Theon International — Clear vision for growth

Theon International is a specialist optronics company serving primarily the defence sector. It commands a leading position in the European market for night vision systems for the military man-portable market and a growing presence in other geographies, including North America and the Middle East. The group has a nascent position in thermal-based systems and is developing its presence in the platform (on-vehicle) market. The total addressable market is estimated at more than $3bn and expected to show a CAGR of 11.5% between 2022 and 2027 (source: Renaissance Strategic Advisors, Theon prospectus) or, we estimate, a CAGR of 16.5% weighted to Theon’s current activity profile. The group operates a product development and assembly model, maximising customer focus and limiting capital requirement, driving high margins (FY23 operating margin: 25.5%) and a higher return on capital (FY23 ROCE: 79%). The last reported order book was €400m, including two high-profile military contracts: one with the Organisation for Joint Armament Cooperation (OCCAR) in Europe to supply the Germany and Belgium military (a joint venture with Hensoldt Group) and a contract in association with Elbit Systems in the US to supply the Marine Corps, providing solid visibility

Our blended peer-based valuation of €19.7/share is the average of €19.4/share using specialist defence companies and €20.0/share using companies with part of their activity involved in augmented vision systems. Our discounted cash flow (DCF) valuation of €15.8/share is somewhat lower, using a high Greece-orientated cost of capital to reflect Theon’s base, albeit this is arguably harsh given less than 1% of sales originate in Greece. Using a defence company peer-based cost of equity would increase our DCF valuation to €21.7/share. We see the key catalyst as future contract awards to build on the soft order backlog, which has declined through FY23 to date, while continuing to build a solid financial track record.

In the five years to FY23, Theon reported a CAGR of 49%, an average operating margin of 22.6% and an average ROCE of 68%. Our expectations are for this performance to continue in FY24, with growth of 55%, an operating margin of 24% and ROCE of around 80%. The company is benefiting from operational gearing delivered by a strong growth profile, alongside its assembly/outsourced model, which limits the capital requirements of the business.

Theon’s key defence market is growing rapidly (NATO member spend is expected to grow by 10.9% in real terms in 2024, according to NATO), with continued growth anticipated given current geopolitical tensions, albeit the impact of the change of administration in the US is currently unclear. Within this, man-portable vision systems are expected to grow faster as the military looks to increase soldier-to-night-vision-equipment ratios to 1:1 in response to new warfare patterns such as the impact of growing drone warfare. The resolution of current conflicts could affect defence spend, having a clear impact on Theon, although a re-equipping cycle post Ukraine and pledges by NATO members combined with Theon’s own expansion plans should also support budgets. Military contracts are key to the group, although in FY23 it reported three customers over 10% of sales (23%,14% and 12%), suggesting that although individual contracts are important, Theon is not reliant on any single customer or contract.

Theon is a Cyprus-registered company with its key operations, including product development and assembly facilities, in Athens. The business was established in 1997 and has become a leading player in the European military optronics market. Theon develops and manufactures night vision and thermal imaging systems for military and specialist non-military markets. It operates an asset-light model as an assembler utilising an extensive supply chain. The key component of a night vision system is the image intensifier tube (IIT) at c 60% of bill of materials, for which Theon has a long-term supply agreement with Photonis Group (a subsidiary of Exosens) and recently acquired 60% of Harder Digital, a small German manufacturer of tubes. The company was listed on the Euronext Amsterdam exchange in February 2024, raising €154m before costs, a combination of €54m in existing shares and €100m in new money.

Augmented vision systems are based on two different technologies:

Night vision operates over shorter distances but provides greater detail and clearer identification of the target. The system intensifies the light available and is therefore, to an extent, dependent on the level of light providing restrictions in certain conditions such as fog or smoke. Thermal systems offer a greater range but, as they only record a ‘thermal signature’, less detail.

The next generation of systems use fused imagery to combine night vision and thermal capabilities into a vision system, offering enhanced vision across a spectrum of conditions. Theon has already developed these products.

