Ultra Electronics — Update 13 September 2016

Ultra Electronics is approaching the twentieth anniversary of its listing on the London Stock Exchange in October 1996, three years after it was subject to a management buy-out from Dowty Group with revenues of £84m. After more than 50 acquisitions, the group has matured into a global specialist defence electronics and software solutions supplier with sales approaching £800m. Following a restructuring to more market facing segments last year, it operates across eight product segments formed into three divisions: Aerospace & Infrastructure (27% of FY15 sales/24% of operating profit); Communications & Security (33%/34%); and Land & Maritime (40%/42%). It is still a predominantly US and UK centric business, which together accounted for 76% of sales in 2015.

Ultra operates primarily as a Tier 3 or Tier 4 supplier, designing and supplying components and subsystems to larger systems suppliers and systems integrators. This provides a broad customer and application base, as well as greater flexibility to target international opportunities. It also affords a degree of margin sustainability due to the niche technological value and capability its products deliver for those customers’ offerings.

Despite many commentators indicating an improved defence spending environment, it remains far from clear that this is a reality. Pre-election rhetoric in the US is being matched by an apparent improvement in budgetary levels, although actual spending outlays may remain flat into 2017.

Ultra continues to invest to drive growth through the development and introduction of innovative technologies, while driving greater efficiency through the implementation of its shared services programme. Ultra spends 5% of its revenues on private venture R&D, which complements the 15% of sales made up of customer-funded development programmes. The relatively high level of development expenditure should stimulate organic growth and be complemented by a continuing pursuit of bolt-on and bolt-in acquisitions supported by the improving cash conversion and FCF.

We are maintaining our underlying forecasts following the interim results in August. We continue to expect a flat year in organic sales terms, reflecting the lack of increase in defence spending in the UK and the US. This will be boosted by full year contributions from Herley and Furnace Parts, although we have adjusted for the dilutive disposal of the ID business (see our note, Sharpening the Focus). We have also already adjusted for the sharp fall in sterling post Brexit, with our assumption for average US$/£ now $1.38/£1 for FY16 and $1.33/£ for FY17 (previously $1.50/£). We estimate this adds around £36m to FY16 sales and £4.8m to operating profit on translation. The longer-term outlook looks encouraging. We believe organic growth in 2017 will trend closer to the long-term expectation of more than 4%, as a confluence of solid commercial growth and still constrained western world defence spend, with export growth also expected to resume,.

The market has, in our view, correctly assumed that defence as a segment remains largely unaffected by the proposed withdrawal of the UK from the EU. However, there is a risk that it may affect global growth and thus once again constrain budget growth. The change of administration in the US also adds a degree of uncertainty with the threat of sequestration still in place for the DOD’s FY18 budget which is due to be proposed in February. In addition, the volatility of FX could reverse limiting the benefits currently being imputed into models.

Ultra has developed a core of critical technology expertise that supports strategically important programmes within the defence and security markets. It operates as a predominantly Tier 3/4 supplier, although capable of systems integration as a Tier 2 supplier primarily for its own solutions. Its major markets are in North America and the UK, with its two largest customers being the US Department of Defence (DOD – 19% of FY15 group sales) and the UK Ministry of Defence (MOD - 11% of FY15 group sales). Development of innovative solutions addressing customer needs has been key to this positioning. Common threads run through its businesses: stealth, cyber, security, power management, communications and control.

Ultra’s strategy is aiming to provide above average growth in revenues in order to create long-term shareholder value higher than other companies in the market. There are four principal elements to Ultra’s long-term growth strategy:

The implementation of a market facing strategy in 2015 is aimed at more effective targeting of growth opportunities, exploiting the core capabilities and utilising synergies across its businesses facing the same end markets. It retains the flexibility afforded by the responsibility devolved to the businesses that has resulted in Ultra holding world leading positions in many of its chosen niches.

As with many defence electronics companies Ultra remains a difficult company to readily describe. It has a range of sensor, electronic and software enabled technologies and expertise that enable a variety of systems predominantly for the defence and security markets. Its initial expertise in antisubmarine warfare (ASW) markets has been broadened extensively by the raft of acquisitions made over the period since it was quoted.

