Victrex PLC

LSE:VCT

Earnings Call Transcript 2023-Q2

[Operator]

Good day, ladies and gentlemen, and welcome to the Victrex Interim Results Meeting, May 2023, hosted by Chief Executive Officer, Jakob Sigurdsson; Chief Financial Officer, Ian Melling, and Chief Commercial Officer, Martin Court. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session through the phone lines, and instructions will follow at that time. [Operator Instructions] I would like to remind everyone that this call is being recorded.

I will now hand over to Jakob Sigurdsson to open the call. Please go ahead.

[Jakob Sigurdsson, Chief Executive Officer]

Thank you. Good morning, and welcome, everyone, to Victrex’s half year results presentation for FY 2023, which is held today via call. So if we – slight introductions first on Slide 2. So I’m Jakob Sigurdsson, CEO. We also have Ian Melling, our CFO, here with us, Martin Court our Chief Commercial Officer as well; and Andrew Hanson, our IR Director, is also in the room.

So before we start, just so that everyone is clear on the format, the slide presentation is on our website. www.victrexplc.com under the Investors tab and by clicking on Reports & Presentations. We will call out the slide numbers when we are speaking. You can also assess – access the webcast, which has the slides moving. The link to this is on our announcement this morning. Secondly, we will have a Q&A at the end. And I will open that up to any questions from the call once we’ve completed the presentation.

Turning on to Slide 3. I’d firstly like to recognize that this is Martin’s last results presentation, although he still has a number of months before you retire from Victrex. I want to pay my own tribute. Martin is a great colleague, a great professional, and he has been a significant contributor to Victrex over the 10 years that he has worked with us.

We are always involved in as well around retirement that allows him to spend more quality time with a growing group of grandchildren. To fill Martin’s roles, we have now made two appointments, which enable us to double down on the significant growth opportunities across both Industrial Sustainable Solutions and the part of our medical business. These will report directly to me, although they will not be having opportunity.

Firstly, we’re delighted to appoint Michael Koch, who has 30 years of experience in global chemicals, including BASF and DSM as well. He also has a strong experience across most of our sustainable solutions end markets. And his last role was as the CEO of Mitsubishi Chemicals, Advanced Materials, which happens to be one of our important VAR customers.

Secondly, Dr. John Devine becomes Managing Director, Medical. John has been with Victrex for 24 years. And some of you may have met him on site visit. And as you know, he brings a wealth of knowledge and experience to the role, and he’s been instrumental in driving our medical business and the pipeline and is now rapidly being converselized.

To move to the next slide, just that was a briefly progress on our strategy. Before we cover the first half highlights, I’d like to spend a moment to step back and consider how we’re making progress in delivering on our polymer and parts strategy. We know adoption time for some of our mega programs can require patience that we are moving much closer to inflection points on several programs right now.

Our sales from new products have been ticking up to 7% of revenue. And whether it’s in the medical area, or in the industrial area, the milestones they’re delivering, not just on the pathway to commercialization, but greater commercialization itself is coming through nicely.

I’m talking about this now. As you know that over the next few years, the fruits of our investment should start to come through. We are now starting to partner and have partners with major OEMs and customers in every mega program. That means that they’re also starting to put their own investment behind initiatives that they have on their own site to develop products based on our technology.

And as we see these start – as we start to see this start greater commercialization, it will start to support top and bottom line growth for ourselves, improve efficiency in our assets and improving cash flow. Remember also, we’re seeing good pricing traction. Our margin is improving from the trough and sales mix is improving as well. Once the macroeconomic environment improves and volumes go back, Victrex will certainly be well placed for recovery.

Next slide, Slide 5. And on to the first half specifically, two messages before we go into the detail of the presentation. Firstly, price, revenue and gross margin is up. Secondly, PBT is lower, very much driven by the macroeconomic impact to a number of end markets translating into lower volumes. We also saw some cost inflation and targeted investment in support of scale for key growth programs in the first half.

Moving on to Slide 6 and the highlights for the first half. Ian will cover the financial details shortly. But overall, we’ve seen strong pricing, driving revenue up 1%, also supported by FX. Our price increase program has gone very well, and remember that the main pricing is by structural increases.

Sales volume was down 14%, reflecting the macroeconomic environment, but also remembering that we had a record FY ‘22, strong first half of last year. So a much tougher comparatives, obviously. We did see growth in aero and auto and medical particularly with a record half year.

We do know that electronics, energy and industrial and value-added resellers are softer than prior year. And to put it in perspective, value-added resellers are 200 tonnes down on the first half compared to the first half of 2022. But last year, we had seen some records in all of these end markets.

I think it’s important to keep in mind that we are very well placed once the macroeconomic environment improves. We should also add that Victrex continues to develop new application areas and new uses of these. This is the life product of Victrex. Your Innovation is at the heart of everything we do.

