Avon Protection Plc (AVON)

Recovery play, grossly under estimated?

This is just some thoughts, it isn't investment advice or incitement to buy in any way, just my views - please do your own thorough research. I’m not an analyst, I’m just a private investor looking after my own money. Nothing I do or say is meant as advice or should be taken as such. Here I publish my ideas and research that I have done and discuss the way I invest.  Anything written here needs to be verified for its accuracy. Assume any stock I write about I likely own, so my views are biased. Inevitably I will get things wrong, everyone is responsible for their own decision making and what they buy and sell. Subscribing and reading this article means you accept the above and you take full responsibility for your own actions and decisions. Small Cap stocks can be illiquid and very hard to sell at times when demand is weak so caution is required. Well the rain has killed any hope of doing anything meaningful outside today so time for a weekend review again this week.  There’s a fabulous feeling about the market currently imo, although many may not feel it. When investors/traders sell off just because they cannot take anymore, when they just want ‘pain relief’ or 5% guaranteed from gilts looks attractive compared to fluctuating equities that may fall at times and not even pay a yield, you know there’s a lot not participating long in this market.  So why do I feel bullish (apart from the fact that I am always optimistic and often get called a perma-bull) ?

Avon is a British based company. Born out of Avon Rubber Tyres the business evolved into rubber milking products for cattle into respiratory masks and protective helmets and is now one of the leading providers of this equipment, with some of the leading products in the world.  Respiratory products and helmets have a 40/60 split respectively as far as sales go with respiratory being the higher margin business.  Their helmets and respiratory masks are world beating with Avon set to be the biggest helmet supplier to the Department of Defence this year.

Avon Protection also manufacture Escape Hoods for evacuation from a contaminated area swiftly – and fun in the bedroom 😊.  A third part to the business is ‘Rebreathers’. Rebreather take human breath and recycle it.  When we breath we take in Air which is 21% oxygen and breath out that air which now contains approx 15% oxygen and more CO2. Rebreathers basically clean this air up, increasing the oxygen and takes out harmful gasses to make it reuseable. The MCM100 Multi-Role Rebreather has been in development for 20 years and is a world leading product too. It’s aim is to allow divers to stay underwater for a lot longer than with just SCUBA gear.

These products are sold to the Department of Defence in the US (DoD) around the world to NATO, other friendly governments as well as government departments like the police and environmental departments, together with diving companies and other private enterprises and first responders.  With increasing global conflict and more violent demonstrations using more dangerous materials, the demand is increasing.  These products take many-years to develop, often a couple of years more to go from enquiry to delivery. It can take two years to get DoD approval, hence there is very high barriers to entry together with the long-standing relationship developed by Avon with DoDs increasing barriers.  Respiratory has a good repeat business model with 40% of revenues coming from replacement filters and parts.

In early 2020, Avon Rubber plc (as it was then) completed its $91 million acquisition of 3M’s advanced ballistic protection business which made body armour for the military. It also divested itself from the old milking equipment business ‘Milkrite’. Buying the armour business proved a disaster. After DoD tests failed and contracts cancelled, Avon managed to dump the business, virtually giving it away.

In 2020 Avon acquired Team Wendy in the US, a company which also provides helmets to the military, law enforcement and leisure helmets used for climbing, first responders etc.  Team Wendy was acquired for circa £100m. Revenue in the year ended 31 December 2019 of US$44.2 million and EBITDA of US$13.4 million resulting in an EBITDA margin of 30.3% Team Wendy is more targeted to the retail market than Avon:

In May 2021 the finance director Nick Keveth, walked. Rich Cashin was appointed CFO in Jan 2022. Cashin was formerly at Meggit and Ultra Electronics.

In May 2022 Paul McDonald stepped down as CEO.

The COO role has been removed.

Jos Sclater Appointed CEO

Appointed 16^th January 2023, Jos Sclater spent the prior 3 years to his appointment at Avon as Group Chief Financial Officer at Ultra Electronics plc. In this role, Jos led a broad-based transformation programme focused on improving growth and efficiency.  He also had group-wide responsibility for the Finance, Treasury, IT, Procurement, Transformation, Continuous Improvement and Risk functions as well as direct oversight of Ultra's Forensic Technology and Energy businesses. Prior to this Jos was Group CFO at Castrol Lubricants and, before that, spent 7 years at GKN plc, including as Group CFO and Director of Corporate Finance & Strategy. Jos started his career as a qualified solicitor and held in-house legal and M&A roles at ICI plc and AkzoNobel 

OK, so what interests me about this company?

Firstly, it is a recovery play of huge potential imo.  As a recovery play you aren’t going to look at the balance sheet and the data and think - wow! Let me call my broker! Recovery plays are nearly always in a mess and the share price is usually pricing every bit of bad news and more into the share price.  In these situations, often, very little recovery is priced in.  I buy recovery plays where I’ve researched the new board, developed a picture of their ability and experience and am prepared to back the new board if they have what I like. I’m betting on faster and better recovery here than the markets expect or the brokers are suggesting.