The company now addresses eight different markets segments through three market-facing operating divisions as discussed in our previous note (Facing up to the market). Following the recently completed disposal of the ID Systems business, the group operates through twenty three businesses spread across the three divisions. The core domain capabilities by business are shown in Exhibit 2, with cyber expertise sitting predominantly in the C2ISR and Communications segments but running across all of the group companies. Ultra now markets its own internal sophisticated cyber security defence capabilities developed over the last three years to commercial customers through its subsidiary CORVID.

In stock market terms the defence sector has continued to prove resilient in recent months, while various market uncertainties have led to sharp declines elsewhere, for example civil aerospace. It seems far from clear that geopolitical tensions are likely to diminish, even if Britain’s decision to leave the EU avoids David Cameron’s Armageddon scenarios.

The generally perceived wisdom is that global defence spending is returning to growth. However, for various reasons this may be slightly premature. We would prefer to regard the western world defence spending environment as having bottomed out, with little hard evidence that defence contractors are going to benefit from an upswing just yet. The situation is further complicated by political considerations, notably in the US with a presidential election later this year but also due to the fallout that may follow the recent Brexit decision.

US defence budget outlook

However, while there is always significant discussion of the US defence budget, the monies actually flowing down to defence contractors are the subsequent expenditure of those already budgeted and authorised amounts, known as outlays in the US. This is the actual defence spending by the US DOD and normally reflects the budgetary trends developed one to two years previously. In Q1 overall spending was flat on the prior year, in Q2 spending actually fell by 4%. While the prospect of an upturn in budget levels is real, its impact is yet to be reflected in increased actual spending.

The outlays can be further broken down into sub-categories, with procurement and RDT&E (Research Development Test & Evaluation), known as the investment budgets (Exhibit 3), the most significant for Ultra. While Ultra noted a more positive trend in its recent trading statement, the basis of this was spending through April. Unfortunately, May and June were rather more depressed in actual spending levels. So, while procurement spend was up 5% in calendar Q1 year-on-year, it fell 9% in Q2. Similarly, RDT&E having been up 1% in Q1 fell by 5% in Q2. Overall, the investment budgets fell by 2% in H116 and remain 20% below the level seen in FY11 (to September 2011). While this should ease as recent budget agreements and an incoming administration of either hue appear likely to regard national security as a priority, it remains to be seen whether the current strategies and focus of investment spending are maintained or altered significantly.

It would seem logical to suggest that if there is indeed a reduction in GDP growth arising from Brexit, of which there may already be some signs, then the new Prime Minister and her ministerial team could launch an interim Strategic Defence & Security Review to respond to the change in circumstance. Such a move may call into question strategic priorities in the UK, and would need to be set against the revised economic projections. Lower growth could once again rein in spending, even maintaining the commitment to NATO of spending 2% of GDP on defence and security which in any event was met only by including intelligence budgets in the overall total. Procurement spending in the UK remains further constrained by an increasing proportion of an overall flat total of c £16bn going to submarine programmes including the Successor programme for Trident submarines. Submarine spending rises by over £1.5bn over the ten-year plan (Exhibit 3).

With regard to Ultra, its focus on strategically important and critical applications (eg submarines, ASW, cryptography, secure communications etc), may well provide significant protection against renewed budgetary constraints. It also benefits from its portfolio effect as any one platform does not unduly influence overall performance.

Brexit would seemingly offer little to reduce European inertia in defence spending. It seems unlikely that the focus on defence would intensify within the European Union in the absence of Britain. Greater integration of forces may occur, but we would continue to regard NATO as the primary institution for regional defence and security and as such, we do not expect to see defence spending increase substantially in the German or French markets other than to fulfil the 2% obligation.

Such a combination would place the emphasis on export market potential to drive organic growth for Ultra. To a degree this would be realised by export sales programmes from the US and the UK, although where independent capability has been developed, Ultra can address local programmes. Development spending to drive all of these remains high at around 20% of sales, including Ultra’s own commitment of around 5%.

