Avon Rubber — Update 17 November 2015

Avon Rubber has transformed itself over the past seven years into a well invested group with a significant new product pipeline and leading niche positions in its chosen markets. This has been achieved through a rigorous focus on product development, operational efficiency and market expansion that has opened up numerous growth opportunities and allowed it to deliver total shareholder return of some 2,872% since 2009. With recent acquisitions adding further technology and markets Avon is well positioned to accelerate its growth trajectory in the coming five years.

We continue to view Avon Rubber as a strong growth story underpinned by a niche leadership position, core long-term contracts and an accelerating pipeline of new product introductions. Our base case fair value using conservative forecasts is 1,110p/share. Given the group’s many opportunities and track record of outperformance, we feel that the potential value of identified incremental opportunities provides a more realistic view of value, yielding a fair value of 1,355p/share based upon FY16 upside forecasts.

Avon Rubber’s FY15 results have demonstrated the success of the consistent strategy. Revenue was up 8% to £134.3m, driven by a good performance across both divisions, supported by a US$:£ currency tailwind equivalent to £7.2m while InterPuls contributed £1m. Avon’s focus on higher margin sales and improved operational efficiency helped drive adjusted operating profit up 19% to £20.2m with a currency tailwind of £1.0m. InterPuls did not contribute due to acquisition timing.

Underlying PBT increased by 20% to £19.8m while the adjusted effective tax rate declined to 15% as a result of a more beneficial mix and the recognition of a deferred tax asset in the UK following utilisation of UK tax losses. As a result, adjusted EPS increased by 28% to 56.1p. The group again generated strong operating cash flow of £24.1m, equivalent to 119% of operating profit. Following £21.3m spent on the acquisitions of Hudstar and InterPuls, net debt stood at £13.2m.

With good EPS growth, cash generation and visibility, the dividend was increased by 30% for the second year running.

Given the global nature of the business there are both economic and performance factors:

During the seven years under the leadership of former CEO Peter Slabbert and CFO Andrew Lewis, Avon Rubber has been transformed to emerge a strong, global leader in its chosen niches in respiratory protection and dairy milking markets. With new CEO Rob Rennie due to embark on the next stage of development for the group, we review the progress and positioning as it continues to accelerate growth. This strategy has delivered total shareholder returns of 2,872% since 2009. Development can be summarised as follows:

Avon has demonstrated that it has been able to identify, execute and deliver opportunities to enhance shareholder value through consistent and reliable management. It is indicative of the group that CFO Andrew Lewis stepped into the Interim CEO position until Rob Rennie’s arrival on 1 December, supported by a senior management team that have been instrumental in the strategy.

Avon Rubber provides respiratory protection equipment for military and other markets. In addition, it is the market-leading manufacturer of consumable milk liners and a broadening range of associated products for the dairy market. Avon’s expertise lies in product design, materials specification and manufacturing efficiency while it is also introducing innovative new service solutions.

Avon’s respiratory protection products are sold direct to military markets where their primary customer is the DOD (Army, Navy, Marines, Coastguard and Air Force) as well as approved governments globally. Other significant markets are first responders including the police and other emergency services, addressed either directly or through distribution channels. SCBA and thermal-imaging equipment is targeted at fire services and other industrial users, primarily through a US distribution network. All products are safety-critical and markets are consequently highly regulated with approval standards creating significant barriers to entry with long product cycles.

Avon’s P&D business consists of a growing range of respiratory products. The main products are respirators or gas masks (M50, C50, ST53, M53 and FM12) together with a range of spares and accessories; the NIOSH-approved emergency hood (NH15); rebreathers for escape and underwater use; and SCBA (primarily the Deltair product range). Consumable filters used by these products are manufactured along with the recently acquired thermal-imaging camera equipment. The respirators and escape hoods offer breathing protection to varying degrees against CBRN threats while the SCBA offers protection in oxygen depleted environments. Avon also has a flexible fabrications business, AEF, which manufactures fuel and water storage tanks and hovercraft skirts.

