Chemring CHG W
September 01, 2009 - 10:07am EST by
cgnlm995
2009 2010
Price: 2,077.00 EPS $2.16 $2.87
Shares Out. (in M): 35 P/E 9.2x 6.9x
Market Cap (in $M): 734 P/FCF 11.1x 8.0x
Net Debt (in $M): 165 EBIT 115 154
TEV ($): 865 TEV/EBIT 7.4x 5.6x

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Description

Chemring presents an opportunity to own a well-managed UK based Defense firm growing >20% organically with a 20% ROIC at less than 7x 2010 earnings, behind a CEO that has dramatically transformed the Company's business model over the past four years.  Since 2005, David Price has overseen the development of Countermeasures into the global dominant player (decoys and flares - now 50% global mkt share) and now hopes to replicate the Company's success in Energetics (pyrotechnics, ammunitions and explosive components).  The market appears to view Chemring as a "value trap" where a low multiple is justified by low growth prospects.  We believe the market does not appreciate the dynamism and growth drivers of the business model, and thus fails to grasp the growth trajectory for the next 3-5 years where management expects >30% per annum growth (low 20s organic).  Interestingly enough, sell-side out-year growth forecasts underestimated revenues by more than 10% per year over the previous 3 years.  For 2009, consensus estimates call for 39% growth (was 23% 5 months ago) and 10% top-line growth for 2010.  We believe the share price, as well as sales and earnings estimates will rise fairly dramatically over the next 6-12 months driven by continued market share gains and accretive acquisitions.

Chemring operates in two segments: Countermeasures (37%) and Energetics (63%).  Within Countermeasures, growth will be slightly above the industry where current global funding plans calling for 15% growth through 2010, which should then trend fairly flat.  Chemring has been granted sole-source status for flares on the F 22, the Eurofighter rollout and the Joint Strike Fighter, providing multi-year revenue visibility for products that are much higher value (and margin) than the average mix ($1,000-$3,000 per flare vs. $80).  The Energetics industry offers mid single digit growth, but major market share opportunities (<5% market share).  Given stringent safety requirements and relatively small contracts, major prime contractors are shifting their focus away from non-core manufacturing activities in explosive-related products.  BAE Systems, for example, after building an extensive relationship with Chemring, transferred its munitions initiator production to Chemring's Nobel Energetics business. 

 Investment Merits

David Price ran the Naval Marine business for Rolls Royce from late 2000-2004 where he grew top-line by 10% per annum while growing earnings at 25%.  This business generated nearly GBP500mm in sales when Price left or more than 4x the size of Chemring when he took the helm in early 2005.  Since joining Chemring, Price has grown sales at a 43% CAGR and earnings at a 48% CAGR against peer growth of close to 20% at the bottom-line.  From proprietary diligence checks, Price has a track record of meeting and exceeding internal targets. 

