Carclo — Update 22 June 2016

In FY16 Technical Plastics (CTP) grew revenues by 9.6% to £70.5m and this generated an improvement in operating profits of 15.7% to £5.8m, with a shift in operating margins from 8.3% to 8.8%. We expect this improvement in operating margins to continue in FY17 and FY18, driven mainly by efficiencies rather than simple operational gearing. There is typically a lag at CTP between taking on new products and then seeing gains from efficiencies in their manufacture.

The second half saw the completion of the Taicing facility in China, which is now fully operational, and management is pleased with the levels of production efficiency already being achieved. It therefore remains confident of the potential for this facility to win business with existing and new international customers for the supply of products into China.

At 76% of revenues, the healthcare market dominates CTP’s revenues and management intends to increase this exposure. Two opportunities identified are micro-moulding and prototyping. Micro-mouldings are, as the name implies, very small plastic products, typically with overall dimensions of less than a few millimetres, that are increasingly finding applications within invasive surgery. Prototyping is the specialist area of limited production run moulding, and management sees potential here with early stage healthcare products, with the expectation that approval and widespread adoption of the product could lead to winning the contract to make the items in volume.

Management stated that it intends to actively develop in these areas, suggesting that while it will probably develop micro-moulding skills in house, prototyping capabilities may have to be acquired.

LED Technologies generated revenues of £40.5m and operating profits of £5.4m, growth of 18.8% and 20.7% respectively. This was driven by the strong flow through of the supercar and premium luxury vehicle project wins seen in recent years at WIPAC, although it should not be forgotten that the Optics business area (approximately £10m revenues) also showed double-digit percent revenue growth.

At the interim stage, management had alluded to the potential of the ‘mainstream’ luxury market and these results included the news that in the second half of the year WIPAC won a programme for a higher-volume car with volumes of over 30,000 vehicles a year due for launch in late 2019. WIPAC had historically shied away from such business. Management now believes that, with the technological, service and production skills that it has developed, this market could add significant value to the group. Key factors in this decision have included the extra purchasing leverage that Carclo believes it can attain via greater volumes, and the fact that in order to achieve better pricing, the major high-end brands bundle their lighting component supply programmes for high-end models in with their high-volume model supply programmes, a practice that has led to some dissatisfaction on the part of those responsible for designing and manufacturing the premium models. Management believes that there is a significant number of similar opportunities across the sports and higher-volume luxury markets.

Although the revenues for early design, development and tooling stages for the medium-volume programme will be broadly similar to a supercar lighting programme, the ongoing manufacturing revenues from the programme post vehicle launch will be significantly greater, in the range of £4-6m a year. However, the cash flow profile will lag somewhat and this will put some pressure on working capital and therefore net debt levels. WIPAC will book revenues for work done, but unlike supercars Carclo will not get paid until the start of the tooling stage, which is typically 18-24 months after the start. The major impact on both revenues and profits will only be seen in FY20. Therefore, the impact of this programme upon short-term estimates is limited other than a short-term build up in debtors. Before then, of course, there could be further medium-volume programme wins.

Precision Engineering, now renamed Aerospace, had a better second half (H2 £3.3m revenues vs H1 £3.1m) and closed the year with Airbus, the major end customer, continuing to increase its production levels.

In May Carclo announced the decision to end further investment in Carclo Diagnostic Solutions (CDS). Having set out and followed a clearly defined path with regard to assessing the technology’s commercial viability, the board’s conclusion was that, although the technology and prospective applications were well received, the anticipated timescales and route to market challenges were not appropriate to Carclo, particularly given returns management foresees for resources invested in the core divisions of CTP and LED.

We have adjusted our forecasts for FY17 following these results and have introduced forecasts for FY18.

We have edged up our revenues estimate mainly because of the stronger performance of LED Technologies, while the negative movement in PBT is due to the increase in finance costs associated with the increase in the IAS 19 charge on the pension deficit, which increased from £9.7m to £19.0m in FY16. In cash terms, the annual recovery payment is still £1.2m, as agreed with the trustees in October 2015.

The most significant change is in the net debt estimate. We now forecast net debt will remain broadly stable over the next few years. As noted above, a key suppressive effect on ‘normal’ cash generation is the expected increase in working capital within WIPAC, primarily associated with the higher-volume vehicle programme win.

In our initiation note in June 2015, we examined Carclo’s valuation on a simple multiples-based approach and found that on an earnings multiples basis, Carclo was trading at broadly similar multiples to what could be described as the ‘jury’s out’ comparators (TT Electronics, Zytronic and Volex) and at discounts to more established growth stories (Laird, Gooch & Housego and Victrex).

The turmoil at Volex has meant that it is no longer a relevant comparator, but Carclo still only trades on multiples in line with or slightly ahead of Zytronic and TT despite the clearer and more consistent growth story.

Even though Carclo has demonstrated further growth in revenues and profits at its core divisions and is poised to move into new growth markets within both Technical Plastics and LED Technologies, the discounts to Gooch & Housego and Victrex remain. We believe that Laird has seen a de-rating in recent months due to its smartphone exposure and so may no longer be quite as appropriate as a consistent growth and quality story comparator.

Applying the FY17e average P/E multiple (19.2x) of the established growth story comparators, excluding Laird, to our adjusted FY17 EPS estimate yields a value of 210p, c 30% ahead of the current share price. Although we think that a certain level of discount is merited, we view the current discount as too great. Further delivery on expectations and greater market understanding of the opportunities could well drive a re-rating.