Carclo — Strong growth in profits as expected

Technical Plastics revenues rose by 25% year-on-year (13% in constant currency) to £87.8m, driven by demand from larger medical device customers that are thinking on a global scale and are keen to work with suppliers that also have global footprints. Growth in the UK was helped by a new programme with Becton Dickinson. Growth in the US was driven by multiple new programmes made possible by investment in capacity at the site in Latrobe, Pennsylvania, during FY15 and at Tucson, Arizona, during FY16. The facility in Taicang, China, which was completed during H216, is performing well as production capacity for the anchor global medical device customer was expanded during the year and a further five new medical programmes were secured. Overall, new business wins reached a record level during the year. Pre-exceptional EBIT grew by 41% to £8.7m. Operating margins increased from 8.8% to 9.9% (10.2% in constant currency), approaching management’s medium-term target of 10%, because of improved efficiencies in the US.

Looking forward, revenue growth is linked to investment in capacity. Expansion is always underpinned by existing customer awards while creating space to secure new customers and product lines in future. The project to double the capacity of the facility in Bangalore to meet expected demand from its major electronics customer for technical parts and assemblies is on track for completion during the summer of 2017. The first phase of expansion at Mitcham in the UK was completed during H217 and the second phase, which is required to support the manufacture of part of Becton Dickinson’s Vystra disposable pen, will be completed later in calendar 2017, ahead of volume production in calendar 2018. Construction of a white room moulding unit at the Tucson site to support work for a West Coast US medical customer was also completed in H217. The next big development is likely to be expansion of capacity at PTD following its acquisition in October 2016.

The PTD business has been successfully integrated into the CTP operation and is fulfilling the acquisition objectives. The division has won several tool making projects for existing CTP customers and a manufacturing project.

Noting the strong divisional growth during FY17, we raise our FY18 divisional revenue estimate from £87.3m to £95.0m and our FY19 estimate from £97.9m to £102.5m. We increase our divisional operating profit estimate by £0.5m in both FY18 and FY19. This is balanced by a corresponding increase in unallocated costs and small reduction in Aerospace EBIT (see below).

LED Technologies revenues grew by 7% year-on-year to £43.4m, supported by the eight new supercar programmes won during FY15 entering production. There was little impact from currency movements. Divisional operating profit grew by 10% to £5.9m reflecting a sustained shift to higher-margin contracts and efficient ramp up of production programmes. Both Wipac and the Optics businesses contributed to the improvement in revenues and profits. Wipac was awarded multiple new vehicle programmes during the period, including the Aston Martin DB11 grand tourer coupe, and McLaren 570S coupe. Work on the first mid-volume programme (ie 10,000 to 30,000 vehicles pa), which included the delivery of several pre-production variants, progressed according to plan. The manufacturing release date of the vehicle is unchanged at late calendar 2019.

Looking forward, growth is dependent on continuing to secure new projects. In April 2017 Wipac announced it had secured a second mid-volume programme for daytime running lights for a hybrid vehicle for a European automotive manufacturer. The group is targeting winning another mid-volume programme during calendar 2018. Management is addressing this shift into mid-volume projects in two ways. Firstly, it has boosted the number of designers that can work on projects through the acquisition of FLTC, an independent automotive design company based in Czech Republic (now Wipac Czech) in March 2017, thus adding over 30 designers in one go. This means that Wipac will be able to work on more low- and medium-volume prestige car projects simultaneously. Wipac’s ability to expand had previously been limited by the rate at which it could find suitably qualified and experienced staff in the UK. The acquisition was a key factor in Wipac winning the hybrid vehicle mid-volume contract. Secondly, Wipac is creating three dedicated mid-volume production cells at its Buckingham facility, two for the mid-volume programmes already mentioned, and one for a programme that was awarded during FY17 where the anticipated volumes are now expected to fall into the “mid-volume” category. Optics moulding is being transferred from the site to CTP’s Czech site to release manufacturing space and support Optics margins. During calendar 2017 Wipac will construct a dedicated 1,000m2 warehouse next to the existing Buckingham facility and transfer all existing warehousing into the new building, freeing space for a further three mid-volume production cells to meet the group’s stated targets. In the medium term, management intends to extend the main Buckingham factory to meet customer demand.

