TP Group — Update 31 January 2017

Since 2009, Phil Cartmell and his team have transitioned the former development house activity that was Corac Group into a profitable manufacturing and services activity. Now developing its position as a Tier 2, defence-led services and engineering company, the strategic direction is resonant of the development of Vega Group, the CEO’s former charge. Its disposal to Finmeccanica (now Leonardo) was the culmination of value creation for shareholders over an eight-year period.

As TP Group enters a new phase of profitable growth through both organic development and strategic bolt-ons, we feel a similar outcome may be attainable. The group offers customers through-life, end-to-end product design, supply and support solutions. Clear gaps in resources and budgets across government, especially in defence, create a sweet spot for the development of agile consultancy service offerings to existing customers. In addition, the specialised engineering capabilities are being integrated to enable the design and manufacture of more complex products and systems. With the ability to extend this reach globally by leveraging the international awareness that arises from leading product positions, a further stream of growth potential should be available. The recent capital reduction is an important factor in enabling the strategy as it facilitates greater incentivisation of employees, as well as more flexible financing options for growth and M&A.

As the group becomes increasingly profitable peer valuations should become more meaningful, with a greater proportion of TP Group’s activities now making positive and growing EBITDA contributions. As a result, we now also incorporate a DCF valuation in determining our fair value for the group. A simple average of the two methodologies returns a value of 9.11p per share (from 8.48p based on SOP only), which implies that a significant discount is being applied to the stock at present. If growth continues and dividend payments can be initiated, we believe there would be a progressive erosion of the current 32% differential.

Having achieved EBITDA break-even in FY15 ahead of schedule, the goal is now to generate sales growth and improve operating profitability and cash flows to self-sustaining levels. Our sales and EBITDA estimates remain unchanged. We have restated and thus increased our normalised EPS as a result of correct categorisation of PPA (purchase price allocation) intangibles, more than offsetting an increased depreciation charge.

As it enters a more expansionary phase, TP Group faces sensitivities that would attach to other product and services companies. It is subject to the usual macro risks that relate to its end-markets, especially budgetary challenges in defence and investment levels in oil & gas, energy and other industrial segments. Contracts can be long term and thus contract risk management and execution are paramount. On the financial side, the group has to demonstrate recurring and growing profitability and cash flow. While we think this is in train, it adds funding risk to future value development. In addition, management states that M&A is a core part of its strategy to develop the business. Ensuring appropriate business cases and integration plans are developed is thus also a vital part of value creation.

TP Group (name changed from Corac in June 2015) started life as a research and development (R&D) company, working to commercialise micro turbine compressor technology for offshore oil collection. It was founded in 1996 and listed on AIM in 2001. In 2012 the current management decided to buy two sustainable businesses for £10.9m to help with cash generation and transform the business into a specialist engineer: Wellman Defence, a supplier of air purification equipment and Wellman Hunt Graham, a manufacturer and supplier of shell and heat tube exchangers. The £0.8m bolt-on acquisition of Shaw Sheet Metal in February 2014 added other lighter engineering capabilities in laser cutting and specialist fabrication. TP Group now operates in four divisions; Maritime (55% of revenue), Engineering (29%), Managed Solutions (13%) and Design & Technology (3%), servicing two main end-markets (Exhibit 2):

TP Group’s largest customer is the UK Ministry of Defence (MOD) (29% of FY15 revenue, see Exhibit 3). In Aerospace & Defence, the company also supplies other nations’ armed forces, security services and large prime contractors, mostly notably BAE Systems and Babcock for the UK submarine programme.

In Energy & Process Industries, TP Group has a diverse range of customers, including upstream energy producers, downstream petrochemical processors and refiners, power generators, equipment manufacturers and engineering, procurement and construction companies (EPCs). 76% of revenues are UK derived, followed by Europe with 11%. However, the company has highlighted significant growth potential in the Far East and Australia (Exhibit 4).

TP Group had revenues of £20.5m in FY15, with adjusted EBITDA losses reduced to zero (£2.1m in FY14). In H116 turnover has grown 13% to £9.4m (£8.3m), again with a break-even EBITDA performance, a £1m improvement on H115. It has an order book equivalent to eight months’ work (£13.4m at H116). While lower than the £14.5m on hand at the start of FY16, the position has improved during Q3 with further major contracts in Maritime and Engineering signed during H216. The pipeline of future sales opportunities has grown to c £150m, including two significant single-source contracts totalling £50m being negotiated with the MOD. The company has historically had a high cash utilisation but, having reduced the burden of self-funded R&D, it generated £0.7m of operating cash in H116, improving net cash to £7.5m (£7.0m at FY15).