Given this background it is not a surprise that current year guidance for organic growth ranging from +/-1% has been given, expected to improve from 2017. We do not expect a major acceleration next year, more of a gradual increase to around 2%, with the long-term trend still over 4%.

The recovery of c 40% of the £100m of orders deferred from 2015 together with new opportunities helped Ultra to improve its book to bill ratio to a healthy 1.0x during H1 FY16. The order backlog of £785.7m at the period end provided order cover for the year of 84%, consistent with the prior year. The company also stated that initial indications in July left cover at the end of the month at 87%, following signature of several major contracts and with other major potential prospects progressing well. In addition to the firm order backlog, the company also has substantial “off order-book” potential in the form of multi–year indefinite delivery indefinite quantity (IDIQ) contracts for the US DOD, framework contracts for various platforms and options. This includes substantial revenue build across civil and military aircraft programmes, especially the JSF. The level of off order-book potential business has increased to £2.4bn from £1.5bn previously indicated.

In our view this expansion reflects the investment that Ultra continues to make in its technology and capabilities. It is also reflected in the broad range of current long-term opportunities

Ultra operates in three divisions that encompass its 24 subsidiaries operating across eight segments. With such a portfolio of capabilities, products and expertise there will be both positive and negative aspects of development and manufacturing phases at any point in time. These drive both revenues and margins dependent on specific mix, with more mature delivery cycles normally generating better returns than development contracts and new product introductions, although this can be dependent on the development risk undertaken and the value proposition offered.

The result has been a period of consolidation with group sales and profitability little changed over the five years from 2011 to 2015. This is despite divergent performances of the three divisions over that period, which are themselves subject to variable performances of the individual business units.

As Exhibit 6 demonstrates, the variety of activities encompassed by a simple divisional title is extensive. The complexity within each division arises as a result of the chosen status of Ultra as predominantly a Tier 3/Tier 4 supplier to over 350 platforms. However, hopefully the graphic enables a quick overview of the principal exposures and products of the business units.

The Aerospace domain, which accounted for 18% of Ultra’s group sales last year, has established strengths in a variety of mission critical electronic systems, control and instrumentation solutions, as well as more niche aviation technologies such as ice protection. It operates across both civil and military aircraft programmes, establishing long-term positions by providing innovative, low cost and safety compliant solutions to platform manufacturers. Civil output is set to continue to ramp up in the large commercial aircraft market and Ultra has gained positions on new regional jet and turboprop programmes such as the Mitsubishi Regional Jet and the Chinese MA700. It has gained business in the large business jet market with Gulfstream and Cessna. Commercial sales growth is thus expected to continue through the rest of the decade. In the military market, exposure to the F-35 programme combined with growth in new transport programmes such as the KC390 and A400M should also drive sales. However, declines in legacy programmes continue with the Typhoon production rate also now set to reduce as the programme is elongated.

Infrastructure accounts for 4% of group sales with Ultra providing critical systems and software for the safe operation and security of transport and energy infrastructure. Transport investment remains in a growth phase with tier 2 airport systems experiencing growth in South America, the Middle East and Asia. Rail investment is also expected to grow, although pricing is becoming increasingly competitive in export markets for Ultra’s range of power management solutions. Smart grid technologies also look set to benefit from the continuing constraint of energy networks, combined with increasing power demand.

Ultra also has strong positions in the Nuclear domain, which accounts for 6% of group sales. Its qualified sensors and safety systems support the growing market in reactor licensing, delivery, security and safe operation of reactors. With equipment on more than 190 reactors in 16 countries as well as on 32 new build reactors worldwide, Ultra has well established presence. While nuclear is a notoriously long cycle business, Ultra should be able to access an increasing demand for plant life extensions and upgrades, as well as exploiting opportunities for new build growth on Generation 3 and NuScale’s Small Modular Reactor (SMR). Cyber protection and physical security of infrastructure is also now an increasing requirement.

Communications accounts for 14% of group sales and provides advanced, interoperable secure communications and systems for voice, video and data transfer. This includes the provision of scalable and low-risk radio, encryption, satellite and specialist systems to military government, law enforcement, industry and commercial customers around the globe.

