Arming your portfolio

Across global protection, defence and military markets, a select band of small-cap companies are poised for resilient growth, writes James Crux

Approach to investing

Approach to investing from Growth Company Investor

Across global protection, defence and military markets, a select band of small-cap companies are poised for resilient growth, writes James Crux

Sadly, conflict is and has been a fact of life throughout human history, as the recent wars in Iraq and Afghanistan ably testify. As and when such conflicts end, there is often a need to use military force to keep the peace for many years to follow, and, of course, conflict, more often than not, creates an increased terror threat.

Against this backdrop, one thing is certain – there is a constant and long-term requirement for ‘global government’ and other organisations to invest in protection and defence products and services of one sort or another, whether it be directly in their military forces, in technological innovations that aid security efforts or a military push, or even in the protection of police forces that keep the public safe.

The march for market share
Forced to live with this reality, investors might choose to examine the market’s select number of small but ambitious companies with market-leading products fighting for their share of some diverse, often large and highly fragmented, markets. To give but a flavour of the opportunities that abound, analysts estimate the global annual market for ‘respiratory protection’, encapsulating products and services able to combat chemical, biological, radiological and nuclear threats, at a sizeable £1.8 billion, half accounted for by North America. Elsewhere, the global market for counter-terrorism and environmental protection products is now thought to be worth in excess of £30 billion per year and growing.

Military advances at Avon Rubber
In the midst of meaningful turnaround and with long-term military business in place is the significantly restructured Avon Rubber, at one time active in the automotive sector but now focused on high-growth opportunities in protection and defence.

Having put past losses behind it, the Full List counter is regaining market credibility under CEO Peter Slabbert and finance director Andrew Lewis. Though it has a profitable, cash-generative business making cow-milking liners for the dairy sector, the real growth story is Avon’s respiratory protection equipment side, which makes products for very large markets including gas masks, self-contained breathing apparatus and emergency hoods.

Avon Rubber has long supplied gas masks to the UK Ministry of Defence (MoD), along with other European armed forces, while its newer products have seen it win lucrative contracts with the US Department of Defense (DoD) and other related agencies. The latest upbeat newsflow arrived in September, with Avon clinching a new five-year deal from the DoD for its new M53 protective mask – the initial order alone under this tie-up is worth $3.7 million (£2.25 million), while the overall contract potential runs to north of $40 million (£25 million).

These tie-ups with the UK and US militaries not only ensure long-term demand for Avon’s products but also provide government-backed, defensive earnings during the current economic malaise. As Slabbert points out, ‘spending on the protection of the soldier is not under threat’. Already fortifying its position in the US market, the biggest in terms of growth potential, Avon is free to pursue opportunities with friendly armed forces around the globe.

Avon’s financials are making positive advances, with the company having returned to profit during the half to March, turning losses of £1.6 million into profits of £1 million pre-tax, as turnover surged 103 per cent north to £44.1 million. When annual numbers to September 2009 are announced shortly, investors can expect a turnaround from losses of £3.9 million to adjusted pre-tax profits of £4.3 million, on revenues of £84.5 million. By September 2010, profits have the potential to push on to £6.5 million, producing a likely rise in earnings from 11.2p to 18p.

Based on those estimates, the shares, which have risen from a 52-week low of 25p to 80p (though remain substantially south of historic levels), are selling for 7.1 times earnings, a ratio dropping to 4.4 based on the 2010 numbers. This lowly rating, stemming from past performance rather than future prospects, offers an opportunity to buy in at an attractive price. Once management restores the market’s confidence, as it is beginning to do, a strong rerating should occur.

Another turnaround counter with credentials in the military sector is AIM-traded protection equipment specialist Shieldtech (see page 5), refinanced and restored to profitable trading. This, admittedly quite small venture, supplies body armour to troops currently active in Iraq and Afghanistan, as well as body protection and other niche products to a number of international police forces. Though its track record as a quoted company is rather mixed, the investment case is looking increasingly robust, with sales having powered ahead 72 per cent to £10.3 million in the year to June. Losses of £863,000 were converted into pre-tax profits of £356,000.

Moreover, the recent securing of a deal under the MoD’s £16 million defence clothing project, involving the supply of ‘soft armour protective ballistic panel inserts’ for use in military body armour systems, demonstrates the esteem in which its products are held. The shares, now 9.5p against a 52-week peak of 14.75p and trough of 3.25p, have definite attractions.

Cohort – still winning friends
Offering exposure to high levels of sure-fire spend is Oxfordshire-headquartered consolidation vehicle Cohort, many of whose staff are ex-armed forces, and another with the UK MoD as a key client. AIM-traded since 2006, this independent technology group’s three core subsidiaries – MASS, SEA and SCS – deliver everything from defence consultancy, electronic warfare and information systems development to surveillance systems and software. In a successful financial campaign to last April, profits pushed 16 per cent higher to £6.5 million, on turnover lifted 38 per cent to £78.6 million, as all three divisions posted record numbers. Significantly, some £60.7 million of the top line, just shy of 78 per cent of sales, arose either directly or indirectly (where Cohort acts as a subcontractor or partner) from the MoD.