On margin, good progress year-on-year and from the second half of 2022 and towards mid to high 50s target. In fact, as Ian will cover, if you look at ahead suggested gross margin, you get close to 56%, which is encouraging. Certainly, we should see further progress once inflation fully subsides. And once we see the ramp-up from our China facility, this will remain a drag in the short term.

Ian will cover the cash position as well. And again, with tougher trading, higher CapEx and higher working capital, it does mark the longer-term opportunity to improve free cash flow once the macro environment picks up again. And certainly, we are well placed for that as an FY ‘24 will be coming off a relatively high CapEx cycle with a significant reduction in CapEx in Confluence, hopefully, with a strong recovery in our key end markets.

Finally, as I indicated a few minutes ago, great progress on the Mega programs and growing signs of commercialization. Now I’ll come back and talk about each of those at a later stage.

I will now hand it over to Ian for the financial summary. Ian?

[Ian Melling, Chief Financial Officer]

Thank you, Jakob, and good morning, everyone. Just on Slide 7 to start with. Firstly, I’d like to add my own thanks to Jakob’s words about Martin. He’s been incredibly helpful to me since I joined Victrex and I’d like to wish him well in what will be a well-deserved retirement when it comes.

Moving on to Slide 8 and the income statement. I’d like to start with an overview of our results for the first half of 2023. As Jakob has said, we have two key messages, which I will reiterate here.

Firstly, we have seen strong pricing, which has supported revenue growth in the half as well as some gross margin improvement. Secondly, reflecting the macroeconomic environment and impact on our volumes, PBT is down driven by the weaker volumes, cost inflation and by targeted investment, we have flagged previously to underpin our future growth programs. I’ll cover the detail here.

At the revenue level, we reported half year revenue of £162.2 million, up 1% on a strong prior year with revenue down 5% on a constant currency basis. It is worth remembering that a number of our markets were very strong in the prior year, value-added resellers, Electronics and Energy and Industrial, particularly, each of these saw double-digit growth during FY ‘22.

VAR itself had a record quarters during Q2 and Q3 last year. We had already signaled that we expected some normalization in VAR. We did anticipate some bounce back after our first quarter, but this has not yet been to the level we were expecting. Whilst we did see pickup in monthly volumes from month-to-month in Q2, as we noted in our outlook statement, it doesn’t mean we need to see a further step-up in the latter parts of the second half, driven by macroeconomic improvement.

Gross profit increased by 2% to £86.7 million but was down 2% on a constant currency basis. This was after the impact of currency hedging where we reported a net loss of £6.2 million compared to a £1.7 million gain in H1 2022.

Remember that the loss on hedging shown within gross profit means a corresponding benefit within the revenue line. The higher cost of manufacture continued to impact us, though we have seen energy costs starting to ease. Raw material inflation remains in line with our assumptions. So gross margin pleasingly was slightly ahead on the year of 53.5% and up sequentially by 410 basis points compared to the second half of 2022.

In December, we indicated we will now show an FX hedge adjusted gross margin, which treats the hedging result within revenue. Pleasingly, this is close to our mid-term goal of a mid to high-50s gross margin at 55.5%.

For the year as a whole, we anticipate gross margin being ahead of the prior year and slightly improved on the first half. On the overhead’s line, we had already signaled an expected double-digit increase on a full year basis. Overhead growth is first half weighted this year, hence the 21% increase compared to the first half of 2022, which is 17% in constant currency, driven by specific items.

Firstly, the activity levels in the first half of 2022 was still depressed as a result of COVID restrictions with travel and trade shows, for example, returning this year.

Secondly, we are seeing an annualization of investments made during the second half of 2022, primarily in medical acceleration as we support scale-up and some excellent progress in both Trauma and knee.

Thirdly, in China, as we move towards commercial start-up later this year, we have had to ensure that we have the appropriate operational resource to staff the plant. Some of these costs will move to COGS when manufacturing commences.

Wage inflation of 5% average salary increase was the highest for some years and will impact the full year. We also put in place one-time cost of living payments for certain targeted grades and this was well received by our employees.

So overheads were up £7.7 million to £44.1 million. It’s worth noting that in the second half, we expect overheads to be similar to the first half and the year-on-year increase H2 on H2 will therefore be more modest. Whilst we will maintain targeted investment to support our growth programs, specifically medical and China, we are also focusing hard on where we can contain costs, noting the tougher trading environment this year.

Moving on, this results in underlying PBT of £42.5 million, which is down 12% on the prior year. Reported PBT of £39.1 million is after exceptional items of £3.4 million. Remember, this is year two for our ERP investment and accounting rules dictate we have to expense this. We expect a total investment of up to £20 million over a three-year period.

Our effective tax rate of 14.9% was in line with our expected long-run average of 12% to 15%, which has increased slightly from 10% to 13% to reflect the changes in UK corporation tax rates. We also continue to benefit from the lower rate available through the UK government’s patent box scheme, with the patents in place since 2017.