Theon’s key strength is as a product development company, designing high quality, rugged and light equipment using best-of-breed components. Key to the design philosophy has been a platform-based approach. This permits ease and speed of customisation for relevant applications, including addressing differing contract specifications, along with interconnectivity of devices.

Theon’s offering can be split by technology (night vision versus thermal) and application (man-portable versus platform). Its primary focus has been on the night vision market (c 90% of sales), primarily in the man-portable segment. Theon has two key product end markets:

The roadmap looks to fill in the product portfolio, expand into new arenas and incorporate the latest technology developments, including the increasing systems and integration requirements.

Theon offers a range of follow-on-services such as training, spares and maintenance and upgrade and customisation. Support is increasingly important as the level of complexity of night vision systems rises. Such support also provides a differentiating factor, enabling Theon to build a longer-term relationship and loyalty with customers. Theon continues to expand its physical geographical presence, highlighted by the recently established business in Denmark, which will support customers in Denmark and the Nordic region. Reliability is key and an IIT lasts 10,000 hours, hence the direct financial opportunity is limited (currently c 1% of group revenue) although such commitment arguably also supports original equipment bids.

Theon operates a low capital-intensity business model. A specialist core provides critical product development and assembly operations, while a network of suppliers and partners provides the required supply chain and distribution bandwidth.

Theon designs and develops systems using best-of-breed technologies and components from third parties, depending on customer specifications. It does not undertake pure technology research. The group focuses on applications engineering, ensuring product optimisation alongside operational performance in key areas like ruggedness, lifetime and battery consumption. A further focus is on ergonomics, increasingly important as the goggles become an integral part of the communication system leading to increased use. This enables speed and customisation of products required for bidding on multiple military contracts.

Theon does not manufacture parts but assembles bought-in components either manufactured to specification or acquired off the shelf. This reduces the capital investment required and brings greater flexibility, albeit requiring significant attention to supply chain management. This provides flexibility in the cost base and is highlighted by FY23 sales per employee of €785k and employee cost to sales of 4.8% (compared with Hensoldt sales per employee of €276k and cost to sales of 34.4%). The recent acquisition of Harder Digital, a small manufacturer of IITs, brings a degree of vertical integration, albeit of a critical component from both a technical and cost (c 60% of bill of materials) perspective.

The group’s key manufacturing facilities are in Athens, with two assembly facilities (3,500m² and 4,800m²), requisite clean rooms and capacity for c €400m revenue with a single shift operation. Theon also has a smaller facility in Germany (300m²) through its joint venture with Hensoldt and an assembly line in North America through an agreement with EOTECH.

Theon partners with other organisations to ensure compliance with local content/offset requirements and to limit the capital investment required. Key agreements at present are in the following countries:

The nationalistic biases in the defence sector, along with the vertical integration of key component (IITs) and systems suppliers in the enhanced vision segment, engender the relationship between suppliers and competitors.

Theon has a broad supply base for the majority of components, which are either manufactured to Theon’s specification or, if standard specification, bought off the shelf. However, for night vision the key element is the IIT, which accounts for c 60% of the bill of materials. There are four key suppliers in the market:

Competition ranges from large prime defence companies such as BAE Systems and Safran to more specialist electronics/systems companies such as Hensoldt and Teledyne FLIR. Key competitors are shown in Exhibit 4. There are also a number of smaller companies generally supplying to their domestic military market (eg NightVision Lasers in Spain or PCO in Poland).

The defence market is set for a period of continued strong growth with the Electro-optical/infrared (EO/IR) segment which Theon serves set to benefit from additional specific factors.

The current global geopolitical situations in Ukraine and the Middle East are inevitably leading to security concerns and increased government spend on defence. This is being supplemented by a replacement cycle for equipment that has been gifted to Ukraine and can best be seen in the context of NATO spend. In 2014, NATO members made a commitment to increase spending as a percentage of GDP to 2%. By 2022, only seven member states were achieving these levels. However, with real growth in combined NATO spend of 3.9% in 2023 and 10.8% expected in 2024, the number of countries reaching the 2% target is expected to rise to 23 out of 31 in 2024 (source: NATO). This is highlighted in Exhibit 5, with the US as the dominant (more than 60%) contributor shown separately.

