Chemring Group PLC

LSE:CHG

Earnings Call Analysis

Earnings Call Transcript 2023-Q2

[Michael Ord, executive]

Good morning, and welcome to the presentation of Chemring's results for the half year to the 30th of April 2023. I am as usual, joined today by Andrew Lewis, our Chief Financial Officer. I'll begin by providing a brief overview of the group's highlights for the half year. Andrew will then take you through the financial results, and I will then provide some more general comments on the market environment, our investment priorities and the outlook for the full year.

Starting with a brief overview. The group's performance during the first half of 2023 was in line with the Board's expectations. As we've previously flagged, both this time last year and subsequently, delays to order intake in 2022 following the extended U.S. government's continuing resolution resulted in a greater weighting of trading performance and cash generation in our Countermeasures & Energetics sector towards the second half of this financial year. We have seen record levels of order intake during the first half of the year, up 81% to GBP 338 million given an overall group order book at the 30th of April of GBP 750 million, the highest it has been in over a decade.

In 8 out of the 10 previous half year periods, our [ Roke ] business has delivered double-digit growth in revenue with the first half revenue this year, up 44% to GBP 78 million and order intake up 41% to GBP 82 million, with the business well positioned to continue its growth trajectory and what continues to be a very buoyant market.

We have also seen a significant increase in activity and demand across our Energetics sector as customers reevaluate their operational usage and stockpile requirements associated with more conventional defense capabilities. Record order intake in this sector has underpinned our decision to approve a 3-year GBP 90 million capital investment program, which will increase our revenue by GBP 60 million per annum and I will talk more on this and the opportunities that we see later in the presentation.

Approximately GBP 232 million of the order book is scheduled for delivery during the second half of 2023. This represents cover of approximately 90% of the expected second half revenues. This leaves GBP 518 million of order book to be delivered in FY '24 and beyond. This growing visibility and the increasing trend of customers moving towards longer-term partnering agreements gives us the confidence to continue to invest for the future. balancing short-term performance with longer-term growth and value creation. The Board's expectations for the 2023 financial performance remain unchanged.

So that concludes my overview. I'll now hand over to Andrew to take you through the financial results.

[Andrew Lewis, executive]

Thanks, Mick, and good morning, everyone.

This period's results are in line with the expectations we set out a year ago when we noted the delays in order intake in the first half of 2022 caused by the extended continuing resolution in the U.S. would adversely impact the first half, second half split this year. The delayed order intake in 2022 as shown on the order intake graph on the top left-hand side of the slide, which shows the catch-up in the second half of last year. The graph also shows the exceptionally strong order intake we've seen in the first half of 2023, a first half record at GBP 338 million. Following the escalation in geopolitical tensions a year ago, orders to ensure governments are adequately stocked with traditional defense capabilities are finally beginning to flow.

Countermeasures & Energetics order intake more than doubled to GBP 238 million, driven by strong demand for our niche energetics products and incentives and information, demand for rates range of capabilities saw order intake up 35% to GBP 100 million.

Moving to this period's results. Having worked hard over the previous 4 years to improve the first half, second half split, it's disappointing to see the operating profit split move from approximately 50-50 to approximately 40-60, but we can only control our controllables, and the U.S. government politics is certainly outside of our control.

So the key facts and figures from this period's results. Revenue was GBP 212 million, which was down 4%. Operating profit fell 21% to GBP 26.6 million. Our operating margin fell 270 basis points from 15.2% to 12.5%, reflecting the operational gearing impact the revenue [ falling ] Countermeasures & Energetics and the continued investment in Roke, which started in the second half of last year. Operating cash conversion in the first half was 64% of EBITDA, reflecting the timing of many deliveries, which were made late in the period, together with the investment in inventory to deliver second half revenue. Rolling 24-month cash conversion is 100%, showing through the cycle the business remains cash generative.

The closing order book is GBP 750 million, the highest it's been in over a decade. And of this, GBP 232 million is expected to be delivered in the second half, which covers 90% of expected second half revenue. I've covered most of the other key operating numbers on the previous slide, so I'll just pull out a couple of other items.