Earnings per share was also down 12% to 41.9 pence per share on an underlying basis and by 11% to 38.8 pence per share on a reported basis.

Finally, a brief word on our dividend. The Board has noted the growing commercialization within our long-term growth programs and our Mega programs, where we have also balanced the more muted macroeconomic environment. We are, therefore, pleased to recommend an interim dividend of 13.42 pence per share equal to the prior year.

Turning to Slide 9 and the underlying year-on-year PBT movements. Unfortunately, after a strong first half in 2022, we can see the effect of the macroeconomic environment on volumes in the first half, impacting PBT by some £3.1 million, even though sales mix was improved. Automotive, aerospace and medical, all group. I’ll come on to this in a later slide.

Pleasingly, price increases came through strongly during the half. And remember, we have sharpened our focus on price to include surcharge pricing alongside structural price increases. Price contributed £5.7 million.

On cost inflation, remember, we started the year with guidance of an approximately £20 million year-on-year impact in the P&L from higher energy costs and raw materials. Energy costs have eased somewhat from that peak, and we should see that to start to flow through the P&L in H2. Year-on-year COGS inflation is now expected to be less than £10 million subject to continued lower energy prices.

Targeted investments, including the impact of annualization of those started in FY ‘22, totaled £4.4 million. As I’ve said, this is primarily in medical and to support the Chinese start up. Currency was supportive in the first half with a benefit to PBT of £2.7 million after the impact of hedging. This resulted in underlying PBT of £42.5 million.

Moving to Slide 10. Our H1 average selling price was £83.60 per kilogram, some 18% better than last year as we saw price increases kicking in, and we saw improved sales mix as well as the benefit of currency. It’s worth noting that the significant majority of pricing benefit has been from structural price increases. And whilst we have implemented surcharge pricing based on energy costs with a number of customers, we now expect the contribution of that to be much lower given lower energy prices.

A brief word on ASP guidance. We started the year with guidance of around £80 per kilogram. We’ve exceeded that in the first half, but with some of the softer and lower-priced industrial end markets are expected to tick up later in the year. That £84 per kilogram is likely to edge down slightly, but we’re still comfortable of being at or just above £80 for the full year.

Turning to gross margin. This slide shows the reported gross margin of 53.5%, up both on a year-on-year basis and up 410 basis points sequentially. The FX hedge adjusted gross margin was 55.5%, and this is despite lower volumes through the plant versus H1 ‘22 and higher energy and raw material costs.

So clearly, we are seeing some recovery from trough levels. It’s worth noting that China will become a drag on gross margin next year once commercialization starts as it needs time to ramp up. And inflation is still impacting us as it is most manufacturing companies even if energy costs have been easing from their peaks.

Moving to Slide 11 and the margin bridge, including the FX of currency. This chart is intended to show how gross margin has been impacted by inflation despite the progress on price increases over the past year.

Starting from H1 2022 with a gross margin of 53.1%, we saw a 1.7% impact to gross margin from cost inflation and a 2.4% impact from currency. This led to the margins of 49.4% in the second half of 2022. In H1 2023, we’re pleased to see that price and mix have merged up gross margin by 3.3%. Inflation is starting to ease from our assumptions, even if it is still present. Currency also supported gross margin by 1.5 percentage points, taking H1 ‘23 gross margin to 53.5%.

As I said earlier, the FX hedge adjusted gross margin is arguably a better indicator with improvement to 55.5%. We continue to see an opportunity to improve gross margin over the medium term. based on operating efficiency, continuing progress on inflation recovery and sales mix, with the start-up of China will slightly hold back progress from FY ‘24.

We would also note that our polymer and parts strategy is focused on absolute profit growth rather than solely on gross margin and of course, on improving return on capital closer to 20%.

Moving to Slide 12. We will cover currency. The impact of currency hedging is shown on the face of the P&L in line with IFRS 9, noting that the offsetting currency impacts on underlying trading are embedded in the other lines most significantly revenue. We saw a £2.7 million tailwind at PBT level during H1 2023. This was largely the impact of the weakening sterling in the prior year.

The loss on forward contracts was £6.2 million compared to a £1.7 million gain in H1 ‘22. As we all know, sterling depreciated against the U.S. dollar quite materially during the second half of 2022. Our effective rate was 1.38 for FY ‘22. This includes the effect of hedging. In H1 ‘23, this effective rate moved to 1.28 against the U.S. dollar, creating the FX tailwind.

Against the euro, the effective rate was 1.17, slightly worse than FY ‘22 at 1.14. So guidance for the year is unchanged. It’s approximately £4 million to £6 million tailwind at PBT.

If we look forward into FY ‘24 at this early stage, given the depreciation of sterling and the current effective rate of around 1.29 and 1.16 against the dollar and euro, respectively, our guidance at this stage is for a currency tailwind similar to FY ‘23, mid-single-digit millions of pounds, though changes in FX rates between now and the end of the year can still change this significantly.