The demand for faster, lower cost, more mobile yet secure links are increasingly in demand in the command and control environment to improve situational awareness through efficient transfer of voice, data and video. In turn this should drive increased bandwidth demand and higher capacity requirements on High Throughput Satellites (HTS) operating on the higher frequency Ka-band over the next five years. Demand for secure key management and increasingly IP-based encrypted system continues to drive demand in the military market, and Ultra has presence in both the UK and the US encryption programmes.

A growing requirement to secure and protect critical national infrastructure (CNI) and national borders should help to drive growth in the C2ISR (Command & Control, Intelligence, Surveillance & Reconnaissance - 23% of FY15 sales) domain. Increasing precision targeting and range of strikes continues to be a key demand in the military market, requiring improved and secure intelligence and surveillance data capture and analysis, increasingly in a real-time environment. ISTAR is being developed for both manned and unmanned air platforms.

Growth in 2017 is expected to largely arise from the full year contribution of Herley, which was acquired on 21 August 2015 for £164.7m and only contributed £24.4m of sales and £4.3m of profit in just over four months. Herley extended Ultra’s electronic warfare EW capabilities, increasing market share and exposure to this growing global budget line.

However, divisional performance will be held back by the sale to private equity of Ultra Electronics’s ID Systems business, which manufactures and supplies Magicard ID card printers and related software globally (see our recent note, Sharpening the focus). ID had FY15 sales of £19.3m and generated an operating profit of £4.0m. It will reduce full year sales and operating profit contribution from the Communications & Security division by 7% and 8% respectively, or by c 3% at the group level, with half of the impact occurring in the current year and the balance in FY17.

The historical core of Ultra, Underwater Warfare, remains the largest of the eight domains representing 24% of group sales. Ultra’s products are benefiting from preferential budget allocations in the US to underwater systems as part of the “pivot to the Pacific”. Submarine combat systems, torpedo production and countermeasures are all being prioritised by the US Navy.

The leading positions in the US are also translating into more opportunities in the Asia Pacific market as submarine numbers continue to increase, and where the spend on ASW is expected to increase to £0.5bn. India in particular is expected to award three ASW contracts in the near future totalling a potential spend of £100m. Ultra’s continuing spend on sophisticated innovative systems continues to enable it to win significant new opportunities in both air and sea ASW markets.

Maritime systems account for 6% of group sales, providing advanced warfighting systems and power management equipment to naval surface ships, submarines and unmanned vehicles. The segment continues to face budgetary constraint in the new build segment, but this is serving to drive capability and cost effective upgrades on existing platforms where service lives are being extended. Ultra also provides signature management and degaussing products where growth is likely to increase due to more sophisticated threat developments such as influenced mines.

Ultra provides power systems and electronic solutions in the Land systems market (5% of FY15 sales). As spending has transitioned away from land forces in recent years the number of new vehicle platforms has reduced and new build quantities have fallen sharply. Whilet this has been offset to some extent by life extensions, support and upgrades it remains an area with reduced growth prospects although the declines appear to have bottomed out. A more integrated battlespace, with unmanned, manned and infantry assets requiring system connectivity and power, provides Ultra with several development opportunities such as for the UK VIRTUS programme.

Despite the recent change in CFO, we would describe the management situation as stable and strong. The continuity provided by Rakesh Sharma’s stewardship as CEO is allowing the current repositioning of the business to develop. The incoming CFO, Amitabh (Ami) Sharma is an Ultra old boy, returning to the fold after 16 years honing his financial management in both private and public entities. Unrelated to the CEO, Ami thus comes to the position with experience of the company, but with a new external perspective that should enable him to further challenge the operations. For the present, we do not expect any major change to the strategic and efficiency initiatives put in place last year. Significant portfolio adjustment does not appear to be on the cards at present, although the sale of ID does indicate a desire to focus capital allocation in order to pursue growth.