Alongside market growth are several additional factors expected to accelerate EO/IR system growth ahead of the general market. These include the following:

Renaissance Strategic Advisors forecasts 9.5% growth in platform-based systems and 16.8% in dismounted systems between 2022 and 2027, providing an 11.5% increase in Theon’s addressable market. We note that Theon’s activity profile is heavily weighted towards the dismounted segment, hence we calculate activity-based market growth potential for Theon of 16.3%.

In addition to market growth, there has been a shift in procurement to larger framework agreements, particularly in Europe, more in line with the US procurement protocol, consisting of multi-year IDIQ contracts with subsequent annual volume agreements or drawdowns. This provides greater certainty and allows improved planning for suppliers.

Significant focus remains on operational performance and delivering on the current order books. In addition, management aims to execute its growth strategy through a combination of organic growth, acquisitions and partnerships. These include the following:

We discussed the roadmap for developing the current product profile above. Clearly, there is a move to integrate systems and enhance communications. This may require additional capabilities which, given the required speed and technical complexity, Theon may need to find a partner for or acquire. Areas of interest that would complement Theon’s current technologies include day sights, laser targeting systems and fire control systems. New products in non-military applications such as hunting or law enforcement are more likely to fall within the group’s existing capabilities. The key is likely to be the ‘go-to-market’ strategy given the potential for local content in regulated markets or the strength of incumbent suppliers in their brands.

In FY23, more than 80% of Theon’s sales were into Europe, suggesting significant under-representation elsewhere in the world. Theon has a network of agents, but significant geographical expansion is likely to require a physical presence, either directly or through a partnership. The recent acquisition of Focus Optech in South Korea provides an example, providing a first presence in the key territory of Asia to support future production.

There are a number of smaller regional or national players in the market. Such acquisitions should provide a relatively low-risk entry into new markets along with synergy opportunities. Such expansion is likely to prove somewhat easier in established regions than winning tenders as an external supplier.

2024 has seen a number of initiatives that fall clearly within the strategic expansion roadmap:

Current key contracts:

Potential future significant contracts:

Exhibit 9 highlights the strong growth seen in recent years. We note that revenue in the first three quarters has already surpassed FY23, which ensures that FY24 will be another year of strong growth. Exhibit 10 highlights the outperformance of the key end markets, the dismounted optronics sector and the European optronics sector.

Exhibit 11 highlights Theon’s positive financial returns. FY21 and FY22 clearly benefited from particularly strong gross margins, which have now returned to more normal levels, in line with management’s medium-term expectations. We also note the operational gearing benefits, with central costs (SG&A/R&D) declining as a proportion of sales as the business has grown (18.3% in FY19 to 6.6% in FY23), providing positive operational gearing. The group generates a high return on capital, as shown in Exhibit 12, benefiting from the low capital-intensity assembly model the group employs, along with a healthy operating margin.

Operational cash flow has also been healthy, with conversion averaging 85% over the last five years and negative cash generation in only one year despite supporting strong growth. There was a clear anomaly in FY22. As Exhibit 13 shows, this was due to working capital requirements reflecting a strong end to FY22 and a strategic decision to acquire additional key components where the supply chain was becoming tight.

Exhibit 15 shows a comparison of peer financials in FY23. For some peers, enhanced vision systems is relatively small. For instance, L3Harris, a key competitor in North America, with Communications Systems division revenue of $5.1bn and group revenue of $19.4bn. Nevertheless, it is worth noting that the relevant divisions of all companies make healthy returns, with Theon clearly at the upper end. Hensoldt is the exception, which might raise some concern given the partnership between Theon and Hensoldt in Europe. As the venture is accounted for as an associate, Theon’s accounts provide more detailed financials of the venture, reporting FY23 revenue of €20.7m and EBIT of €1.7m.