I find it interesting that Sclater was CFO at GKN and Ultra Electronic and both ended up getting taken over on his watch once recovery was in place. I also find it interesting that Rich Cashin CFO was at Ultra Electronics with him – these two have form when it comes to recoveries and getting taken over by a pier.  Bad boards don’t become good boards, you need changes at the top. Jos Sclater comes with a great CV. Watching the company interim presentation you can see this is a guy that is confident and knows what he is talking about.  I watch CEOs on these presentations and some don’t have the numbers in their head and don’t fully grasp the features of their own products, and they lack experience, not here. The barriers to entry, the quality products means these products should command much better operating margins.  In the trailing 12 months, with all the issues they have been dealing with, the operating margins have slipped to 2.5% after being negative 11.7% in 2021. In 2018 they were 13%.  Sclater has said in the presentations that he’ll get margins back to mid-teens.

The sale of the armour business completed with the end of this financial year so with that out of the way I expect margins to rise significantly. The body armour business was a complete disaster.  At the start of 2021 the shares were trading at £46 a share, they currently trade at just around £9.50.  Nearly all of this fall was generated by the failures of the Body Armour, failing testing at the Department of Defence, lost orders and eventually giving the business away for nothing, crystalising a huge loss, which has now been fully written down, $24m. Importantly though, throughout this debacle they haven’t had to raise any money so they have had no share dilution, in fact there are now 30m shares instead of 31m as they have been doing buybacks, which the new board has cancelled.

Aside from the fact this looks like a great recovery play in itself, there are some great outside factors.  After Ukraine and Israel, countries are rapidly reviewing their defence strategies. Defence budgets have been run down, now they are playing catch-up, big time.  Helmets are Avon’s first big sell. According to the CEO, ‘the helmet business is at the start of a rapid period of growth and margin expansion’.  Sclater says they expect to see a fast and large increase in sales in the medium term with one helmet factory going from zero to 75k helmets p.a. at a pretty fast pace. Recently they have announced a $14.2 million order from the U.S. Defence Logistics Agency for helmets. The ordering cycle for respiratory masks means they are not expecting big orders until next year for masks or filters due to the Dept of Defence having taken a huge order last year, but that will be a bigger boost going forward.  The new Epic helmet is their most advanced and most profitable helmet.  There are 3 tiers of the new Epic helmet and 50% of helmet orders are now Epic.  Avon are in-line to become the biggest supplier of helmets to the US Department of Defence this year.   

On Jan 15^th the co announced an order from the German military for Rebreathers.  The co said it was a multi-million Euro order, however the Times say it was a double-digit million Euro order. This doesn’t surprise me.  Remember during the Russian invasion of Ukraine, the Nord Stream pipelines were attacked and blown up. Germany were on the end of that, they have been the first with a big order but the Times suggest the US could place a big order too.  It is worth reading this imo, this is real stuff few have been thinking about: https://commonslibrary.parliament.uk/seabed-warfare-protecting-the-uks-undersea-infrastructure/  governments are scampering to defend sub sea interests.  At the results presentation, Sclater said they have never had so much interest in their rebreathers and that they have had funding from the US to develop a shallow water rebreather. Oil, energy and telecommunications run under the sea and are critical so I expect many countries to be placing orders, especially now that Avon can use the German order as a standard bearer. It is believed that the Nord Stream pipeline was destroyed by bad actors on a yacht using Octogen explosives. This means these subsea pipelines and cables are at risk of terrorism too. Defence is in a sweet spot here and Avon Protection are playing in a high growth part of it. Other defence companies have seen their shares move up strongly. These rebreathers have been in development for 20 years but have not been bringing in profitable sales in the main, until the recent major order from the German Navy.  Rebreathers should become profitable this year imo.

New CEO Jos Sclater has been involved in several turnarounds, notably Ultra Electronics and GKN, both of which ended up in take-overs.  I would also note that the board and the CEO are talking more upbeat and about recovery.  This is just a year after Sclater took the CEO job – that is quick.  I expect a genuine recovery play that is working to have news like this within 6-18 months.  If there is no real sign in 18 months it probably isn’t going to happen imo.  If the news is at the 9 month area the recovery has strong momentum usually, imo.

Another confidence factor for me is director buying to accompany the above characteristics – there has been no shortage of director buying since Sclater arrived,

Another positive feature for me is the bowl on the chart in recent months – this is a clear chart change from all the ‘saw tooth’ ups and downs of traders hopping in and out to investors buying to hold and taking up those trader sells.

That gives me a lot of positive flags above.

They paid a 42.5 div over the trailing 12 months but at the interims they said this would be adjusted to make it sustainable so looks like a bit of a clip is likely. 14.3c (12.3p) divi was paid at H1. Any divi will be covered 1.8 to 2 times across the cycle.