The increase in the finance expense was driven by the increase in interest rates in the second half of last year continuing into the first half of this year and being reflected in our cost of borrowing. The underlying tax rate for the period has risen to 15%, which reflects our expectations for the full year rate. The comparative year benefited from the recognition of a noncash deferred tax asset in the U.S., which has not recurred in 2023. The Board has declared an interim dividend for 2023 of 2.3p, up 21%, which continues the progression of growing our dividend and moving towards the medium-term objective of 2.5x dividend cover.

The revenue and profit bridges show the key drivers of the group's results this period. At a revenue level, Sensors & Information was positively impacted by strong market conditions and excellent execution at Roke offset by lower HMDS revenue in the U.S. Sensors business.

As expected, given the timing of order intake in 2022, revenue in Countermeasures & Energetics saw a modest reduction in the period with the niche Energetics businesses stronger, offset by lower U.S. Countermeasures revenue.

At an operating profit level, in Sensors & Information, we see strong growth in the Roke products and services business where revenue growth dropped through to operating profit as expected. This was offset by the impact of the discretionary operating expense investment in the Roke Academy and Roke's graduate and apprentice scheme and a softer half in the U.S. Sensors business driven by lower HMDS volumes. In Countermeasures & Energetics, operating profit fell in line with the reduction in revenue. Further detail on both segments follows in later slides.

Moving to the segmental results and starting with Sensors & Information. The results show revenue up 9% to GBP 97.9 million and operating profit down 2% to GBP 19 million. reflecting the strong period at Roke, which delivered another period of significant growth and high margins, offset by lower revenue and profit in the U.S. Sensors business following the HMDS program changes in 2022. As shown by the graph on the right, Roke's information security and data science business, operating primarily in the U.K. national security and defense markets has an impressive growth track record over the last 5 years.

To position Roke well for ongoing future growth, we're ensuring we continue to invest. In the second half of 2022, we established the Roke Academy and committed to expanding Roke's graduate and apprentice schemes. The circa GBP 2 million costs seen in the second half of 2022 has been replicated in the first half of 2023 as we now see the full year effects. Our ambition for Roke is now to achieve GBP 200 million of revenue by 2025 and GBP 250 million by 2028.

As expected, revenue and profits in the U.S. Sensors business was significantly lower than the first half of 2023 as the HMDS program moved into a sustainment in the second half of last year. Deliveries under the full rate production contract for EMBD continued and a further delivery order of $15 million was received under the $99 million 6-year framework contract, which secures expected volumes for the third year. The next customer procurement decision is expected on the JBTDS program in the second half of 2023.

Given there are a number of moving parts in Sensors & Information in the first half of the year, I thought it might be useful to provide further breakdown of what's happened in the period in the form of detailed revenue and operating profit bridges. The key takeaways being: Roke Products and Services revenue was up 39%, and Roke revenue for the first half included GBP 6.7 million of incremental pass-through revenue with no margin associated with it. Pass-through revenue now totaled GBP 17 million, approximately 20% of rate revenue. This diluted the segmental margin incentives and information, which adjusting for this would have been 23%.

Going forward, as Roke primes more contracts, we see pass-through revenue increasing and therefore, maintain our segment margin guidance of mid- to high teens for Sensors & Information over the medium term.

The bridge shows the impact of the HMDS transition to sustainment in the second half of 2022, which has impacted the first half and first half comparison as 2022 included significant HMDS deliveries. For our U.S. Sensors business, 2023 is very much a transitional year between programs of record as HMDS volumes to reduce and focus turns to biological detection. Beyond 2023, as the potential full rate production contract for JBTDS ramps up, revenue and profit in the U.S. Sensors business could return to previous levels.

Moving on to Countermeasures & Energetics. Revenue was down 12% to GBP 114.2 million and operating profit down 29% to GBP 15.2 million, driven by the timing of order intake in 2022 following the extended continuing resolution in the U.S. Favorable market conditions in our niche Energetics businesses underpin the group's strategic decision to approve a 3-year GBP 90 million investment to increase capacity by GBP 60 million per annum. The development of the Countermeasures & Energetics order book over the last 5 years is shown on the graph on the bottom right of the slide, which shows the significant growth in the last 18 months.