Turning to Slide 13 and CapEx. Total CapEx was £22.2 million, slightly lower than the prior year of £26.7 million. Around half of this is to support our China assets and capability with the remainder on Mega programs and maintenance CapEx. This new facility in Panjin is in commissioning with the aim of commercial production later in 2023. It is worth mentioning again the strategic rationale for China.

Firstly, it is China for China, it is extending our portfolio of PEEK rates. We’re working with existing and new customers in China supporting incremental business. It is also supporting a range of end markets, primarily in industrial and building on our strength in China. We have already seen – we already have a strong sales presence and a technical center in Shanghai. The investment in a new PEEK facility in China is building on this.

Finally, CapEx guidance is unchanged for FY ‘23, it’s around £45 million. We should then see this step down slightly to around 8% to 10% of revenue, but noting that it will be above historic levels due to proposed ESG investment built into our mid-term CapEx plan. How we can change our processes as we seek to offer the least carbon intensive PEEK in the world.

Turning briefly to Slide 14 and cash flow. Clearly, the weaker trading environment has impacted us here alongside higher working capital. Firstly, our working capital movement of £32.7 million was driven by inventory increasing to £117 million from cost inflation, recovery of inventory from lower levels following the pandemic and strong demand last year and to reflect finished goods stock build to manage the UK asset improvement program where we will see plant shutdowns this year. Inventory is expected to remain at a similar level through the rest of FY ‘23.

We do see an opportunity to unwind inventory from levels above £100 million once we have started to see a ramp-up in China and once our UK asset improvement program is completed. On inventory specifically, the balance sheet is shown in the appendix of the presentation on Slide 33. This increase in working capital drove operating cash flow to be negative £1.8 million compared to operating cash flow of £10.9 million in the prior year.

Looking at the other major items impacting cash flow. Total dividends paid of £40.1 million was the final FY ‘22 dividend. This was a lower cash outflow than the prior year of £83.5 million, which included both the final and special dividends from FY ‘21 paid during H1 ‘22.

Taxation was £5.6 million paid in the prior year compared to a £3.9 million receipt in H1 ‘23 as a result of refunds of payments on account. As a result, the net cash outflow was £29.5 million versus £67 million in the prior year, the difference being primarily the higher dividend payments.

From a closing cash position of £68.8 million in FY ‘22, we saw net cash at the half of £38.4 million, which includes £4 million of cash ring-fenced in China as part of our investment program. Remember that FY ‘23 will be a high CapEx year and a year of higher working capital before we can start to reduce both CapEx and working capital over the next couple of years to support improved cash flow.

Finally, a brief word on the uses of cash. Growth investment remains the priority, and we continue to review some interesting opportunities, particularly on the medical side. On shareholder returns, we did engage with shareholders during the half and have now added to share buybacks as an option alongside special dividends.

We are not announcing any share buyback here, but it is worth noting that any buyback is likely to be modest up to £25 million, reflecting the liquidity of Victrex shares. Buybacks may therefore be used for smaller sums of cash with special dividends driven by cash at a level consistent with paying a 50 pence per share minimum special dividend.

With that, I say thank you, and I’ll hand back to Jakob.

[Jakob Sigurdsson, Chief Executive Officer]

Thank you, Ian. If we move on to Slide 16, turning to business performance in more detail.

Firstly, on Medical. We’ve seen a record half year performance with revenue up 17% and 6% in constant currency, with strong growth in all regions in Asia, in particular. This is not just the pent-up demand that I’ve talked about previously. We’re also seeing continued diversification of our medical business with emerging and developing applications as PEEK’s strong truckload and application users continue to grow.

I also want to cover separately our Mega program progress. This is an area where we continue to support our customer scale up. For example, we opened a new product development center in Leeds earlier this year, which is a key part of supporting customers in trauma and knee specifically, with design and development of their specific offerings.

We are starting to reap the rewards of these investments. And to remind everyone that we do see the opportunity for medical to be over 30% of revenues over the next 5 to 10 years from around 20% of revenues at the half year stage, driven by core business growth and the potential game-changing opportunities in both trauma and knee.

If you go back a few years, the question was repeatedly asked whether we could diversify enough into medical business, which have opportunities both in spine and non-spine. And that we are now proving that we’re doing that. Non-Spine is now 52% of the medical revenues and progress is made in a number of areas in CMF, skull plates using PEEK will support better brain function are using metal plates. It’s now getting close to 10 million business alone with sort of potential in Asia and the U.S.

Arthroscopy as well is growing double digits and so is cardiovascular applications. And we have some more emerging business in both drug delivery and active implantables, which I will come to on the next slide.

So on Slide 17, with over 15 million patient implants, we know that PEEK has a strong track record in spine and increasingly in other application areas within medical clinical data and the usage of PEEK in the body is already strong and rapidly growing. The higher-profile Mega programs, we’re also getting good traction in more knees application. And this slide has some great examples to that effect.

