Ultra Electronics — Update 28 February 2016

The results for 2015 have been delivered largely in line with our expectations and those of the market. In addition there are some more promising signs in the macro environment, notably the more positive outlook for defence spending. Ultra continues to invest heavily to capitalise on the forthcoming opportunities.

While there was a modest shortfall in revenues from the Maritime & Land Division, the company modestly beat our earnings expectations at the main group level, with healthy margin performances in all three divisions. Overall sales improved by 1.8%, with adjusted operating profit up 1% and EPS up 0.7%. Given the exceptional challenges faced during the year following the termination of the Oman Airport contract and the fallout from the Patriot Act in the US, this was a creditable performance.

Organic revenue development saw a fall of £57.1m down 8.1%, with just over a quarter of that reflecting the impact of the Oman Airport contract termination of £14.9m and the impact of the Patriot Act on SoTech accounting for an even larger £21.9m. However, this was more than offset by a £42.3m contribution from acquisitions, primarily Herley, combined with a positive FX impact of £28.4m.

Despite the challenges during the year, all three divisions returned adjusted operating margins close to the previous year: Aerospace & Infrastructure 14.8% (14.9%), Maritime & Land 17.3% (17.7%) and Communications & Security 16.9% (16.5%). The overall group adjusted operating margin was held at 16.5%, against our expectation of a modest decline.

This left adjusted operating profit modestly ahead at £120.0m (FY14: £118.1m), with the organic decline offset not just by currency (+£2.2m) and acquisition contributions (+£5.8m), but also by net cost improvements of £7.2m. Management reduced headcount by 467 people in 2015 at a cost of £3.2m. Since the beginning of 2012, headcount now totals 1,572 at a cost of £14.1m.

Cash flow was in line with our expectations, leaving net debt at £296m at the year end. Management increased the full year dividend by 4.1% to 46.1p.

The one area of surprise was the order situation. While optically the backlog appears similar to the half year, the consolidation of Herley during H2 masked an underlying shortfall of some £100m in the order intake anticipated by management. This mainly reflected the deferral of several large incremental orders into FY16, including a ship power products contract for the US Navy expected to be worth £15m, a UK sonobuoy contract, an EW contract for Turkey and the New Torpedo Defence System (NTDS) contract in India also worth £30m. The award of the £15m contract to refit the second Fatahillah corvette for the Indonesian navy has been delayed until after acceptance of the first ship and is now expected in 2017. So a significant amount of the deferrals are expected to be awarded this year alongside the already anticipated FY16 opportunities.

Management has provided a relatively cautious assessment of the immediate prospects for FY16, largely based around the macro conditions. Low financing costs, oil prices and inflation should all be positive economic stimuli, but the lack of levers left to central banks in the face of concerns over emerging markets growth and potential deflation. While in our view the main issue for Ultra is largely one of budgetary constraint versus customer aspiration, this may now be moving more positively for the defence sector, even in Europe. It should be noted that funding flows tend to lag budgetary authorisations, meaning improved demand is more likely to be seen next year. Other areas such as rail, nuclear and oil & gas continue to face challenging market conditions.

Ultra’s exposures by geography and market segment are shown in Exhibits 2 and 3 below.

In this context, sales in the current year are expected to be relatively flat organically, with margins again relatively stable. There should be some positive FX benefits to both sales and profits if sterling remains weak against the dollar, and Herley will make a full year contribution that will lift operating profits and enhance EPS. Overall, we expect to see moderate growth in EPS, with an improved cash conversion rate.

Beyond the current year we expect to see the current investments start to drive accelerated organic growth, and we expect order growth to display an element of catch-up as the orders deferred from last year are booked. As defence funding starts to flow at improved rates, areas such as electronic warfare and anti-submarine warfare are likely to remain key areas for investment given recent activity in the Middle East. Combined with the positive development in aerospace markets, we would expect organic growth to exceed 4% in the medium term, notwithstanding potentially more sluggish infrastructure markets.

The S3 (Standardisation and Shared Services) programme also remains on track to deliver the targeted annual savings of £20m pa in the longer term. The initial one-off implementation charge of £4.9m was taken in FY15 as expected and shared service centres are being set up in the UK (Wimborne) and the US. Procurement savings are already being delivered and the programme should start to be be self-financing in the current year as benefits offset incurred costs. Once realised the savings will be used to support increased R&D and improve pricing competitiveness, with the balance supporting margins.

As previously disclosed, Mary Waldner, the CFO, is to leave the company imminently to take up her new role at Lloyds Register. Ultra has appointed Ami Sharma as the interim CFO while the replacement process continues. Unrelated to the CEO, Mr Sharma is a former group financial controller of Ultra who left the company in 2005 to pursue other high-level financial roles, both quoted and unquoted, in the private sector.

The renewed optimism in defence markets has lifted ratings in recent months and we have rolled our sum-of-the-parts methodology forward to a 2017 basis. Our previous basis returned a value of 1,799p, and the shares have been trading comfortably above that level. Our FY17 SOTP-based fair value is almost 6% higher at 1,904p, as shown in Exhibit 4 below.

Our FY16-based SOTP fair value equates to an FY17e P/E rating of 14.0x. We believe such a rating is justified by Ultra’s strong cash generation, with high margins in areas attracting long-term defence spend, as well as the latent commercial aircraft revenue growth potential as new aircraft build rates increase.

We have modestly reduced our growth assumptions for the current year, but continue to assume an improvement in organic growth in 2017. This has led to the earnings revisions highlighted in Exhibit 1 on page 2.

Free cash conversion is likely to remain the focus of attention for the market. In FY15 the company achieved only a 68% level, well below historic highs, with the Oman contract termination depressing this by 6pp. The deferrals of new orders also led to a more neutral working capital performance in the second half than we had expected. Management has guided for a range of 70-80% for FY16, implying around £100m of operating cash flow, which will gain be affected by Oman as well as higher capex. It should improve further from FY17 as working capital control improves.