The commissioning and characterization of the new Countermeasures facility in Tennessee continued through the period. The closing order book is GBP 597 million with expected second half revenue for Countermeasures & Energetics, 99% covered by the order book at the 30th of April, which leaves significant order cover in place for 2024 and beyond, providing excellent future visibility.

This slide breaks out the movement in Countermeasures & Energetics. The Energetics businesses responded to increased customer demand with strong operational execution, driving a 19% revenue increase but with order intake up 192%, there is a need to invest in increased capacity to satisfy demand. The bridge also clearly shows the impact of the extended U.S. continuing resolution in 2022 on U.S. Countermeasures revenue in the first half of this year. Energy prices were higher than the comparative period as elevated costs continued from the second half of 2022.

The cash flow shows the group's net debt at the end of the period at GBP 25 million, an increase of GBP 18 million since year-end. The operating cash conversion ratio in the period was 64% of EBITDA, as deliveries were back-end loaded and inventory has been procured to secure second half revenue forecast.

Across the last 24 months, operating cash conversion has been 100% of EBITDA, demonstrating the sustainable improvement in business practices, [ can on ] occasions be impacted by timing differences in any individual 6-month period. The significant nontrading item in the period was CapEx which at GBP 12 million was focused on our sites in Scotland and Norway. Mick will speak in more detail of the plans to add capacity in our 3 niche Energetics businesses over the next 3 years. And as a result, we expect CapEx to remain elevated through to 2025.

With net debt of GBP 25 million at period end, a net debt-to-EBITDA ratio of 0.3x and banking facilities of GBP 150 million in place, the group is in good financial health and positioned well to continue to invest for growth.

Finally, looking at the order book. At a group level, order intake was up 81% to GBP 338 million and the closing order book was a record GBP 750 million, with GBP 232 million expected to be delivered in 2023, giving 90% cover of expected second half revenue. In both segments, strong long-term customer relationships, sole source or market-leading positions, underpinned by significant product IP has enabled us to capture significant customer demand as market dynamics have changed.

Turning to each segment and starting with Sensors & Information. Order intake was up 35%, reflecting the strong period at Roke, which continues to benefit from increased demand and importantly, funding from its national security and defense customers. The order book in this segment tends to be shorter cycle. Of the GBP 153 million order book, GBP 67 million is expected to be delivered in the second half giving 72% cover of expected second half revenue.

In Countermeasures & Energetics, order intake was up 113% to GBP 238 million, reflecting strong order intake in our niche Energetics businesses which was up 192% to GBP 149 million. The closing order book of GBP 597 million, GBP 165 million of which is for delivery in the second half giving 99% cover of expected second half revenue.

Looking beyond the second half of this year. In Countermeasures & Energetics, 2024 is already 78% covered and 2025, 60% covered.

And with that, I'll hand you back to Mick. Thank you.

[Michael Ord, executive]

Thank you, Andrew.

The current geopolitical uncertainty brought about by both Russia's invasion of Ukraine and increased threats in the Asia Pacific region has highlighted the need for increased defense expenditure, particularly for members of NATO. More broadly, it has highlighted the need for countries to reequip our modernize their defense capabilities to meet the threats of peer-on-peer conflict. The outlook for global defense markets is, therefore, increasingly positive with growth predicted over the next decade.

Increased competition from China is driving a significant U.S. defense modernization program as well as a strengthening of U.S. military alliances. The U.S. continues to be the largest defense and security market in the world and remains opportunity-rich for the group's capabilities. The FY '24 budget request from the Biden administration for the U.S. DoD is $842 billion, and has a strong focus on strengthening cooperation with allies, modernization procurements to maintain full spectrum dominance and the largest ever investment in research and development.

European allies, both NATO and non-NATO members have plans to increase defense investment to address the replacement of defense capabilities provided to Ukraine, remove capability gaps and enhance stockpile and readiness levels. and the increasing focus on partnerships and alliances, such as [ Five Eyes ], [ Orkus ] and NATO is also expected to drive greater cooperation and alignment between allies. Priority areas for spending include active cyber defense, operational mission support, electronic warfare, space launch, missile systems and biological security, all of which are areas where Chemring is well placed. But the area where we have seen the most dramatic change in customer priorities has been across our Energetics sector, as customers reevaluate their operational usage and stockpile requirements associated with more conventional defense capabilities. This change in spending priority presents significant opportunities for our businesses in Norway, Scotland, Chicago and also for Roke, and I'd like to spend a few moments illustrating this point in the next few slides.