The most exciting part of TP Group’s business is TPG Maritime (formerly Atmosphere Control International (ACI). TPG Maritime supplies critical air management systems for submarines that allow the boats to remain safely submerged for months on end. Its biggest selling product is the Combined Oxygen Generation System (COGS), which takes in sea water and produces oxygen and hydrogen as a by-product. It is one of only two companies outside China, Russia and the US to produce such systems and is the ‘go-to’ supplier for all European sophisticated submarine programmes, as well as the other submarine producers in accessible markets around the globe. In the UK TP Group is a supplier to the ongoing Astute class submarine build, it is supporting operations of the Vanguard class boats and is making preparations for the next generation of UK submarines. Growth in submarine exports drove a 22% rise in revenues from Asia compared to 2014. European business also increased by 75%, primarily due to additional work on the French submarine programme. Future opportunities exist in Brazil and Australia, as well as in the UK.

In 2014 management established a plan to co-ordinate its approach across the group’s different products and services, using a three-pronged offering:

The four business units are all working to implement this model across all products and end-markets, meaning that customers can benefit from a true end-to-end service if desired.

There has been a focus on managing costs to improve margins. Procurement has been centralised to realise benefits of scale across the business units. There has also been vertical integration as a result of acquiring Shaw Sheet Metal in February 2015. Metal fabrications that were previously bought are now produced in house, thus lowering overall system costs.

In January 2015 TP Group announced its exit from numerous development contracts for compressor systems. This removed exposure to ongoing development costs and focused the portfolio on commercially viable and sustainable projects, with lower technical and financial risk. In addition, the Slough Technology Centre has been closed and the team reorganised and re-housed into less expensive, yet more suitable premises at a saving of c £0.8m per year.

Management is actively looking for acquisitions to add capability and value to the group. Targets are likely to fit the company’s specialist engineering theme, with products or services adjacent to current offerings. The 2015 Annual Report highlighted the following four areas of focus:

CEO Phil Cartmell joined TP Group in 2009. He was previously CEO of Vega Group (2001-08), where he returned the company to profitability by reducing central costs and selling underperforming parts of the business. Vega was then sold in February 2007 to Finmeccanica (now Leonardo), the major Italian aerospace and defence contractor, for a substantial premium. TP Group is currently a similar size to Vega in 2001 and is facing many of the same challenges, so Mr Cartmell undoubtedly has the correct skill set to drive growth. The CFO, Derren Stroud, only joined the company in March 2016, but has a proven track record as FD in a number of niche technology and engineering businesses, including IAC Acoustics, Retail Decisions and Envox Worldwide.

Management and employee incentivisation may also develop positively. Existing share options cannot be exercised below 15p per share, which currently is such a long-term potential as to provide little encouragement, especially to recent and incoming talent. The capital reduction should enable more appropriate medium-term incentives to be put in place.

TPG Maritime is the largest of TP Group’s business units, generating 55% of revenue in FY15. It is the equipment and supply business of ACI, and a stable source of long-term revenue, profit and cash generation for the company. The world submarine market is growing and in the UK submarines represent the largest and fastest growing line in the UK defence budget (as per Exhibit 7). As a result, TPG Maritime’s highly sophisticated products are in high demand. It has completed the preliminary design of atmosphere systems for BAE Systems for new submarines and a follow on design contract was awarded in November 2016. The project will generate revenue for at least three decades, with the first boat due to enter service in 2028. TPG Maritime also supplies air management systems to DCNS, which has been selected to design and supply 12 boats to the Australian navy.

The outlook for the business is strong, with the MOD and TP Group imminently entering single-source negotiations on two contracts announced in July and August, cumulatively worth £50m.:-

With single-source margins the topic of much discussion in UK defence procurement policy at present, we would be surprised if TP was not facing some increased pressure on price in these negotiations. The strategic importance of the systems and support supplied should, however, weigh in the company’s favour. In addition, we would expect management to be seeking innovation and efficiency gains to enable returns to be maintained at least at historic levels.

The TPG Engineering business unit is the combined activity of Hunt Thermal Technologies in Dukinfield and Shaw Sheet Metal in Oldham. It is a leading supplier of heat exchangers that operate in demanding applications, with complex metallurgy and highly specialised technical requirements in markets such as downstream oil and gas or chemical process industries.

The exposure to oil & gas capital expenditure meant that the business is currently operating in a challenging end-market environment. Revenue fell in 2015 and it made an EBITDA loss of £0.2m. There have been significant management changes, with a new head of engineering and sales director now in place. Recently customer focus has been on refurbishment and site support in the absence of sales of original equipment, which should recover as markets improve. In FY15 the order book nearly halved from 2014 levels (£2.5m) to £1.3m, although the order intake for FY16 was much stronger.