In cardio, PEEK is used in the impeller within heart pumps. It brings its inert nature, durability, strength and biocompatibility into play. So we now have seen 250,000 heart pumps using PEEK. And in the total artificial heart, which has much more PEEK content, we saw last year over 300 patients globally being treated with this solution using PEEK rather than metal.

PEEK is also seeing growing uses in drug delivery devices and in active implantables. On the slide here, we have an insulin pump which required a durable and biocompatible solution, which is precisely what the PEEK brings. Relatively small revenues right now, but in post-COVID world, where we were care at home and self-care is becoming more important. These smart devices are growing in importance.

If we move on to Slide 18, I want to talk about Trauma. Here, we see great progress, and we’re on track for revenue of greater than £1 million during the year, which we expect to build into mid-single-digit revenues over the next 18 months. Remember that the proposition in Trauma is all about enhanced union rates compared to titanium-based plates. With Victrex PEEK, union rates are significantly better than titanium. So there’s a clear problem to solve here and PEEK seems to have a perfect fit to help in better patient outcomes.

In the partnership with In2Bones, where Victrex mix the plates in the UK, that is going from strength to strength, and we’re seeing demand exceeding initial expectations by a factor of 5 as we had – as we navigate 2023. Already, we see more than 200 implants using PEEK-OPTIMA also reinforced. Remember, this is composite technology, which we have invested in and built significant IP on over several years now. The slide also has a great quote from In2Bones CEO, Alan Taylor, with emphasizes how PEEK composite trauma plates are starting to take hold commercially.

I’m also pleased to announce that we have signed an agreement with Paragon Medical, a leading global contract manufacturer, which will support global scale up for us as well. This will be based on RRP and technology, but it means that we don’t have to put additional capital down in every region. And we will get our support from a world-class contract manufacturing organization to deliver on scale and up pace.

If we move now on to Slide 19 and knee. We’re seeing really strong progress in the Maxx clinical trial, 35 patients already been implanted, 10 already having passed the 15 months post and two already passed two years without any intervention. We’re also collaborating with Aesculap, a part of the B Braun Group, which is a top five knee company, and interest from others in this space is growing.

So we’re now at a stage where we can start to look ahead and consider what our manufacturing scale could look like. One of the reasons we invested in a lease facility, for sure.

Maxx could have a commercial need from 2025 and Aesculap potentially a year later. Aesculap have already been conducting trials with robust for several years right now with really, really encouraging results. Remember, the opportunity for knee is around 1 billion of addressable market for PEEK-based implants.

With one in five patients unhappy with the metal-based knee replacement today, is a significant problem to solve. The main benefits are clearly the potential for reduced bone loss, but more importantly, for metal-free alternatives and solutions. There are additional benefits associated with both weight and thermal conductivity, but the other two are probably the main clinical factors that will drive adoption.

So we’re really pleased with the progress here. The clinical trial is a safety trial. We can now start to consider the manufacturing pathway remembering that the IP and manufacture know-how sits within Victrex.

On Slide 20 on medical acceleration, a brief word. Last year, we talked about how we see the opportunity to increase the share of medical within group revenues to support this. We have identified investment to support scale-up of our game-changing opportunities, particularly in Trauma and Knee. What this slide aims to show is that our customer push with admittedly, it has been for a long, long time, is now turning into more of a customer pool. We’ve signed to larger customers and others who are engaging with us, and they are now starting to put their investment into it as well.

Whilst this is referring to medical, we could also say that for other Mega programs, for example, Technip and Magma program made a sizable investment to buy Magma and as well to invest in a new Brazilian facility. So customer pool is increasing across all our opportunities, which is the ultimate sign of commercialization and adoption of the projects that we have been working on for such a long time.

Now moving on to Slide 21 for industrial update. Overall, the macroeconomic environment impacted us in several of our main volume end markets, but some good progress too and we’re well placed to recovery with a strong pricing, improving margin and opportunity to rebuild volume beyond last year’s record. If I start with automotive, 1% volume growth in a recovering end market. The recovery has been steady, although we see a greater opportunity in the second half.

Remember that auto is an area we were not anywhere near the total of 95 million, approximately 1 million passenger cars built in 2018, the market dropped as low as approximately 75 million cars during 2020. It is on a slow road to recovery, but there’s still a lot to go after if we’re going to – or when we will reach the heights of 2018.

Forecast car build is set to grow this year to around 84 million cars, but there is clearly still pent-up demand out there as evidenced by long backlog for new vehicles. Our progress in diversifying our business continues in mobility, which I will come on to shortly.

On aerospace, I was lucky enough to be out of the JEC composite recently in Paris meeting customers and collaborators and we’re having some great conversations there, but not just conversation. We’re seeing increased playing build help us recover in aero. We know that airports, for example, saw 8% increase in deliveries in last year earnings update and Boeing up 41%, all this from a lower base. And our range of application is increasing to 9% volume growth, but 19% revenue growth with our composite business and full business going particularly well.