Noting that all major programmes are on track, we leave our divisional revenue estimate unchanged giving relatively modest divisional revenue growth of 6.2% and 8.5% in FY18 and FY19, respectively. We expect substantially stronger revenue growth in FY20, which is when volume manufacturing for the first mid-volume programme kicks in, although we are not issuing estimates for the year at this stage. We leave our divisional revenue estimates unchanged and nudge our divisional EBIT estimate up by £0.2m in FY18 and £0.3m in FY18.

Divisional revenues grew by 10% year-on-year to £7.0m while operating profits were flat at £1.3m. This reflects the substitution of some sales of control cables, which is a declining market, for lower-margin precision machined components. Overall, the market remains stable and the business is highly cash generative. Noting the shift in product mix to lower-margin work, we adjust our divisional revenue estimates so that there is no growth in FY18 and FY19 rather than modest year-on-year growth and reduce both our FY18 and FY19 divisional EBIT estimates by £0.2m.

Group revenues grew by 16% year-on-year during FY17 to £138.3m. This was the result of strong growth in both the core businesses, particularly CTP, an estimated £3m attributable to the PTD acquisition and the impact of weaker sterling on the retranslation of overseas sales. Revenues increased by 10% in constant currency, in line with our £130.0m estimate. Pre-exceptional EBIT rose by 25% (22% constant currency) to £12.5m with underlying operating margin rising by 60bp to 9.0%. Financing charges increased by £0.2m to £1.5m because of an increase in the non-cash charge (£0.8m FY17 vs £0.4m FY16) relating to the IAS 19 pension deficit, though net bank interest reduced by £0.2m to £0.7m. Pre-exceptional PBT rose by 26% to £11.0m, slightly ahead of our £10.7m estimate, with the difference attributable to currency translation effects. EPS (adjusted for exceptional items) increased more slowly, by 20% to 12.1p, because of the dilutive impact of the October placing.

The modest increase in FY18 and FY19 CTP revenue estimates results in a small uplift to group FY18 and FY19 estimates. The EBIT estimates for these two years are not changed. However, a small increase in IAS 19 finance charges has resulted in a modest reduction in group PBT and EPS estimates in both years. Noting management’s stated intention to reinstate the dividend in FY19 provided that this is sustainable and legally possible (see below), we amend our FY19 DPS estimate accordingly.

The revisions give group revenue growth during FY18 and FY19 of 7% and 8%, respectively. This growth is underpinned by the combination of expansion in capacity at CTP and growth at Wipac from the new programmes secured during FY17. The improvements in operating margins modelled for the two core businesses result in a 0.7pp rise in group operating margin to 9.7% in FY18, followed by a 0.9pp rise in FY19.

Net debt increased by £1.3m during FY17 to £26.0m, in line with our £25.6m estimate. Working capital rose by £6.7m, partly reflecting increased revenues across CTP and Wipac, partly an increase in debtors relating to the first mid-volume vehicle programme. This is because Wipac is booking revenues for the design phase of the mid-volume programme but, unlike supercar programmes, will not get paid for this work until the start of the tooling phase, which is typically 18-24 months after the start of the programme. Capital expenditure was similar to the previous year (£7.9m FY17 vs £8.3m FY16). £6.4m of this investment was for CTP, with almost half allocated for expansion in the UK. There was also significant investment in production equipment to support increased activity at Wipac. The debt position was improved by the placing in October 2016, which raised £7.7m (net) at 120p/share. £4.6m (including working capital adjustment) of this was used to finance the initial consideration payable for PTP, the remainder to repay part of the group’s medium-term loan facility and invest in capacity. The £1.0m cash consideration for FLTC was funded from the group’s short-term debt facilities. Management notes that the group has total bank facilities of £41.0m and has good headroom on its main banking covenant limits. Management’s own target is a net debt to EBITDA ratio of 1.5x in the medium term. It achieved 1.51x at end FY17 compared with 1.77x at end FY16. The gearing at end FY17 (59%) was distorted by the size of the pension liability, which has been adversely affected by changes in bond rates (see below). Interest cover was a comfortable 8.1x.