  • Attractive valuation with clear market dislocation: With organic earnings growth of more than 20% (30-50% overall), 20%+ ROIC and peers that trade at a premium despite growth and return profiles, Chemring should trade at GBP44 (15x) unlevered 2010 earnings.  This suggests 113% upside.  The valuation dislocation exists for two reasons: 1) analysts continually discount out-year growth (happened the last three years leading to gradual estimate upgrades and steady price appreciation), and 2) analysts fail to grasp the structural nature of global defense spending growth  given: a) the return of the Cold War (Russia's desire to regain its regional dominance and act as a counterweight to the US on global intervention issues), b) China's intent to become a regional military power forcing other countries, including the US, EU, Japan, India, and Russia, and many developing countries and regions to modernize and expand their military capabilities, and c) new security threats including global terrorism, requiring non-traditional defense needs such as border protection and increased security presence around vital facilities such as utilities, power plants, nuclear reactors, water treatment plants, energy production, refining and transportation infrastructure.
  • Non-cyclical businesses with strong backdrop and market positions: Strong growth with 20% ROIC supported by high regulatory and technical barriers to entry with non-cyclical end markets suggest that Chemring is a high-quality business.  The business requires frequent replacement (consumables that must be replaced consistently due to short shelf-lives with potentially lethal consequences) and offers decent pricing power given the Company's cost position relative to peers and price of the product relative to customer spend ($138 million for an F-22 Raptor versus $3,000 for Chemring's highest-priced flare).  Chemring's Countermeasures business is THE design authority for the UK MoD and has been granted sole source status on many US platforms, further insulating the company from competition.
  • Significant scope for growth: Management believes they can achieve 40% sales growth by aggressively penetrating low-cost, niche energetic businesses where they can expand upon their market dominant positions through a) price competitiveness (economies of scale), b) higher product quality (automated manufacturing versus manual for mom and pop peers), c) superior service (global reach with 4 former Generals/Admirals on staff), d) providing an alternative to large, integrated peers who attempt to make outsized margins on disposables (Rheinmetall invests hundreds of millions into building a tank and then hopes to recoup the investment by pricing the munitions at an amount significantly higher than variable cost) and e) consolidating fragmented, scale-lacking peers with phenomenal growth prospects.  For example, The Company acquired NIIITEK, an explosive detection company with market-leading technology, for cash consideration of $40 million.  Just a few months after the acquisition's close, NITEK announced orders totaling $100 million with estimated operating profit of ~$20mm, valuing the acquisition at just 2x operating profit.  This small business could generate $200 million by 2011.  Between organic market share gains and shrewd acquisitions, we believe the market continues to dramatically underestimate Price's potential to sustainably grow the businesses.   
  • Strong management

 

  • Investment Risks

    The US accounts for 46% of sales.  While the Company sells to many different counterparties through many different subsidiaries, a major slowdown in overall defense spending would negatively impact the business.  Furthermore, the Federal budget calls for countermeasure spending to almost double from 2007 levels to 2010 suggesting significant conflict exposure.  While reserve replenishment should lead to significant growth through 2012, revenues could decline in this business if war spending declines and new business is not won (exports and new platforms).

  • Competition:
  • Chemring's sole source status on a significant portion of its Countermeasure business could come under pressure from emerging competitors.  While the certification process is very difficult and even certified players such as Cobham's FR Countermeasures Inc (now sold) could not generate profits in the US, new players could enter this market over time (possibly larger players integrating their supply chains).
  • Strategy execution risk:
  • Management will continue to make bolt-on acquisitions, which introduces integration risk and could distract management from running the core business.  This investment is predicated on significant market share gains continuing through 2010.
  • Dependence on US DOD

Model

 

Chemring (CHG LN)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$ in mm, FYE Oct-

2005

2006

2007

2008

2009

2010

 

 

 

 

Countermeasures

91

118

127

157

189

217

 

 

 

     

 

Organic Growth

15.3%

30.4%

6.8%

24.5%

20.0%

15.0%

 

 

 

 

 

 

 

Acquisitive Growth

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

 

 

 

 

 

 

 

Energetics

30

69

128

197

313

451

 

 

 

 

 

 

 

Organic Growth

-11.0%

39.3%

55.6%

31.3%

35.0%

20.0%

 

 

 

 

 

 

 

Acquisitive Growth

8.2%

64.9%

18.9%

16.8%

18.0%

20.0%

 

 

 

 

 

 

 

Total Revenue

121

188

255

354

502

669

 

 

 

 

 

 

 

Growth

9.9%

55.2%

35.7%

39.0%

41.8%

33.1%

 

 

 

 

 

 

 

of which, % acquired

1.8%

0.0%

10.9%

8.5%

10.0%

12.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Countermeasures

25

34

39

46

55

63

 

Peer Multiples

P/E

EV/EBITDA

Margin

27.3%

28.6%

30.5%

28.9%

28.9%

29.0%

 

 

 

2009

2010

2009

2010

Energetics

2

10

28

46

74

108

 

COB LN

 

10.0x

10.0x

7.2x

6.9x

Margin

7.6%

15.0%

21.7%

23.2%

23.5%

24.0%

 