AE250, our low-melt PEEK rate either as a polymer or tape is now well established and accepted within the industry. And it was demonstrated in parts of various sizes and forms by over 35 parties at this largest composite share show in the world.

Last year, we talked about the demonstrator for Airbus’s Clean Sky 2 program. I’m pleased to say that the 10x key content opportunity is something we’re broadening with our tier and OEM companies as we further develop opportunities and leads with in this business based on our unique AE250 technology.

Moving to Energy & Industrial. Volumes down 21% as capital expenditure in this area was weighing back. Energy fared better, down only 6%, but clearly tough right now in general industrial. Fortunately, we’re able to continue developing new uses for PEEK through new application areas, and I will cover these on the next slide.

Electronics, we – you know that this area has been tougher lately and volumes were down 13% against a strong period last year. Semicon fab spending is forecast to be down 16% versus last year, all but with a strong rebound in 2024 of 21%. In smart devices, the latest forecast suggests a decline of 4% versus 2022 according to Gartner. But we are well placed in both of these areas.

In semicon, Victrex has a play both in the fab process and also in OpEx spending in smart devices, our film business is well placed for continued innovation, smaller, smarter and higher performing devices.

On value-added resellers, remember that last year was a record in value-added resellers, particularly in the first half, so already a tough comparative. Volumes are down 21% or about 200 tonnes, which explains a large part of the volume drop half year on half year. We had already signaled that we expected some normalization this year. But it’s clear that the industry is dealing with a major bullwhip effect affecting demand in both compounders and stock ships.

Unfortunately, volumes have been softer than anticipated, but we have a long-standing relationship with our customers and a greater insight into their order patterns than ever. So we are well placed for when volumes return, and we do expect to see some improvement later in the second half.

Moving on to Slide 22 and emerging applications. Just a quick word on some examples where PEEK continues to develop in Knees applications. On renewables, we’re seeing some business coming through in very specific renewables business in wind. PEEK is a good play here in harsh environments compared to metal where metal fatigue and cause cracking on certain applications. And in robotics, it’s an era – area we have touched on before and is now starting to see some progress in new business as durability and reduced noise vibration requirements are starting to increase.

Turning to Slide 23 on e-mobility. Very pleasing progress here. Remember that we are focused on the next generation of batteries and motors, 800 wells to be specific where the range and performance requirements are higher. Our XPI polymer is used to cold wires on very tightly wound wire for e-motors. We’ve been winning new business in this area, infill and in polymer.

We’ve been working with several of the major wire coaters and the car manufacturers to progress our PEEK solutions with of a processability and sustainability benefit beyond the performance requirements alone. The good news here is that we’re on track for more than £3 million revenues this year in these Mega programs and expect to build it rapidly from here onwards.

Slide 24 on Magma. Remember that TechnipFMC acquired the Magma Global business back in 2021. And this is another example of a major OEM investing their money to deliver that technology to the market and thereby demonstrating the customer full approach. Victrex is entwined the opportunity for Magma going forward. The exclusion of pipe is our know-how. We supply the peak polymer and the composite tape.

The big price is Brazil and TechnipFMC have submitted bids for offshore packages there. We continue to support them ahead of the outcome, which could be material for Victrex with an estimated 8 tonnes of PEEK per kilometer of pipe assumed across an 8- to 10-year time frame in multiple fields.

During 2023, we will see some sample manufacturing. And it’s worth noting that TechnipFMC have engaged with us at the board level several times in the past year. So a strong relationship to ensure preparedness [Technical Difficulty]

[Martin Court, Chief Commercial Officer]

I think we may have lost Jakob on the call. You still there, Jakob? I think – we’ll apologies, everybody. I think we’ll carry on from the Magma slide, just going to turn to it. Okay. So we cover the e-mobility which was on Aerospace. So Magma, I think we covered the Magma slide.

So the next slide is Slide 27, which is the bar chart in terms of the Mega programs and talking about the pathway to £10 million. There is a bubble time in the appendix as well for those who need it.

In terms of the progress here, just in terms of just the sort of movers on this slide. So what I want to show here is the next step on the journey to £10 million. Aside from Knee, which is making good progress in clinical trials, remember that all the Mega programs have technical and commercial feasibility now. So this shows the pathway. There is a slide in the appendix as well, which talks about the actual milestones that’s on – in the appendix slide. So I think that was the main body of the presentation. We’ll probably just turn to the end market outlook on Slide 28.

Ian, do you want to talk on the outlook in terms of the end markets?

[Ian Melling, Chief Financial Officer]

Sure. With the pent-up demand and performance not yet back at pre-COVID levels, we are optimistic on aerospace with build rates scheduled to gradually increase through the next 12 months. We’re also optimistic on medical with surgery rates still below pre-COVID levels in many regions. The impact of further lockdowns in China has continued to impact surgeries there. We’re neutral on electronics, energy and automotive.

