement of the executive team that delivered an increase in the quality of the business and consequent move in the share price from 20p to 1,036p. However, chairman David Evans remains and CEO Rob Rennie is now tasked with capitalising on the platform at his disposal to drive a new phase of growth through both organic and potentially accelerated acquisition means.

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.

Avon’s respiratory protection products are sold direct to military markets where its primary customer is the DoD (Army, Navy, Marines, Coast Guard 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. Self-contained breathing apparatus (SCBA) and thermal imaging equipment is targeted at the 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 Protection & Defence (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 National Institute of Occupational Safety and Health (NIOSH) approved emergency hoods (NH15 and NH15CO); 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 and CO 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.

The Dairy business designs, manufactures and sells products and services used in the automated milking process, primarily rubber ware 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 and 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 it also manufactures 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. InterPuls broadened Avon’s geographic reach, while the addition of established distribution relationships in emerging markets should accelerate growth.

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.

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.

Avon continues to seek value-enhancing acquisitions to support technology development and market positioning, with a number of such deals completed. These have all been integrated into the group with debt paid down providing a strong balance sheet for potentially larger deals ahead:

The key question for investors, in our view, is now whether Avon, having demonstrated its ability to acquire and integrate bolt-on deals, will continue this path or seek to make a game-changing acquisition. Now CEO Rob Rennie has been in the post a year, we wait with interest to see his vision for the group. With current net cash of £2.0m, cash generation of close to £20m pa, £33m of banking facilities available and the capacity to raise further funds if required, we believe the group could have potential firepower of c £100m at its disposal should it choose to pursue larger acquisitions.

Avon Rubber’s FY16 results have demonstrated the resilience of the business:

Avon continued its track record of outperforming our expectations, coming in some 5% above our FY16 PBT forecasts, a hallmark of the delivery culture instilled by outgoing CFO Andrew Lewis and his team. This was achieved despite the challenges in the Dairy market and in the absence of any significant impact order in Protection & Defence. Importantly in our view, the successful integration of the acquisitions and completion of Project Fusion product development provides the group with a clear base from which to continue its significant expansion over the forthcoming years.

With FY16 having delivered a positive result in a challenging market, we have identified tailwinds for FY17 and beyond that support a £3.2m/15% upgrade to our FY17 operating profit forecasts:

With the majority of Avon’s revenues denominated in dollars, the current £/US$ exchange rate of 1.25 would imply a c 17 cent swing from the FY16 average rate if sustained. With a sensitivity of approximately £0.6m per 5 cent change in the rate based on FY16 figures, we estimate that this will contribute a c £13m uplift to revenue and a c £2m uplift to our previous FY17 PBT forecasts.

We anticipate that the impact will be spread proportionately across each division, with one-third of the benefit relating to Dairy and two-thirds benefiting Protection & Defence.

FY16 results were delivered despite a weak milk price market, which, as in the past, led to a lengthening of consumable usage and, following the acquisition of InterPuls, a delay in capital equipment expenditure. However, we believe that both these factors are likely to begin to reverse during FY17, while further growth factors in line with the strategy are also clearly evident.

Milk price recovery underway

FY16 saw a continued and sustained decline in milk prices that endured throughout the year. Since June, however, there has been a sustained recovery with prices some 50% higher than the lows. With feed costs falling, dairy farmers have a window of opportunity whereby margins are expanding and delayed expenditure can be considered. As witnessed in 2009 and 2013, the lag between milk price recovery and resumption of consumable spend is approximately three months and, for larger capital equipment, three to six months. As a result, we expect to see a recovery in the traditional liner business first, followed by a more gradual recovery at InterPuls.

InterPuls demand recovery and expansion into the US

Management had previously indicated that InterPuls was likely to see a decline of c 25% due to the weakened milk price environment during FY16 and this proved to be the case. Given the typical lag between price movement and demand recovery, we anticipate that half of that drop, equivalent to a tailwind of c £4m revenue, should return during FY17, providing a boost to the overall Dairy figures.

Likewise, one of the core opportunities for Avon with the acquisition of InterPuls was the potential revenue synergies achieved by expanding the business into the US through its established distribution and customer network. With initial US sales already achieved in Q4, we believe this will be a key demand driver over the course of FY17, FY18 and the next three to five years as market share is won and the broader offering begins to be recognised.

Growing the global brand

The group has followed a clear strategy of expanding the Dairy brand globally in key target markets where emerging technology and policy shifts are driving operational and purchasing behaviours such as China and Brazil. With operations in China now established and generating profits, we expect Brazil to follow a similar path, with initial investment costs stepping towards profit within two to three years. Following the recent (November 2016) earthquake in New Zealand, there is also a potential impact on the group’s major competitor, Skellerup, with disruption of infrastructure around its only global supply point in Christchurch likely to lead to delivery challenges. While we do not expect to see a short-term impact of such delays, there may be opportunities for the group to capture global market share if there is supply chain disruption, which could hit from early CY17.