With the Omani airport contract issues now effectively behind the company, focus can return to a more normal composition of technology development and production cycles. While the current mix of ongoing contracts is less favourable than it has been in recent years, a transition back to a greater proportion of production revenues should occur over the remainder of the decade, expanding margins, boosting cash flows and enhancing returns. An increase in export activity, bolstered by more favourable FX should also enhance margins in the medium term. Set against this is a continued pressure on government budgets and a constant search for value for money propositions from suppliers, inevitably including downward pressure on pricing, which the S3 programme and other efficiency savings are designed to counter. Our medium-term forecasts assume below target organic revenue growth of 3.5% and flat adjusted operating margins of 16.4%.

Discounted cash flow (DCF)

Our cash-based capped DCF valuation basis is in our view a conservative basis for estimating cash flow values as it does not assume any growth in the terminal value. While we do normalise working capital to zero and capex to equal depreciation, it still eliminates some element of the potential tail value. The DCF on a calculated WACC of 7.1% currently delivers a value of 2,026p. A 10bp change in the WACC affects the value by c1.7%.

Our SOP valuation uses domestic and international peer comparators whose principal activities service the defence and security markets. Year to date performances have varied significantly within this group as company specific travails for some contrasts with a generally positive view of the sustainability of returns as defence spending prospects have improved. In both cases valuation multiples have tended to expand during the first half of 2016.We base our SOP assumptions on FY17 and the results are presented in Exhibit 10 below. It returns a value per share of 2,048p.

Our operating assumption and estimates remain as revised following the interim results (see our recent note, Strategically positioned for growth). Thus, despite the dilutive disposal of Ultra ID that completed on 24 August, full year earnings expectations remain largely as expected at the time of the FY15 results.

Revenues contracted organically in H116 by 2%, but the underlying performance allowed management to tighten the guidance range to +/-1% for the full year, implying a second half improvement. In addition, the full-year contributions of Herley and FP are expected to add around 5% to sales, and FX translation for the full year should be around a 6% benefit year-on-year (FY16 average US$1.38/£ versus FY15 $1.53/£).

H2 will be adversely affected by the dilutive disposal of Ultra ID Systems for £22m which in FY15 had annual sales of £19.3m generating around £4m of adjusted operating profit.

Ultra has two ongoing integration and efficiency programmes in process. The group’s S3 (standardisation and share services) programme remains on track to deliver £20m of cost savings by 2018. At the end of H116 Ultra had spent £7.6m out of the budgeted £30m, with £3.4m of savings already realised and another £4.5m identified, £2m of which are expected to be achieved in H216. The balance of the savings should be identified as the company continues to optimise areas such as procurement processes, IT platforms and finance. Ultra are keen to ensure that the entrepreneurial culture of the group is maintained despite the process, rather than centralising control, in order to maintain innovation and flexibility.

In addition, the integration of Herley remains in line with the acquisition case, and in fact $1.8m of cost synergies are already identified at this stage compared to an anticipated $0.8m. Ultra is thus well on the way to achieving the expected total of $8m of benefits to be realised by the end of 2018, and indeed expect to remain ahead of the plan through next year.

Operating cash conversion for the full year is expected to be in excess of 70%, implying some unwinding of first half working capital outflows with a slowing H2 consumption of advance payments. At the net debt level the FX impact is expected to be similar to the half year, with the £8.2m performance bond call, pension payments and transaction costs only adjusted for the £22m proceeds from the disposal of Ultra ID Systems. Cash conversion is expected to improve to around 85% in 2017, with no further Oman related outflows expected.

The main variables remain FX and the level of advances which is contingent on order success during H2, but for which no upside has been incorporated in our model. The rate of attrition of advances is nevertheless stabilising following the significant utilisation on the ECU RP contract over the last couple of years which has now completed.

The pension fund was closed to future benefit accrual on 5 April 2016, which led to a £15.5m curtailment gain. This was the primary reason for a reduction in the balance sheet liabilities from £84.8m at the start of the year to £66.9m at the half year. A triennial actuarial review is currently underway, the outcome of which will become clear by the prelims early next year.

Capital allocation is expected to remain as before, with investment for high return organic growth continuing and generating a progressive dividend improvement, with both bolt-in M&A and some modest portfolio optimisation continuing.