Carclo — FY19 likely to be a game of two halves

Technical Plastics revenues declined by 2% year-on-year (0.2% in constant currency) to £42.8m. As flagged in October, three new medical programmes were delayed by customers during H119 and, while these programmes had all entered production successfully by the end of the period, the delays resulted in divisional underperformance. Margins improved in the UK as new production programmes started in Mitcham, but overall divisional operating margin reduced by 1.5pp to 5.9% because of continued direct labour shortages in the US. Divisional operating profit reduced by 22% to £2.5m.

Noting the delays to the three medical programmes, we have cut our divisional estimates slightly, as shown in Exhibit 2. We now model 1% revenue growth in FY19, followed by 8% in FY20. The H219 sales recovery is based on the three new medical programmes ramping up, together with new tooling programmes, the majority of which have already been secured. While management is confident that the remainder will commence in the current financial year, we note that there remains the risk that some of these may slip into FY20. Management expects margins to benefit from the positive impact of the operational improvement programme that was instigated in January 2018. This involves a wide range of measures including negotiating price increases, optimising existing manufacturing processes and changing US management. These operational improvements reduce the division’s reliance on the tooling revenues from new business wins, which are inherently variable. Our estimates model a 1.0pp improvement in divisional operating margin to 8.4% in FY19, rising to 8.5% in FY20. We have not modelled any cost savings in FY20 (£0.4m annualised savings expected) relating to reducing the space required by the Czech operation following the planned completion of a non-medical programme and treat the anticipated £1.0m restructuring costs, most of which are expected to fall in H219, as an exceptional item.

Divisional revenues were unchanged year-on-year at £25.6m as a change in the profile of the contract portfolio resulted in higher production revenues as programmes shifted to the manufacturing phase and lower project revenues. Since all of the eight new vehicle production programmes planned for FY19, with their attendant start-up inefficiencies, commenced during the first half, operating margin fell by 1.3pp to 11.9%. Divisional operating profit fell by 10% to £3.0m.

Our divisional estimates, which are unchanged, model 2% divisional revenue growth this year and 7% in FY20. The H219 upswing includes design and development revenues from two electric vehicle mid-volume programmes, one in Europe, the other in the US, that were awarded during H119. In addition, production on one of the three existing mid-volume programmes has already commenced in FY19. The other two existing programmes, including the largest programme, are expected to start production during FY20. Management expects divisional margins to improve during H219 as production on these programmes accelerates. We note that these long-running programmes give good visibility of production volumes over the medium term. The potential for winning new projects, which is key to divisional growth, remains good. Wipac is well positioned to win work on electric vehicles because of its expertise in creating compact and lightweight lighting systems for luxury cars. Management has begun to make plans for a greenfield US operation to support the US mid-volume vehicle programme, which will be needed to support volume production towards the end of FY21.

Divisional revenues rose 9% year-on-year to £3.1m as newer programmes started to reach planned volumes, while operating profits grew by 69% to £0.6m reflecting a better product mix. Demand for spares has stabilised and the division has won a number of new programmes that moved into production during the period. Overall, the market remains stable with new aircraft build rates remaining strong. Noting the outperformance in H119, we raise our divisional FY19 estimates slightly (see Exhibit 2), leaving the FY20 numbers unchanged at FY18 levels.

Group revenues declined by 1% year-on-year (0.3% rise in constant currency) during H119 to £71.5m, as an improvement in LED production revenues was counteracted by negative currency effects and the delays to the three medical programmes. Profitability was affected by the delays to the medical programmes, a continuation of labour shortages in the US and the effect of starting all of the new lighting production programmes scheduled for FY19 during the first six months of the year. Pre-exceptional group PBT reduced by 22% (14% in constant currency) to £3.6m.

Looking forward, management is confident of a recovery in H219 because the delayed medical programmes have now commenced production and the inefficiencies resulting from multiple production start-ups in the LED division have been resolved. There are signs too that the initiatives to improve CTP margins are gaining traction. We therefore leave our estimates, which were revised downwards in January following a trading update, broadly unchanged, shifting some revenues and profits from CTP to LED (Exhibit 2). We increase our FY19 interest payment by £0.1m to reflect the increase in net debt at the end of June, which is not expected to reduce until close to the year end.