ULE LN

 

14.0x

12.6x

9.2x

8.4x

Centralized Costs

(4)

(6)

(5)

(6)

(8)

(11)

 

VTG LN

 

13.0x

13.0x

9.4x

8.7x

Amortization

(0)

(1)

(3)

(17)

(5)

(6)

 

CHLD LN

 

15.0x

15.0x

9.0x

8.7x

Total EBIT

23

38

58

68

115

154

 

Peer Average

 

13.0x

12.7x

8.7x

8.2x

Margin

18.9%

20.1%

22.7%

19.2%

22.9%

23.1%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EBITDA

27

44

68

95

133

175

 

CHG LN

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Expense

(4)

(9)

(8)

(11)

(10)

(10)

 

Sellside

 

10.0x

8.7x

6.9x

6.2x

EBT

19

29

50

57.4

105

144

 

CGNLM

 

9.2x

7.0x

6.5x

4.9x

Taxes

(6)

(10)

(16)

(16)

(31)

(42)

 

Premium to Peers

-29%

-45%

-26%

-40%

Rate

-29.5%

-33.8%

-31.9%

-28%

-29.0%

-29.0%

 

 

 

 

 

 

 

Minority Interests

(0)

0

(0)

(0)

(0)

(0)

 

 

 

 

 

 

 

Total Net Income

14

19

34

41

74

102

 

 

 

 

 

 

 

Average Shares Out.

29

31

33

33

35

36

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

EPS

0.46

0.62

1.03

1.23

2.16

2.87

 

 

 

 

 

 

 

Cash EPS

0.47

0.63

1.11

1.60

2.26

2.99

 

 

 

 

 

 

 

Growth

 

36.1%

74.3%

44.4%

41.7%

32.3%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total ROCE

16.5%

17.4%

19.1%

19.4%

21.5%

24.4%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash Flow

2005

2006

2007

2008

2009

2010

 

Market Stats

 

 

Intrinsic Value

 

EBIT

23

38

58

68

115

154

 

Current Price

 

20.90

ROCE

 

19.1%

add: Depreciation

4

6

7

10

13

15

 

Market Cap

 

696

Growth

 

15.0%

add: Amortization

2

2

4

17

5

6

 

Net Debt (Cash)

165

Norm. NOPAT

110

less: Interest Paid

(3)

(5)

(7)

(11)

(10)

(10)

 

Enterprise Value

861

Fair Multiple

15.0x

less: Taxes Paid

(7)

(11)

(12)

(16)

(31)

(42)

 

Dividend Yield

1.7%

Fair EV

 

1,644

less: CapEx

(1)

(10)

(15)

(31)

(28)

(31)

 

Mgmt Ownership

0.3%

Fair Equity Value

1,480

Total FCF

18

20

35

37

65

92

 

 

 

 

 

Fair Value per Share

44.44

Total FCFS

0.60

0.63

1.06

1.11

1.88

2.61

 

 

 

 

NOPAT on 23.0% EBIT margin

Dividends

(3)

(4)

(6)

(12)

(22)

(30)

 

 

 

 

 

 

 

Acquisitions

(23)

(63)

(47)

(71)

(50)

(70)

 

 

 

 

 

 

 

 

Catalyst

  • Earnings Announcements
  • Acquisitions
  • Contract awards
  • New coverage (Credit Suisse is the only global bank covering the name)
  • Capital flows out of cyclicals into underperforming defensive sectors (Healthcare, Defense, etc.)
  •  