The Dairy business designs, manufactures and sells products and services used in the automated milking process, primarily rubberware such as liners and tubing. These consumable products come into direct contact with the cow and the milk and are replaced regularly to ensure product hygiene, animal welfare and to maximise milk quality. The €30m acquisition in 2015 of InterPuls, a milking components specialist in electromechanical components, such as pulsators, milk meters, automatic cluster removers, milking clusters, washing systems, vacuum pumps, bucket milkers and pipeline system components has added significantly to the product range, making Avon the complete milking point solution provider. Avon’s products are sold through distributors under the Milkrite and InterPuls brands while they also manufacture a decreasing proportion for major OEMs.

The global market is concentrated in high consumption automated milking markets in North America and Western Europe where Avon has significant market shares. Potential exists outside these traditional markets, in particular in China, India, Russia, Eastern Europe and South America, all of which are currently experiencing rapidly increasing demand for dairy products which is being satisfied through mechanised milking. The acquisition of InterPuls will broaden Avon’s geographic reach, while the addition of InterPuls’s established distribution relationships in emerging markets should accelerate growth in these regions.

Avon’s strategy is to target its core market niches, expanding its product offering, developing its own trusted and recognised brands, securing routes to market and delivering an increasing proportion of higher value, higher margin products and solutions to its customers as shown in Exhibit 1 below highlighting the stepped approach to expansion pursued by management.

In addition to organic growth, the group has demonstrated its ability to identify, pursue and close value-enhancing acquisitions addressing specific technology gaps in the portfolio. With a strong balance sheet, a clear strategic vision and further systems and service based growth opportunities, we believe that the strategy will continue to deliver shareholder value for the foreseeable future.

Avon has trailed that it is seeking value enhancing acquisitions to support technology development and market positioning and a number of such targeted acquisitions have recently been completed:

Avon acquired VR Technology in 2013 to accelerate rebreather technology. Originally focused on personal dive computers (a device to monitor divers’ air consumption and ensures correct decompression stops during a dive), VR subsequently developed rebreather designs of their own.

Hudstar Systems purchased for $5.1m in 2015, designs and manufactures electronics hardware and software for the fire service industry, including head-up displays, wireless communication systems, personal alert safety systems, pressure transducers, telemetry systems and remote air management systems. It manufactures electronics equipment for Avon’s Deltair product, principally the console unit.

After the year end the Group announced the acquisition of Argus, the thermal imaging camera business of e2v for £3.5m. This further strengthens Avon’s product range in the fire and first responder markets and has several benefits, reflecting the group’s strategic approach:

In August 2015 Avon made the significant strategic acquisition of InterPuls for a total consideration of €29.75m. This acquisition, combined with existing activities, makes Dairy a leading international provider of milking point technology, providing complete teat to pipeline solutions for the sector:

With new CEO Rob Rennie due to begin on 1 December, the transition has been overseen by CFO Andrew Lewis acting as Interim CEO, supported by a strong senior management team that has created and delivered the growth strategy together. These include: Sarah Matthews-DeMers, Associate Group Finance Director; John Kime, President of Avon Protection Systems; and Paul McDonald, MD of Dairy. We have met each of the team on numerous occasions and have been impressed with the collective clarity of vision. It is this depth that suggests to us that the strategy is likely to be maintained and evolved rather than completely re-written.

Avon Rubber’s FY15 results have demonstrated the success of the consistent strategy:

Avon’s results came in marginally ahead of our previously upgraded forecasts by 1% at the PBT level but a significant 8.5% at the EPS level due to lower than forecast tax rate. We are increasing our FY16 PBT forecast by 4% and initiate FY17e PBT growth of 5% to £22.6M. We raise our FY16 EPS forecast by 8% to 57.2p and initiate FY17e growth of 3% to 58.7p as tax rates normalise and the impact of the higher effective Italian tax rate comes into full effect.

