Solid State — Update 23 November 2015

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.