Our business in Norway, Chemring Nobel, is one of the largest European suppliers of specialist energetic materials manufacturing at scale, both [ HMX ] and [ insensitive ] energetic materials, which are extensively used in missile and munition systems. Chemring Nobel supplies many U.S. and European defense prime contractors and is a key strategic supplier to the industry, supporting many major missile and munition programs across NATO. This was illustrated in April when the business was recognized as one of the top suppliers in Northrop Grumman's global network of more than 10,000 global suppliers.

Since 2022, demand for specialist energetic materials has increased very significantly, with governments now seeking to both restock missile ammunitions provided to Ukraine, and increase their own national resilience through holding higher levels of inventories. Governments are also seeking to increase the capacity and resilience of their industrial supply chains. Customers are now seeking long-term strategic supply agreements in order to secure their place in our production schedules, which provides the group with improved visibility against which to make investment decisions.

With demand exceeding current supply and with the market expected to grow significantly over the next decade, Chemring is very well positioned to further capitalize on this opportunity.

Moving now to our business in Scotland where we have seen similar changes in customer priorities. Chemring Energetics U.K. is highly experienced in the design, manufacture and through life support of propellent materials and pyromechanical devices. And it is a key supplier for many European defense prime contractors and the U.K. MOD. Again, we are seeing that demand for these products, particularly propelled materials for missile systems has very significantly increased as customers reevaluate their requirements for conventional defense capabilities.

A clear illustration of which was the receipt in March of a GBP 43 million order for the delivery of critical components used in the next-generation light anti tank weapon system or [indiscernible], as it is more usually called and we expect further orders for this and other systems.

As a critical sole source supplier for multiple missile ammunition systems across the land, air and naval domains, our customers are increasingly looking for longer-term partnering agreements in order to secure supply, which provides the group with improved visibility against which to make investment decisions. In the U.S., a space has become established as a military domain and with the growth of commercial space launch markets, the opportunity for those with a well-established delivery reputation, our broad supply chain incumbency has continued to grow. Surely, in response to the changing threat environment, the U.S. DoD is investing heavily in building missile inventories and in developing next-generation missile systems.

Operating in niche market positions with sustainable competitive advantage, including high barriers to entry and proprietary intellectual property and know-how, our business in Chicago, Chemring Energetic devices is a highly respected and successful supplier to U.S. government agencies, defense prime contractors and a growing number of commercial space launch providers with expertise in designing and manufacturing high integrity devices used in space launch, aircraft safety and missile applications. The business has incumbent supplier status often as a sole source provider across multiple U.S. programs.

We believe these markets present significant growth opportunities and our focus is on capturing that opportunity through a combination of investing to satisfy, increased customer demand in in-service systems and in new product development to capture new programs.

Organic growth is our primary plan, but we may also accelerate growth through incremental inorganic acquisitions. The significant increase in activity and demand across our Energetics sector, which is expected to grow for at least the next decade, presents a valuable opportunity to expand capacity at all 3 businesses capturing the projected long-term growth demand. The group has, therefore, initiated a 3-year capital investment program through to financial year 2026 at a cost of approximately GBP 90 million. This will complete the process of investment in safety, automation and modernization of the portfolio that we announced in 2019 and will also add significant additional capacity at these 3 businesses. When complete, we expect this additional capacity to generate incremental revenue of GBP 60 million per annum and operating profit of GBP 13 million per annum.

Turning now to our Roke business, which against an increasingly unstable global and domestic security environment has continued its positive momentum into 2023. The U.K. government integrated review refresh published in March this year, focused on the U.K.'s ability to deter, defend and compete across all domains, most notably in areas including cyber, information advantage and the digitalization of defense. The review also focused on addressing the U.K.'s vulnerabilities and how we generate strategic advantage in an increasingly contested and volatile world.