TPG Engineering has now opened its first opportunity to supply nuclear power markets through the contract won from GE Oil & Gas in December 2016. Further opportunities exist for both civil and defence applications making nuclear an interesting potential area of growth. TPG Engineering is to increase its capex at its Dukinfield site to upgrade and enhance capabilities and streamline processes. Recruitment of additional engineers and technicians is also anticipated.

This is a new business area for the group, aimed at expanding its presence as a long-term service provider in the aerospace & defence and energy markets. The business unit has been spun off from the successful Maritime division because it stems from a contract with the MOD to provide a managed supply chain and logistics support for atmosphere filters fitted onto Royal Navy submarines. Management believes there is a growing requirement for outsourcing specialist services because the number of UK MOD civil servants is reducing against the backdrop of a growing procurement budget. Longer term, the intention is to replicate the model in the Energy and Process industries. During the first half of FY16, TP Group was admitted to the following government frameworks:

TP Group’s inclusion within these frameworks is testimony to its strong relationship with the government and therefore bodes well for its ability to win future business in this space.

Design & Technology is the smallest of the business units and stems from the original work undertaken by Corac Energy Technologies. The business is in the process of transforming itself from a technology developer to a technical consulting and design services business. It is making a strategic shift to revenue-generating R&D rather than cash-consuming R&D as it has been in previous years. In this regard, it will support technical requirements of the other divisions in TP Group.

Like TPG Engineering, it is exposed to the struggling oil & gas market, which has directly affected some of the developments in the upstream sector. However, management remains focused on commercially viable activities based on core technologies.

It benefits from a longstanding relationship with Spirax-Sarco. In March 2015 management signed a 10-year exclusive global licensing and manufacturing agreement for packaged steam products containing TP Group micro-turbines and compressors. Work on the European CryoHub programme continues and the next delivery of the American gas let-down expander project is expected in H217.

Like most specialist services and engineering companies there are a number of commercial, political and financial factors that could influence the performance of the business.

As the focus of TP Group continues to move towards profitability and cash generation, the market should increasingly be able to rely on traditional earnings multiples to compare the stock to its peers. The comparators should be complementary to our existing peer group-based sum of the parts, which we have now augmented by adding a capped DCF valuation. Our fair value is now calculated as a simple average of these two measures, which currently returns 9.11p per share (from 8.48p based on peer SOP only). It is interesting to note that on our initial forecast for FY18, TP Group is currently trading on an 11.1x multiple.

Our utilisation of defence and engineering services peers remains unchanged, although we now use EBITDA multiples for the new divisional structure. It is evident that the robust performance of the defence sector in recent years has been further boosted in recent months by a more favourable FX environment since the Brexit vote, as well as renewed optimism on global defence spending levels following the US election. Performance among the engineering stocks has tended to be more subdued due to increased global macro uncertainty, although again a fall in sterling is a stimulus for exporters and companies translating overseas profits. We continue to value the Design & Technology division at zero despite continued losses, as we believe it will be made profitable by additional third party design and engineering contracts in the future. Our current sum-of-the-parts value has increased moderately to 9.25p per share (from 8.48p).

Using our capped DCF methodology (six years forecast with assumption of zero growth in the terminal value) derives a value of 8.97p per share. Our medium-term forecast period includes top-line growth in the 1-5% range for each year from FY19E, with EBITA margins rising progressively towards 13%. The calculation assumes a cost of equity and WACC of 8.0% which, while fairly standard, it could be argued is a little presumptive in terms of TP Group’s maturity. Reversing the calculation, the implied WACC from today’s market valuation is 11.4%, which in our view fails to reflect TP Group’s current transition to profitable growth. We show a sensitivity analysis for WACC and terminal growth rate in Exhibit 9 below.

We had previously failed to properly normalise our earnings calculations for acquired intangibles, which led us to overstate adjusted losses on that basis. In addition, we now assume greater levels of capital investment in the business as it pursues growth, leading to a higher depreciation charge over the forecast period. We also now treat the mark-to-market of derivative instruments in the financial result as a financial exceptional, excluding it from the normalised earnings calculation. As a result, we now forecast an improvement to positive EPS, albeit modest, in the current financial year, with significant progression thereafter.

As a result of the upbeat trading statement in December we have increased our earnings expectations for the group. While our sales forecasts are changed modestly, adjusted EBITDA contributions rise more significantly. FY16 adjusted EBIT is slightly lower than previously due to the higher depreciation charge, with modest improvement to our FY17 number. Adjusted PBT and EPS are in fact significantly higher. The higher investment has also led to a modest reduction in our net cash expectation this year. All of the adjustments are reflected in the revision table (Exhibit 10).

Following the capital reduction, which has created distributable reserves, we expect capital allocation priorities to be organic development and M&A funding. The potential initiation of dividend payments would then occur at an appropriate point in the future.