Net debt increased from £31.5m at end FY18 to £35.9m at end H119. Working capital rose by £5.3m, primarily because of increased subcontract tooling activity for mid-volume programmes ahead of manufacture. As each of the mid-volume programmes passes into production, this will trigger a milestone payment that covers the cost of making the tooling, substantially reducing payables. We expect this process to start towards the end of FY19. Capital expenditure (including investment in software) during H119 totalled £2.9m (net), most of which related to investment in production machinery in Wipac to support the new mid-volume contract and the normal replacement cycle in CTP. We expect the company to continue to invest substantially in production capacity to support revenue growth, modelling £9.5m capex in FY19 and £11.7m in FY20.

During H119 the pension deficit, as calculated under IAS 19, reduced slightly from £24.7m (net of deferred tax) at end March 2018 to £24.5m as a result of improved corporate bond yields. This position is a substantial improvement compared with the deficit of £42.6m reported at end H117 (September 2016), when the discount rate had dropped to a low of 2.1% following the EU referendum vote. At that point, the scale of the deficit had eliminated the available distributable reserves, thus making dividend distribution legally impossible, so only the interim dividend was paid for FY16 and no further payments made after that. The board intends to resume dividend payments once the level of distributable reserves is sufficient for a sustainable and regular dividend to be reintroduced.

The level of payments into the pension scheme was agreed with scheme trustees on the basis of the triennial valuation at 31 March 2015. Payment levels are currently under review as part of the triennial valuation process. We model payments for FY19 and FY20 at a level similar to FY18 (£1.2m).

Examination of the comparators shows that Carclo, which has a diversified business model, is trading on multiples that are substantially lower than those for medical device companies and below those for automotive and aerospace industries. We use a sum-of-the-parts approach to determine an indicative FY19e P/E multiple for Carclo, as this methodology acknowledges that around half of its divisional operating profit is attributable to the sale of products to the global healthcare industry. Where available, the P/E multiple applied to each division is the mean for each sector, as shown in Exhibit 3. There are a number of companies manufacturing high-volume medical products but the key one of relevance, which we use in the sum-of-the-parts calculation, is Gerresheimer, as its products are primarily for use in medical/pharmaceutical test facilities, rather than for patient care (Ambu, Coloplast and Straumann). As can be seen from Exhibit 3, the latter trade on much higher multiples and are excluded from our sum-of-the-parts calculations. As shown in Exhibit 4, the weighted average P/E multiple derived from the multiples for the three sectors is 13.0x.

Applying the weighted average P/E multiple of 13.0x to Carclo’s FY19e (to March 2019) EPS of 11.3p gives an indicative valuation of 147p/share. We believe that the discount of over 40% to our indicative valuation of 147p implied by the share price is too severe given the stability provided by long-term customer relationships combined with the potential for growth in Carclo’s two main divisions. Applying an arbitrary 10-15% discount (which is consistent with our previous treatment) gives a valuation range of 125-133p (see Exhibit 4). This is lower than our June note, which calculated a valuation range of 144-153p/share because of the reduction in the mean auto peers P/E multiple from 13.9x to 10.6x. To cross-check our valuation, we compare EV/EBITDA multiples implied by our P/E-derived values with a blended sum-of-the-parts EV/EBITDA for the peer group. Our indicative valuation of 125-133p implies a year one EV/EBITDA range of 6.7-6.9x (see Exhibit 3), which is at a discount to the peer group blended year one EV/EBITDA multiple of 8.0x.

Carclo’s share price rose to more than 100p during July, when the company was the subject of a proposed offer from Consort Medical. Following withdrawal of the bid and the negative trading update in October, the share price has fallen back and is currently 78p. We believe that newsflow confirming that the margin issues affecting CTP have been resolved should help close the valuation gap, with potential for further share price appreciation beyond this as Carclo begins to deliver on the mid-volume automotive lighting programmes and investors can appreciate their impact on the bottom line.