As many of these activities are aligned with Roke's core capabilities, we expect the demand for Roke's market-leading skills and technologies will only increase further. The change in customer spending priorities I outlined earlier has resulted in Roke seeing strong order intake across all of its business areas. In Roke's National Security business, a key element of the integrated review refresh the need to update statecraft for systemic competition is increasing demand for active cyber defense and operational mission support capabilities for U.K. government customers. This increased demand when coupled with a constrained national skills market is motivating customers to secure a longer-term capacity and capability from Roke. In turn, we continue to invest in the Roke Academy to accelerate the growth of our cyber skilled workforce. With Roke also increasingly leading on multiyear framework contracts, we have seen Roke's National Security order intake rise by 35%.

In Roke's Defense business, the increasing importance of cyber and electromagnetic activity often referred to as [ CEMA ], which includes electronic warfare. In today's threat environment has led to a growing number of customer inquiries for Roke's suite of electronic warfare and information advantage, hardware and software products. To provide context, Roke currently has customer requests for quotations in excess of GBP 200 million outstanding and is well positioned to win several multiyear orders.

Across the period, order intake for Roke's Defense business was up 117%. Another notable highlight in the period was the progress made in the Roke [ Features ] business. Features delivers solutions to clients outside of national security and defense markets enabling industry to apply technology to enhance resilience and build differentiated competitive offerings. Futures customers currently include the U.K. Home Office, Rolls-Royce, Waygate Technologies and Vodafone. Features is also now supporting a new client, a FTSE 100 multinational mining company through the development of innovative solutions and applications, Roke technologies such as autonomy and intelligent sensing can enhance how minerals are processed, unlocking production capacity, improving efficiency and reducing waste.

Roke's newest business area, Intelligence as a Service which is built on the acquisition of [ GE elect ] and is driven by the needs of our national security, defense and commercial customers to access open source intelligence. Roke is created an Intelligence as a Service business offering, which combines proprietary data sets, artificial intelligence and customer-facing platforms to provide actionable intelligence and insight to both government and commercial customers.

People are at the heart of our rope business, and we maintain a laser focus on ensuring we attract and retain an ever-increasing number of highly skilled engineers scientists and program delivery personnel, and we will continue to invest in our graduate scheme, apprenticeship program and the Roke Academy. Successful execution of this strategy has seen Roke headcount increase from circa 400 at the end of 2018 to over 1,000 today. We also continue to invest in Roke's infrastructure and expanding its U.K. geographic footprint to both follow the mission with our clients and to access new pools of talent. And we continue to invest in R&D and new product development to maintain critical mission relevance for our customers.

In parallel, we'll seek to supplement organic growth with bolt-on acquisition targets that support our Roke growth strategy. At the FY '22 full year results in December, we stated that our vision for the 5 years to 2027 was to maintain Roke's growth and organically doubling Roke's annual revenue to greater than GBP 200 million, whilst maintaining strong margins. With the increased activity we are seeing across all of Roke's business areas, we have revisited that assessment and have raised our ambitions to organically increase Roke's annual revenue to greater than GBP 250 million by 2028, whilst continuing to maintain strong margins.

So in conclusion, we have continued to make strong progress in the first half of the year as we build a high-quality and resilient business and as we invest for future growth. Current geopolitical uncertainty has highlighted the need for increased defense expenditure, particularly across NATO. More broadly, it has highlighted the need for countries to reequip and modernize their defense capabilities to meet the threats of peer-on-peer conflict. This has led to record H1 order intake and the highest order book the group has seen for over a decade. The U.S. government's extended continuing resolution in 2022 has led to a second half bias in our trading performance. However, with over 90% of our expected H2 revenue in the order book as of the 30th of April 2023, the Board's full year's expectations remain unchanged.

With market-leading innovative products, technologies and services that are critical to our customers and with a world-class workforce, and a strong and deployable balance sheet, I am confident that Chemring will continue to deliver on our commitment to balance near-term performance with longer-term growth and value creation.

So that concludes the presentation. If you do have any questions, please don't hesitate to get in touch with us. So thanks for joining us today, and we look forward to presenting our continued progress at the full year results in December.