The continued investment in capex (which we estimate at £12.5m in FY18 and £9.0m in FY19 if investment in capitalised R&D is excluded) is expected to drive increased profits, supporting a decrease in net debt to £21.6m at end FY19. Before that point, however, the £3.4m increase in working capital during FY18 associated with developing the tooling for mid-volume programmes ahead of manufacture, together with relatively high levels of capex, is expected to result in a £2.0m increase in debt during FY18 to £28.0m at the year end.

During FY17 the deficit, as calculated under IAS 19, increased from £18.9m to £27.0m net of deferred tax as a result of a decrease in corporate bond yields from 3.5% to 2.6%. This position is a substantial improvement compared with the deficit of £42.6m reported at the interims, reflecting the modest improvement in bond yields since September when the discount rate had dropped to a low of 2.1% following the EU referendum vote. In September 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 has stated its intention of resuming dividend payments in FY19 provided that bond yields at that time are at an appropriate level to ensure that any reinstatement is sustainable. At the interims management noted that this would require bond yields to rise well above 3% as each 0.25% pa decrease in the discount rate increases the scheme liabilities by c £7m.The board continues to take steps to maximise the distributable reserves in the plc.

The level of payments into the pension scheme was agreed with scheme trustees in March 2015 and will be reviewed at the next triennial valuation, which is scheduled for March 2018. We model payments for FY18 and FY19 at a level similar to FY17 (£1.2m).

Examination of the comparators (Exhibit 3) shows that Carclo is trading on multiples that are substantially lower than those for healthcare companies. We therefore run a sum-of-the-parts calculation to determine an indicative FY18 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 4. 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 the 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. This sample is therefore not used in the sum-of-the-parts calculation. As shown in Exhibit 4, the weighted average P/E multiple derived from the P/E multiples for the three sectors is 16.5x.

Applying this weighted average P/E multiple of 16.5x to Carclo’s FY18 EPS (12.9p) gives an indicative valuation of 212.5p. We think that Carclo’s relatively small market capitalisation merits some discount to this. However, the implied discount (45%) to the indicative valuation of 212.5p with a current share price of 147p is, in our opinion, too severe given the stability provided by long-term customer relationships combined with potential for growth in Carclo’s two main divisions. Applying an arbitrary 10-15% discount gives a valuation range of 181-191p (see Exhibit 4). To cross-check, we apply the same methodology to calculate a blended sum-of-the-parts using the year two EV/EBITDA multiple from our sample of peers in the three segments. Our indicative value range of 181-191p gives a range of year 1 EV/EBITDA multiples of 8.2-8.6x (see Exhibit 3). The lower bound (8.2x) is equivalent to the blended year 1 EV/EBITDA multiple with a 6% discount applied. The upper bound (8.6x) is equivalent to the blended year 1 EV/EBITDA multiple with a 1% discount. Our valuation range was previously 153-162p/share. This increase reflects a substantial uplift in the average P/E multiples for automotive companies. We see potential for share price appreciation towards the undiscounted indicative value of 212.5p as the mid-volume programmes start to pass into production in FY20.

The share price has picked up from the low of 110p in November 2016 as investors now recognise that the withdrawal of dividend payments announced in August does not imply problems with underlying trading performance and profits. Newsflow regarding further automotive programmes should help close the valuation gap.