Exhibit 16 shows quarterly performance to date, along with our forecasts for the full year and hence the final quarter. Clearly, we are anticipating a strong close to the year for the group. Such seasonality is normal after the holiday affected Q3 in Europe, supplemented by governments tending to utilise budget surpluses by the end of the period. Exhibit 17 highlights the high level of Q4 contribution in FY22 and FY23, as well as that anticipated in Q424.

Management’s guidance has remained unchanged through the year for revenues of €330–350m along with operating margins in the mid-teens. The company recently stated that management will provide guidance for FY25 before the end of the calendar year. The company is currently participating in tenders with a total value in excess of €500m. Announcements here will clearly be helpful for sentiment and confidence given the decline in the ‘soft backlog’ seen so far over the year. Note that the company has already announced orders over €150m in Q4 (including €74m announced on 20 November) as part of normal business including year-end purchases as annual defence spend budgets conclude.

Further detailed biographies of key management and board personnel can be found on page 20. Exhibit 21 highlights the stability and experience within the team.

Theon is subject to a range of potential risks and risks. The majority of these we view as relatively standard for a defence-related company.

Resolution of the current conflicts might suggest a reduction in defence spend and hence a risk to Theon’s revenues. However, there are a number of reasons that support a more positive market. There will be replacement demand, which is likely to be supplemented by increased penetration per soldier; government spend commitments, at least within NATO, are unlikely to reduce; and technology developments, including the need to fully integrate equipment, will fuel an upgrade cycle.

The group’s business is dominated by significant defence contracts. In FY23, the three largest customers accounted for 23%,14% and 12% of sales. We note that the concentration for other defence companies is higher: Avon Technologies US DoD 45%, QinetiQ UK MoD 62% and Cohort UK MoD 34%. The award and timing of such contracts is therefore critical to the fortunes of the group. In addition, the ability to deliver and performance guarantees provide a degree of uncertainty.

As a supplier of military equipment, the company must comply with government export regulations. In addition, these are subject to change as geopolitical situations develop, which could affect the group’s ability to win new business or deliver on existing contracts.

As an assembler, the performance of the supply chain is critical for the company to deliver product. The key component of IIT (c 60% of bill of materials) has been in short supply. To overcome this, Theon has signed a long-term supply agreement and acquired a controlling 60% stake in Harder Digital, a smaller German manufacturer of IITs.

Founder, CEO and Vice Chair Christian Hadjiminas’s current holding of c 75% gives him significant control over the company.

We look at a ‘relative’ valuation compared to listed companies operating in a similar space and an ‘absolute’ valuation using a DCF model.

We have valued Theon against two peer groups. The first includes companies involved in enhanced vision systems, albeit this is a relatively small part of some of these companies (eg L3Harris with $19.4bn in revenue). The second covers small to mid-sized defence-orientated companies offering an array of specialist activities. The first cohort suggests a valuation of €20.0/share and the second €19.4/share based on average EV/EBITDA, EV/EBIT and P/E in 2024–26e.

Our DCF uses five-year forecasts followed by a terminal value. Defence budgets are set for the medium term, as are contracts with suppliers, even if only IDIQ in nature. Combining this with independent forecasters’ views of the next four years provides a degree of confidence for this forecasting period. We then flex the terminal value depending on grow rates.

The second key element is the discount rate. The Greek bond yield is currently 3.6% and market risk premium 8.3%. We use a Beta valuation of 0.75 derived from the peer group of defence companies, suggesting an overall cost of capital of 10%. Assuming a long-term growth rate of 2%, Exhibit 23 suggests a valuation of €15.8/share. Theon has less than 1% of sales to Greece, with the majority to state governments, which might suggest that using a Greek cost of equity is somewhat harsh. We note that using a cost of equity similar to other defence stocks with an average of 7.7% would translate to a valuation of c €21.7 per share.

Our DCF valuation of €15.8/share is below our peer-based relative valuation of €19.4–20.0/share. This gap reflects the higher cost of capital used. With our valuation assuming a similar cost of capital to other defence stocks, our DCF increases to €21.7, above our peer-based valuation. Hence, overall, we believe that €19.7/share, the average of the two peer groups, provides a fair valuation.