Expanding the service offering – from Cluster Exchange to Farm Services

With Avon having seen further growth in its Cluster Exchange service to now cover some 467,000 cows across 1,530 farms and following the acquisition of InterPuls, the group is expanding its service scope to farm owners. The expanded Farm Services offering has moved beyond just the milking cluster to include Pulsator and Tag exchange solutions. A pilot service is being tested throughout FY17 and, should a similar level of uptake be witnessed akin to the Cluster Exchange programme, we would anticipate this to ramp up significantly from FY18 onwards. The benefit of the service to Avon is that investment in manufacturing such equipment can be made back-to-back with service contracts rather than speculatively, while customers stand to benefit from improved asset management, efficiency and lower through-life cost of ownership.

The completion of the significant investment phase of the group’s co-ordinated Project Fusion product development programme was achieved in FY16. The group now has a significantly enhanced and refreshed product suite that is scalable and applicable across its key target markets, ranging from top-end military through to first responder, law enforcement and fire markets. The group therefore has several key drivers supporting the outlook in P&D for FY17 and beyond:

Law enforcement reference customer – NYPD

The group has targeted the US law enforcement and non-US military and law enforcement market with sales in FY16 of £31.6m (FY15: £27.7m). Winning Q4’s $9m CBRN/CO Escape Hood order, a key output from Project Fusion, provides not only the first substantial evidence of the success of this product development programme, but also a significant reference customer in the NYPD. With numerous other police departments across the US also having similar requirements for front-line officer protection, we believe this is a key win for the group.

Fire market expansion supported by Fusion and Argus integration

The October 2015 acquisition of Argus, the thermal imaging camera business of e2v, provided a significant expansion in Avon’s capability in the fire market beyond its traditional roots in self-contained breathing apparatus (SCBA), which itself has been refreshed with the development of the group’s Deltair SCBA. Significantly, Argus provided the group’s US salesforce and distribution partners with access to a leading thermal imaging camera, which was previously not offered by Avon in the US market and has a shorter replacement cycle, at around five years, than the traditional SCBA cycle of 10-15 years. This provides not only a broader product range, but also more frequent touch points allowing an associated pull-through of sales opportunities.

Joint Service Aircrew Mask nearing production award

Avon secured ongoing development and test funding for the DoD’s Joint Service Aircrew Mask (JSAM) during FY16, with tests being conducted aboard the aircraft platforms on which it will be operated. Once this is complete, a production contract worth over $70m is expected to be placed, with first revenues anticipated in FY17. As yet we do not include this in our forecasts until such an order is placed. As the mask will be qualified for operation on board the US platforms, this provides an export opportunity where such aircraft are in use in foreign militaries.

AEF rebound from a down year

Following several good years, AEF had a relatively weak FY16 due to variability in the timing of DoD procurement. We expect that this will reverse during FY17 and return a more positive contribution, as had been the case in each of the last three years where it had contributed c £1m of profit compared to a contribution under half of that in FY16. The business is also seeking to expand its product range to reduce potential volatility and won a small order for aircraft lift bags in FY16.

We identified several opportunities in our July 2014 update note, some of which have contributed to FY16 performance; however, further upside remains as highlighted in Exhibit 3 below, none of which is reflected in current forecasts, while the acquisitions achieved over the past two years provide new growth drivers.

The wide range of opportunities available to the group provide the potential for significant growth over the next five years, while specific timing and ramp up rates may vary.

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:

We continue to view Avon as having a core underlying valuation supported by the existing business, which has demonstrated its capacity to deliver even in a more challenging market environment and in the absence of impact orders. We therefore continue to value the group based on the methodology set out in our November 2015 Outlook note. This yields a core fair value of 1,330p/share, as shown in Exhibit 4 below, up from 1,200p/share due to the improved debt position and upgraded forecasts as we move to an FY17 valuation basis.

Adding the incremental opportunities, which we believe continue to exist as before, our potential upside scenario generates a fair value of 2,000p/share, as shown in Exhibit 5 below.

With several opportunities available to the group, we believe that news regarding each individual success could act as a catalyst to a re-rating. While timing is not certain, we would anticipate that the outcome across the group is likely to be somewhere between our two fair value assumptions based on the historic track record of achievements. The implied fair value of 1,330p/share equates to an FY17e P/E ratio on current forecasts of 20.1x or an EV/sales multiple of 2.4x. 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.