FY15 results demonstrated the benefits of the numerous opportunities being pursued in P&D. With a good performance across all parts of the division, reported revenue increased by 7% to £98.8m (0.3% at constant currency). Core DoD, Fire and AEF business all grew, offsetting a decline in non-DoD revenues (£27.7m versus £31.0m) following two large impact orders delivered in 2014. Margins improved despite higher DoD sales as operational efficiencies were achieved following closure of Lawrenceville and increased prices were achieved in the DoD contract. This allowed operating profit to grow by 17% to £15.9m. 50k DoD mask orders remained in hand at year end, providing cover into Q216 before which a further release is anticipated. Avon also received an award for 124k filter pairs in H215 under the new dual sourced contract. Other developments included:

Dairy continued to increase its position up the value chain through a broadening Milkrite product portfolio and greater recurring revenue streams. FY15 showed the benefits of this strategy with revenue up 11% to £35.5m (6% at constant currency) driven by the successful roll-out of the Cluster Exchange Service and increased Milkrite market share, while InterPuls added £1m of revenue following completion in August. Operating profit increased by 12% to £6.4m, reflecting existing business only as InterPuls did not contribute in FY15 due to the seasonal effects of acquisition timing. While some softening of the market was seen in Europe during H2 this appeared to be turning again at year end, while other developments continue to support growth:

Management has demonstrated a clear strategic thought process, trailed intentions with investors and then successfully executed on its plans. We identified several opportunities in our July 2014 update note, some of which have contributed to FY15’s performance, however further upside remains as highlighted in Exhibit 2 below, while recent acquisitions provide new growth drivers:

As can be seen, the wide range of opportunities available to the group continues to provide the potential for significant growth over the next five years. While specific timing and ramp up rates may vary, as highlighted by the move to the right of the JSAM production programme, this balance of opportunity allows other areas to outperform. One such area was the further uptick in US Impulse Air market share (+4%) in FY15 for example.

Importantly, as the group has already established sales and marketing routes to non-DoD and commercial markets, the structure is already in place to take new products to them. This should show in achievable margins and provide operational leverage potential as contracts are won, new business is developed and a broadened portfolio enters sales channels. Existing business can also be rejuvenated such non-DoD opportunities for AEF to offset more volatile DoD spares revenues.

The successful approach to identifying upside growth opportunities is demonstrated in Exhibit 3 below, which highlights the progressive PBT since management took charge in 2009. Exhibit 4 highlights the changes to our year two forecasts from introduction to actual results since FY10:

The group has outperformed our original expectations in each of the last four years by between 3% and 16% despite our initial forecasts calling for an average annual 17% PBT increase each year during that period. We believe management has created a culture of delivery and outperformance which shows through in technology development, operational efficiency and ultimately results.

Given the global nature of the business there are both economic and performance factors, as well as those related to the exposure to the US DoD as the largest customer:

We continue to view Avon Rubber as a strong growth story underpinned by a niche leadership position, core long-term contracts and an accelerating pipeline of new product introductions. When combined with a culture that fosters innovation as witnessed by the Cluster Exchange Service approach, incremental contract and cross-sell opportunities created by recent acquisitions, we believe that it deserves a premium to peers.

Our conservative forecasts provide a base fair value of 1,110p/share as shown in Exhibit 5 below:

Given the group’s track record of outperformance, this base valuation, close to the current share price, undervalues Avon in our opinion. We rather look at the upside potential generated from the numerous opportunities outlined throughout this note and provide an indication of the indicative value that can be generated if these are delivered over the coming 12 months as in Exhibit 6 below.

The implied fair value of 1,355p/share equates to a FY16 P/E ratio on current forecasts of 23.5x or an EV/Sales multiple of 3.1x. While this appears relatively fully valued, we highlight that acquisition multiples achieved in the sector can easily reach these levels with the takeover of Latchways by MSA equating to a multiple of 3x sales for a business we feel did not have the same IP, contract visibility or growth prospects as Avon.