Carclo — Positioned for recovery

Technical Plastics revenues rose 2% year-on-year to £89.7m. As flagged in September, four large tooling and automation programme awards were delayed. The largest was placed just prior to the year-end and the two smaller programmes were awarded early in FY19. The second largest contract, which relates to the second phase of an existing programme, has not yet been confirmed but is likely to be awarded later in FY19. In addition, a large and longstanding non-medical customer had indicated a ramp up in demand for moulded components during H218, but this did not materialise. Margins were affected by high levels of direct employee turnover in both the US and Czech businesses. The Czech situation was resolved by the middle of the year, but employee turnover remained high in the US during H2 as well. The programme instigated in January 2018 to improve divisional margins (see below) which engages employees in Continuous Improvement and Lean Manufacturing programmes, appears to have significantly reduced labour turnover already. Margins were also affected by significant raw material price increases in the US. These were passed on to customers under contractual agreements but with a time-lag between the resin price increase and the corresponding uplift in charge to the customer. Divisional operating profit reduced by £2.0m to £6.7m and EBIT margin by 2.5pp to 7.4% in FY18.

Our divisional estimates, which are unchanged, model 3% revenue growth in FY19, followed by 7% in FY20. Growth is supported by capacity expansion, which as always is linked to customer contracts, while creating space to secure new customers and product lines. For example, 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 was completed during FY18. This provides some growth capabilities for the existing major customer in India, which is not in the medical sector. Importantly, it enables the Indian operation to take on projects in the medical sector. The second phase of expansion at Mitcham in the UK, which was required to support the manufacture of part of Becton Dickinson’s Vystra disposable pen, was also completed during FY18, ahead of volume production in FY19. The facility in Taicang, China, which was completed during H216, met management’s goal of reaching profitability during the year as it scaled up production for the anchor global medical device customer and commenced production for several other global medical accounts. We note that management is seeking to increase the proportion of work related to the medical sector in order to reduce the variability of demand from other sectors. During FY18 the technical and validation skills and facilities at the Czech site were upgraded so that it can take on medical projects, as well as marketing this enhanced capability. As a result of these actions, the Czech operation has secured its first major medical project which is scheduled to commence production in late CY18.

Noting the delays to major new tooling and automation contracts, in January management instigated a comprehensive programme to reduce reliance on winning new tooling and automation contracts by improving underlying operating margins from existing business. As well as the employee programmes referred to earlier, this initiative has involved a review of the supply chain to improve working capital management, a review of pricing and changes to management. Our estimates model a 1.0pp improvement in divisional operating margin to 8.5% in FY19 and FY20.

Divisional revenues rose by 17% year-on-year to £50.6m, with good growth in design and development work for luxury and mid-volume cars. Divisional operating profit increased by £0.5m to £6.4m. EBIT margin declined by 0.9pp to 12.7% as a result of cost of validation and pre-production work on a number of programmes that will begin to generate revenues in FY19.

Divisional profit was adversely affected during FY18 by delays in the award of three new contracts. The first of these was awarded just prior to the year-end. Management is confident that it will win the second by H219 as it is working on a funded pre-design contract relating to the project, but the third project looks unlikely because the customer has changed its cost aspirations. The potential for winning new projects, which is key to divisional growth, remains good. Electric vehicles and autonomous vehicles present a good opportunity, as the likely volumes (at least initially) match the division’s capability.

In the short term, divisional growth will be supported by the existing mid-volume programmes entering production. Production will start on two towards the end of FY19. The third programme, which is the largest, will start production in early FY20. The Buckingham facility has been reorganised to accommodate this. Optics moulding has been moved from this site to CTP’s Czech site (a move that also helps with Optics margins) and a dedicated 1,000m2 warehouse constructed next to the existing Buckingham facility, freeing up space in the main production facility that was previously used for warehousing. The new manufacturing space is being used for three mid-volume production cells. In the medium term, management is likely to need to extend the main Buckingham factory to meet customer demand. Our divisional estimates, which are unchanged, model 2% divisional revenue growth this year and 7% in FY20 as the mid-volume programmes ramp-up.

Divisional revenues dropped by 15% year-on-year to £6.0m, while operating profits halved to £0.7m. A major contract for a one-off machined component upgrade completed at end FY17 and was not replaced by other contracts until part-way through FY18, while the spares market was weak. Overall, the market remains stable and the business is highly cash generative. Our divisional estimates, which are unchanged, model divisional revenues and EBIT remaining at FY18 levels throughout the forecast period.