        sort by   Expand   New

      Description

      Chemring presents an opportunity to own a well-managed UK based Defense firm growing >20% organically with a 20% ROIC at less than 7x 2010 earnings, behind a CEO that has dramatically transformed the Company's business model over the past four years.  Since 2005, David Price has overseen the development of Countermeasures into the global dominant player (decoys and flares - now 50% global mkt share) and now hopes to replicate the Company's success in Energetics (pyrotechnics, ammunitions and explosive components).  The market appears to view Chemring as a "value trap" where a low multiple is justified by low growth prospects.  We believe the market does not appreciate the dynamism and growth drivers of the business model, and thus fails to grasp the growth trajectory for the next 3-5 years where management expects >30% per annum growth (low 20s organic).  Interestingly enough, sell-side out-year growth forecasts underestimated revenues by more than 10% per year over the previous 3 years.  For 2009, consensus estimates call for 39% growth (was 23% 5 months ago) and 10% top-line growth for 2010.  We believe the share price, as well as sales and earnings estimates will rise fairly dramatically over the next 6-12 months driven by continued market share gains and accretive acquisitions.

      Chemring operates in two segments: Countermeasures (37%) and Energetics (63%).  Within Countermeasures, growth will be slightly above the industry where current global funding plans calling for 15% growth through 2010, which should then trend fairly flat.  Chemring has been granted sole-source status for flares on the F 22, the Eurofighter rollout and the Joint Strike Fighter, providing multi-year revenue visibility for products that are much higher value (and margin) than the average mix ($1,000-$3,000 per flare vs. $80).  The Energetics industry offers mid single digit growth, but major market share opportunities (<5% market share).  Given stringent safety requirements and relatively small contracts, major prime contractors are shifting their focus away from non-core manufacturing activities in explosive-related products.  BAE Systems, for example, after building an extensive relationship with Chemring, transferred its munitions initiator production to Chemring's Nobel Energetics business. 

       Investment Merits

      David Price ran the Naval Marine business for Rolls Royce from late 2000-2004 where he grew top-line by 10% per annum while growing earnings at 25%.  This business generated nearly GBP500mm in sales when Price left or more than 4x the size of Chemring when he took the helm in early 2005.  Since joining Chemring, Price has grown sales at a 43% CAGR and earnings at a 48% CAGR against peer growth of close to 20% at the bottom-line.  From proprietary diligence checks, Price has a track record of meeting and exceeding internal targets. 

       

      Model

       

      Chemring (CHG LN)

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      $ in mm, FYE Oct-

      2005

      2006

      2007

      2008

      2009

      2010

       

       

       

       

      Countermeasures

      91

      118

      127

      157

      189

      217

       

       

       

           

       

      Organic Growth

      15.3%

      30.4%

      6.8%

      24.5%

      20.0%

      15.0%

       

       

       

       

       

       

       

      Acquisitive Growth

      0.0%

      0.0%

      0.0%

      0.0%

      0.0%

      0.0%

       

       

       

       

       

       

       

      Energetics

      30

      69

      128

      197

      313

      451

       

       

       

       

       

       

       

      Organic Growth

      -11.0%

      39.3%

      55.6%

      31.3%

      35.0%

      20.0%

       

       

       

       

       

       

       

      Acquisitive Growth

      8.2%

      64.9%

      18.9%

      16.8%

      18.0%

      20.0%

       

       

       

       

       

       

       

      Total Revenue

      121

      188

      255

      354

      502

      669

       

       

       

       

       

       

       

      Growth

      9.9%

      55.2%

      35.7%

      39.0%

      41.8%

      33.1%

       

       

       

       

       

       

       

      of which, % acquired

      1.8%

      0.0%

      10.9%

      8.5%

      10.0%

      12.5%

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Countermeasures

      25

      34

      39

      46

      55

      63

       

      Peer Multiples

      P/E

      EV/EBITDA

      Margin

      27.3%

      28.6%

      30.5%

      28.9%

      28.9%

      29.0%

       

       

       

      2009

      2010

      2009

      2010

      Energetics

      2

      10

      28

      46

      74

      108

       

      COB LN

       

      10.0x

      10.0x

      7.2x

      6.9x

      Margin

      7.6%

      15.0%

      21.7%

      23.2%

      23.5%

      24.0%

       

      ULE LN

       

      14.0x

      12.6x

      9.2x

      8.4x

      Centralized Costs

      (4)

      (6)

      (5)