Electronics, we note that WSTS forecast a 4% decline in semicon shipments in 2023, though Asia is dragging the overall picture down. Energy, whilst we’re still – whilst it’s still quite buoyant now, we do note that rig count increases have slowed. For example, Canada rig count was down to two in the last month, and the U.S. has been relatively flat month-on-month.

We also know that in the industrial part of Energy and Industrial or what we call manufacturing and engineering, we may see signs of CapEx being rained back. Automotive is a tough one to call, all whilst the IHS data suggests growth in both car production to 85 million cars and in sales to £83 million, we still need to see further signs of that backlog coming through.

Finally, in VARs, as we signaled earlier, we’ve seen some signs of normalization in the current quarter nothing drastic, but certainly not to the run rates we have been seeing. We had a record Q3 2022 with 700 tonnes of VAR and a record year of 2,122 tonnes in the prior year. So we remain cautious on VARs at this early stage.

So to sum up, I really – Sorry.

[Martin Court, Chief Commercial Officer]

I think we’re ready for – to move to Q&A. Andrew?

[Andrew Hanson, Investor Relations Director]

Yes. I think if we hand over to Q&A. Alesia, could be back on the call.

[Martin Court, Chief Commercial Officer]

Operator, can you hear us?

[Operator]

Yes, sir. Thank you very much. We will shortly begin the question-and-answer session. [Operator Instructions] The first question is from Chetan Udeshi of JPMorgan. Please go ahead.

[Chetan Udeshi, JPMorgan]

Hi, morning. A couple of questions from my side, I was just looking at the numbers that you guys printed for automotive and aerospace volume recovery. No, if I look at the IHS data, it seems to suggest that the automotive volume production recovery is clearly stronger, and we’ve also seen the aerospace volumes getting stronger through last two quarters.

I’m just curious, especially given Victrex’s exposure is more to the European auto market where we’ve actually seen quite a good recovery in Q1 in terms of production for autos.. Why are the volumes for Victrex in auto and aerospace still so low when we think about versus the end market, which seems to be clearly recovering faster?

And the second question – I’m sorry, but this may be a bit of a tough question, but I think it’s worth putting through. This is something in the same sort of let’s say, just that I’ve been asking in the previous quarters as well, but your CapEx is up, it’s almost doubled versus pre-COVID. Your OpEx is up 25% versus pre-COVID and the earnings are lagging more than 10% versus pre-COVID.

When is this divergence going to end at Victrex? Next year, a year after? Clearly, I think we all can see the progress on midterm pipeline. But at some point, I guess we all have to see it in numbers. And I guess that’s where the key debate is on the stock. When do we see that? And if we don’t see that, what is the plan B from management team. Thank you.

[Jakob Sigurdsson, Chief Executive Officer]

So Chetan, I think I’m back. Can you hear me?

[Jakob Sigurdsson, Chief Executive Officer]

Yes, we can.

[Jakob Sigurdsson, Chief Executive Officer]

So I’m happy to take the second one. I didn’t hear the first one. So either my colleagues will take that one or you’ll have to repeat it. But anyway, my apologies for dropping off. Something happened at my end from a technology perspective. But when is it going to pay dividend? that’s your question effectively, Chetan.

And if you look at it, we have and not just us, but a number of industries going through a series of Black Swan events in recent years. We’ve been dealing with COVID, we’ve been navigating chip shortages, and then the last Black Swan that appeared was the Ukrainian atrocities. And that has had a huge impact on businesses large disruptions to supply chains, big shifts in demand patterns accompanied with various kinds of bullwhips that I think we’re seeing actually going through some of our key customers right now.

Through all of this, we have maintained our vision of preparing ourselves for the growth that we believe is residing and the growth opportunities that are resided within Victrex. And we’ve continued to invest both in hardware, naming capacity expansions at Hillhouse with incremental investments, the opportunities that we are now seeing coming through in China, opening up the polymer plant later this year in a compounding plant, but also making sure that from a design perspective, we are in a position to meet the specific requirements on the behalf of customers, which clearly show up on the SG&A line as well.

So to answer your question, I don’t think anybody is expecting this demand trough to be with us forever. And if we look at historical recessions, you will see them last anywhere from between six to nine months. And I think we have a reasonable belief that we could start to see improvement towards the end of the year. But that’s important to keep in mind then that at that point in time, we are really, really well positioned to take advantage of what usually is a very sharp uptick in demand at Victrex when demand returns.

So we are well prepared from that, both as it relates to our assets and also as it relates to our inventories. And on top of that, we’ll be coming off a high CapEx cycle that has allowed us to prepare for the future and essentially taking care of all the major investments that we need to support the business for the next five years or so. So if you keep that in mind, I think you see a recipe for strong translation towards the bottom line, particularly when you consider the fact that some of our Mega programs will start to contribute at or about that time.