The recent trading update is here

https://www.investegate.co.uk/announcement/rns/avon-protection--avon/trading-update-restatement-of-fy22-results/7814078

The results webcast video is here, a must watch imo – this convinced me to buy and hold. There’s interesting stuff in here like being able to save $1m per factory in waste reduction and how two factories were not even getting on with each other. 

One really interesting aspect I have picked up on is the development to delivery timescale.  It seems the company expects a product to take about a year or more to complete from enquiry to delivery but constantly see 6-12 months added onto this for revising the design and other approval delays including objections from competitors to slow up their progress in getting it through the appropriations committee.   With Ukraine kicking off less than two years ago, the enquiries and potential orders this initiated, probably haven’t yet got to the stage where full committed orders have been placed but perhaps they aren’t that far away?

Currently trading on a PE for this year of 42 but with a trailing twelve month PE of 23 and a fwd PE for 2024 of 19.

Debt:  “The year end net debt position on a covenant basis is now expected to be approximately $65m, as a result of the timing of cash receipts from the shipment of several large orders in the last month of the financial year. We expect the receivables associated with these orders to be paid during the first quarter of the 2024 financial year, which will further reduce net debt by up to $20m.” the company says.

Mk Cap £285m

Stockopedia show the earnings trend starting to turn up recently.

EPS for this year has gone from 38.4p to 41.4p.  EPS for 2025 has gone from 49p to 58.4p, both since November, making a PE of 16 for 2025.  I think they may be a gross underestimate.  £282m sales forecast for next years, at mid teens margins – you can do the maths.

On Friday, the company put out a trading update:

“AGM Trading Update - Continued strategic and operational progress

 Avon Protection plc is pleased to announce a trading update for the first quarter of its 2024 financial year ("Q1"), ahead of its Annual General Meeting today.

 Trading update

Order intake for the first quarter was 36% higher than the prior year, reflecting strong demand for helmets and rebreathers, following the recently announced contract from the German Navy, partially offset by a modest decline in respirator orders. The order book was 21% higher than the prior year. Year-on-year revenue growth of 27% was in line with our expectations, reflecting the continued successful delivery of NG IHPS helmets to the U.S. DOD and robust demand for pads and commercial helmets. 

 As expected, cash conversion was very strong reflecting the unwind of the elevated FY23 year-end receivables balance following the high volume of deliveries in the final quarter of FY23.

 Following the successful First Article Testing process on the ACH GEN II helmet, work is now ongoing to ramp up production ahead of product deliveries in the second half.

Continued strategic progress

Our focus on operational excellence and continuous improvement is now starting to deliver the expected scrap reduction benefits and recent actions taken in support of functional excellence will start to deliver benefits in H2 2024, in line with expectations.

Our transformation programme is progressing in line with our plan.  In December 2023 we informed employees about our plan to close our Irvine, California facility by Summer 2025 as part of our site optimisation programme. Benefits from the consolidation of the California production into our other Head Protection sites will begin in FY26 and will significantly improve competitiveness and financial performance over the medium term. 

FY24 outlook unchanged

The trading performance in the first quarter, and the progress made to date on transformation, support our full year expectations of high single-digit revenue growth and solid progression in adjusted operating margin in H2.

Jos Sclater, Chief Executive Officer, said:

"After a year of strengthening the business, we are now focused on our objectives of creating a competitive advantage through superior execution, growing faster than our markets by delivering new and improved products to our customers, and increasing margins through our transformation programme.  While there remain a number of opportunities and risks for us to navigate in the year ahead, I am pleased to see the results start to reflect the strategic and operational progress we are making. We remain focused on the actions required to deliver our medium-term objectives."

 Avon will report its half year results for the six months ending 31 March 2024 on 21 May 2024. Prior to this, the Group will host a capital markets day on 8 February 2024.

I think it is worth looking at what the forecasts are:

It’s worth comparing past sales volumes and operating profit to today’s forecasts. Sclater says he’ll get operating margins to mid-teens medium term (results presentation link above) and there has been no share dilution.

I am still traumatised from having bought Avon down at around 30p bottom and selling at around 50p in a month, at the financial crisis bottom in 2009, when it was the milking equipment business. I never dreamed it could become what it has, so perhaps my view is coming from a sort of revenge investment or an attempt to repair my battered soul.  But I look at this business, its technology, its moat, its customer base and the £285m market cap and I ask myself, could this become a FTSE250 business again, after all, that £46 high was just 3 years ago?  Defence is fornt and centre for governments today. Could it even have a market cap of £2.5bn in the not too-distant future?  I feel it has got that ability but you will obviously have your own view.

All just my opinion, obviously do your own research.  I am just revealing why I bought this stock and my thought process for general interest and this isn’t a recommendation. I looked backwards at these from £45 and saw I’d missed a bargain – got to look forwards and envisage imo. You make your own mind up, you make your own buy and sell decisions. I’m no analyst, I’m just a dumb private investor

Cockney Rebel.