Dividend-paying and with a healthy order book, Cohort closed the year with significantly improved net funds of £3.7 million, leaving it strongly positioned for further acquisitions, supplementing healthy organic growth. At 160p, off their 220p peak, the shares sell for just over ten times forecast earnings of 15.7p, and given the group’s track record and growth prospects, occupy strong buy territory.

Fuel cells – the future is now
In the future, the military will place less emphasis on heavy artillery and more on innovations such as unmanned planes, which plays into the hands of US-based Protonex Technology, the Massachusetts-headquartered company guided by energetic CEO Scott Pearson.

Now a real products business, rather than a technology developer, the company makes compact, light and high-performance fuel cell systems with huge advantages over batteries and small generators in terms of weight, noise and environmentally damaging emissions. Though Protonex is targeting commercial and consumer markets, the near-term focus is the military space. The bulk of its revenues come from the supportive US military, from which it has received millions of dollars of funding to develop power systems for soldiers, military vehicles and unmanned aerial vehicles (UAVs). In tests, a UAV powered by this technology flew for more than 23 hours, an unofficial endurance record for a fuel cell-powered flight.

First-half results to March showed sales of $2.6 million (£1.6 million), down from $3.2 million a year earlier, with mild revenue disappointment reflecting military contract delays. Losses widened to more than $7.5 million. Having since completed its financial year to September, Pearson says, ‘We hit our cash flow targets for 2009. Now, for us, 2010 is about introducing products, two in military and one in commercial.’

Second-half sales were significantly ahead of the first, and product development contracts with the US military, a likely source of robust long-term revenues, are supporting Protonex’s transition into a grown-up, commercial business. These include a $600,000 contract with the US Naval Research Laboratory to further develop high-power fuel cell systems for small UAVs and a $2 million contract award from the US army to build, test and deliver ‘solid oxide’ fuel cell power systems, well suited to generating electricity from alternative or renewable fuels.

Though profits could be some way off, Pearson says, ‘We have a healthy amount of cash – enough to see us through to the end of 2010, and then we might look at re-upping.’ Given its impressive military credentials, investors not averse to risk might see Protonex’s shares, now 37.5p, down from their 2006 85p AIM issue price, take flight over the medium to long haul.

Eruma – a penny protection punt
Higher-risk fare is the micro-cap Eruma, currently loss making but with market-leading counter-terrorism and intruder prevention products in its portfolio that are creating a buzz in its markets. Also active in the emergency lighting arena, the company commands a meagre sub-£2 million AIM price tag at 1.05p, down from a peak of just below 10p.

Via its Security Blinds arm, Eruma makes and sells products providing physical protection to property and personnel. Best known is its Home Office-endorsed bomb blast-resistant blind, which can foil the intentions of both terrorists and criminals. Recently unveiled half-year figures to June showed improvements across ‘all key measures’ of the business, with sales putting on more than 50 per cent at £561,000. However, although losses were pared by over 20 per cent, the interim deficit remained an alarming £524,000 and the company has had to issue lots of shares, diluting future earnings for prospective punters, in order to top up its working capital coffers. As such, Eruma occupies speclative rather than firm buy territory.

What will intrigue investors is the recent pick-up in orders for its potentially life-saving products, as terror threats persist. Sales are said to be surging ahead of last year’s levels and in May the company secured a mystery ‘landmark’ order for its product, which in tests has been shown to deliver ‘unrivalled’ protection for buildings against bomb blasts.

Looking to become profitable at the operating level next year, Eruma is also making positive noises about its alliance with glass protection specialist Pentagon Protection, another that is not for widows and orphans, signed in the summer to help the two better tap global opportunities in lucrative counter-terrorism and environmental protection sectors.

Bombastic growth at Chemring
Once enlisted in the smaller company ranks, international countermeasures specialist Chemring has been one of the wider sector’s success stories of recent years and continues to deliver bombastic growth rates, despite being firmly entrenched in the FTSE 250 ranks with a market value of £924 million. Under the command of CEO Dr David Price, business appears to be booming, with the company having recently announced a multi-year flare contract win with the US DoD.

Involving the supply of decoy flares used by the US army and US Air Force to protect aircraft from missiles, the five-year deal, the largest received by Chemring from the DoD, is worth up to $804 million to the company, which continues to see steady demand for its flares from the UK and other European nations.

Elsewhere, Chemring’s ‘energetics’ division – supplying the US Army with mine detection systems that are used by its peacekeeping operations around the world and in which a number of other nations are showing strong interest – is going great guns and expanding its training and simulation activities with the US army.

Based on market forecasts for the year to this October – analysts predict a jump in profits from £57.7 million to £106.5 million and in earnings from 160p to 215p ahead of £123 million of profit and EPS of 245p – the £26.15 shares trade on prospective multiples of 12.1 and 10.7, which look undemanding for a ‘second-liner’ offering proven and attractive growth.

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