Group revenues grew 6% year-on-year during FY18 to £146.2m while pre-exceptional EBIT declined by 13% (£1.7m). Financing charges (excluding IAS 19 charges) increased by £0.2m to £0.9m, reflecting higher debt levels so pre-exceptional PBT decreased by 18% (£1.9m) to £9.1m.

Net debt increased by £5.5m during FY18 to £31.5m. Working capital rose by £7.3m, primarily because of increased subcontract tooling activity for mid-volume programmes ahead of manufacture. Capital expenditure (including investment in software) was higher than the previous year (£9.1m in FY18 vs £8.1m in FY17), most of which related to additional capacity in the UK and Indian CTP facilities and production equipment for Wipac.

The continued investment in capex (which we continue to estimate at £9.5m in FY19 and £9.0m in FY20) is expected to drive increased profits, supporting a decrease in net debt to £24.8m at end FY20.

The contract delays and one-off operational issues that adversely affected CTP’s performance have largely been resolved. We leave our estimates, which were revised downwards in January following a trading update, broadly unchanged. We have adjusted the tax rate to 24% for both FY19 and FY20 to reflect the cuts in US corporation tax. Noting the cautious comment regarding reinstatement of the dividend, we push this out from FY19 to FY20.

During FY18 the pension deficit, as calculated under IAS 19, reduced from £27.0m at end March 2017 to £24.7m (net of deferred tax) as a result of improved corporate bond yields. This position is a substantial improvement compared with the deficit of £42.6m reported at end H117 (September 2016), when the discount rate had dropped to a low of 2.1% following the EU referendum vote. At that point, 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 reiterated its intention of resuming dividend payments once the level of distributable reserves is sufficient for a sustainable and regular dividend to be reintroduced.

The level of payments into the pension scheme was agreed with scheme trustees on the basis of the triennial valuation at 31 March 2015. Payment levels will be reviewed at the next triennial valuation, which is scheduled for March 2018. We model payments for FY19 and FY20 at a level similar to FY18 (£1.2m).

Sarah Matthews-DeMers will be joining the board as group finance director on 18 July 2018. Sarah is currently director of strategy and investor relations at Rotork where she recently led a wide-reaching strategic review of all aspects of the business. Prior to this she was associate group finance director at Avon Rubber where she was part of the senior management team that transformed Avon from a £60m to a £350m market capitalisation company. Sarah will take over from Richard Ottaway, group financial controller and company secretary, who was appointed acting chief financial officer following the departure of Robert Brooksbank on 31 March 2018.

In addition, non-executive chairman Michael Derbyshire will retire from the board at the AGM in July 2018, having served over 12 years as a non-executive director, almost six years of which has been spent as chairman. Michael will be succeeded by Mark Rollins, who joined the board as non-executive director on 1 January 2018. Mark is currently also senior non-executive director of Tyman and Vitec and non-executive chairman of Sigma Precision Components UK. He was group chief executive of Senior from March 2008 to June 2015, having previously served as group FD of Morgan Crucible from July 2000.

Examination of the comparators shows that Carclo, which has a diversified business model, is trading on multiples that are substantially lower than those for medical device companies and below those for automotive and aerospace industries. We use a sum-of-the-parts approach to determine an indicative FY19e 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 3. 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 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 and are excluded from our sum-of-the-parts calculations. As shown in Exhibit 4, the weighted average P/E multiple derived from the multiples for the three sectors is 14.8x.

Applying the weighted average P/E multiple of 14.8x to Carclo’s FY19e (to March 2019) EPS of 11.4p gives an indicative valuation of 169p/share. We believe that the discount of over 40% to our indicative valuation of 169p implied by the share price is too severe given the stability provided by long-term customer relationships combined with the potential for growth in Carclo’s two main divisions. Applying an arbitrary 10-15% discount (which is consistent with our previous treatment) gives a valuation range of 144-153p (see Exhibit 4). This is broadly unchanged from our January note which calculated a valuation range of 145-154p/share. To cross-check our valuation, we compare EV/EBITDA multiples implied by our P/E-derived values with a blended sum-of-the-parts EV/EBITDA for the peer group. Our indicative valuation of 144-153p implies a year one EV/EBITDA range of 7.4-7.7x (see Exhibit 3), which is at a small discount to the peer group blended year one EV/EBITDA multiple of 8.2x.

Carclo’s share price has picked up since the 80p low following the January trading update, but is still substantially below the 125p level immediately prior to that announcement. We believe that newsflow confirming that the margin issues affecting CTP have been resolved should help close the valuation gap, with potential for further share price appreciation beyond this as Carclo begins to deliver on the mid-volume automotive lighting programmes.