      (6)

      (8)

      (11)

       

      VTG LN

       

      13.0x

      13.0x

      9.4x

      8.7x

      Amortization

      (0)

      (1)

      (3)

      (17)

      (5)

      (6)

       

      CHLD LN

       

      15.0x

      15.0x

      9.0x

      8.7x

      Total EBIT

      23

      38

      58

      68

      115

      154

       

      Peer Average

       

      13.0x

      12.7x

      8.7x

      8.2x

      Margin

      18.9%

      20.1%

      22.7%

      19.2%

      22.9%

      23.1%

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      EBITDA

      27

      44

      68

      95

      133

      175

       

      CHG LN

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Interest Expense

      (4)

      (9)

      (8)

      (11)

      (10)

      (10)

       

      Sellside

       

      10.0x

      8.7x

      6.9x

      6.2x

      EBT

      19

      29

      50

      57.4

      105

      144

       

      CGNLM

       

      9.2x

      7.0x

      6.5x

      4.9x

      Taxes

      (6)

      (10)

      (16)

      (16)

      (31)

      (42)

       

      Premium to Peers

      -29%

      -45%

      -26%

      -40%

      Rate

      -29.5%

      -33.8%

      -31.9%

      -28%

      -29.0%

      -29.0%

       

       

       

       

       

       

       

      Minority Interests

      (0)

      0

      (0)

      (0)

      (0)

      (0)

       

       

       

       

       

       

       

      Total Net Income

      14

      19

      34

      41

      74

      102

       

       

       

       

       

       

       

      Average Shares Out.

      29

      31

      33

      33

      35

      36

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      EPS

      0.46

      0.62

      1.03

      1.23

      2.16

      2.87

       

       

       

       

       

       

       

      Cash EPS

      0.47

      0.63

      1.11

      1.60

      2.26

      2.99

       

       

       

       

       

       

       

      Growth

       

      36.1%

      74.3%

      44.4%

      41.7%

      32.3%

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Total ROCE

      16.5%

      17.4%

      19.1%

      19.4%

      21.5%

      24.4%

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

       

      Cash Flow

      2005

      2006

      2007

      2008

      2009

      2010

       

      Market Stats

       

       

      Intrinsic Value

       

      EBIT

      23

      38

      58

      68

      115

      154

       

      Current Price

       

      20.90

      ROCE

       

      19.1%

      add: Depreciation

      4

      6

      7

      10

      13

      15

       

      Market Cap

       

      696

      Growth

       

      15.0%

      add: Amortization

      2

      2

      4

      17

      5

      6

       

      Net Debt (Cash)

      165

      Norm. NOPAT

      110

      less: Interest Paid

      (3)

      (5)

      (7)

      (11)

      (10)

      (10)

       

      Enterprise Value

      861

      Fair Multiple

      15.0x

      less: Taxes Paid

      (7)

      (11)

      (12)

      (16)

      (31)

      (42)

       

      Dividend Yield

      1.7%

      Fair EV

       

      1,644

      less: CapEx

      (1)

      (10)

      (15)

      (31)

      (28)

      (31)

       

      Mgmt Ownership

      0.3%

      Fair Equity Value

      1,480

      Total FCF

      18

      20

      35

      37

      65

      92

       

       

       

       

       

      Fair Value per Share

      44.44

      Total FCFS

      0.60

      0.63

      1.06

      1.11

      1.88

      2.61

       

       

       

       

      NOPAT on 23.0% EBIT margin

      Dividends

      (3)

      (4)

      (6)

      (12)

      (22)

      (30)

       

       

       

       

       

       

       

      Acquisitions

      (23)

      (63)

      (47)

      (71)

      (50)

      (70)

       

       

       

       

       

       

       

       

      Catalyst

    • Earnings Announcements
    • Acquisitions
    • Contract awards
    • New coverage (Credit Suisse is the only global bank covering the name)
    • Capital flows out of cyclicals into underperforming defensive sectors (Healthcare, Defense, etc.)
    •  

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