So as we head into ‘24 and onwards, and that’s where I’m specifically referring to Trauma where we’re seeing rapid adoption, and we’re going to – and we are running as hard as we can right now just to keep up with demand and scaling it up. And that’s why we announced the partnership that we announced today with Paragon as an example, to be able to meet those events on scale and at pace.

And secondly, on e-mobility, as I referred to in my introduction, seeing great progress, both in terms of wire coatings and various other applications associated with the trend moving towards 800 wells.

And thirdly, I would point to Magma, where we should be seeing some news flow as we head through this year where Technip is putting their money where their mouth is and investing in facilities in Brazil. And that’s where we will benefit from both selling PEEK and carbon – and to ultimately make the pipe.

So a short summary, I think you’re hearing all the elements of a very, very strong performance as we head out of this current demand trough. And that’s what we’re very much preparing the ship for.

[Martin Court, Chief Commercial Officer]

Chetan, maybe I’ll take the first question. So on automotive and aerospace we are showing increases over the year. But already, I think Jakob mentioned in his commentary that we’re seeing growth in those two spaces. We expect that to continue as the market continues to recover through the rest of the year. I think the results are impacted more by the offset of electronics and VARs there that Jakob talked about. So we are seeing good growth in automotive and particularly as we look in this transition in the automotive space between ICE and e-vehicles, then we are seeing growth in both products of that portfolio and continue to push there.

On aerospace, then there’s been clearly a different level of recovery in the European build and the U.S. build, but we’re now trying to increase activity in both of the primary players in airframe and we’d expect that to continue to grow for the rest of the year.

[Chetan Udeshi, JPMorgan]

Thank you.

[Martin Court, Chief Commercial Officer]

Did I answer your question Chetan?

[Operator]

Thank you. The next question is from Alex Stewart of Barclays. Please go ahead.

[Alex Stewart, Barclays]

Hello. Hi there. I think you said that the ASP guidance full year was about £80 per kilo, which is roughly what you guided to before. So in the first half, you delivered £84 a kilo, which is much better than you were expecting, but you’re not changing your full year guidance. So implicitly, that means the second half must be 76%, 78% depending on where volumes come out per pounds per kilo.

So my question really is, why are you expecting a lower second half ASP than before, even after delivering a higher ASP than expected in the first half? I know you talked about mix and all the rest of it, but with ASP down that much half-on-half, it looks like it would seriously impinge on your absolute gross profit in the second half too. So I just don’t understand why the second half implied ASP guidance has been cut. If you could talk through that, maybe I got your guidance wrong on the £80, but that seems to be what you’re saying. Thanks.

[Ian Melling, Chief Financial Officer]

Alex, we’re not cutting our ASP guidance, just to be clear. We are still guiding to an ASP, I think we said to slightly above £80, whereas at the start of the year, I think we were saying we could get to around £80. So I think our guidance has improved slightly. We are being a little bit cautious I think, and the main reason for that would be mix.

So clearly, depending on the strength of recovery in the VARs, which, as you know, are our lowest priced customers then that will impact the mix. We had a strong mix with Medical in the first half. We expect Medical to continue to be strong. But clearly, the volumes involved with VARs and much larger potentially and will have an impact on the overall ASP.

So we expect to continue to see positive price. Currency should still be supportive if it stays where it is now. And we should see a slightly higher ASP for the full year than what we guided at the start.

[Alex Stewart, Barclays]

But sorry, just to go back on this. I appreciate you’re not changing the full year ASP guidance materially. But given that you exceeded the guidance in the first half, it necessarily implies quite a big step down on half-on-half in the second half and therefore below what you were previously guiding to in the second half. So I’m talking more about the second half implied guidance involved in the full year guidance.

[Ian Melling, Chief Financial Officer]

And I think, as I said, Alex, I think that will come down to mix. And we do – we have been weaker than we were hoping for in the first half, and that has buoyed our ASP, if you like, so weaker in the VARs area. So as VARs comes back and becomes a higher percentage of the total, that will reduce our ASP in the second half.

Now where that comes out exactly will depend on where that mix is. But everything else, I think, is headed in the right direction. So could we exceed £80. Yes, we’ve said we can exceed £80. But I would expect when VARs returns, that will reduce our ASP from where it is currently.

[Alex Stewart, Barclays]

Okay. That’s helpful. And then just a quick follow-up. If I look at the other chemical companies in Europe, they’re using price to offset both COGS inflation and fixed cost inflation. You are showing decent progress offsetting COGS inflation. But over the last couple of years, you’ve had double-digit million increases in your corporate costs, which appear not to be passed through.

So for a company that makes a product that’s highly valued and highly profitable, how is it that are the chemical companies able to offset fixed cost inflation through pricing and you’re struggling to do so to protect the bottom line. I’d be really interested in your thoughts on that? Thank you.

[Jakob Sigurdsson, Chief Executive Officer]

I think we have made really, really good progress. I’ve seen in the numbers during the year for sure. But we also have to keep in mind that we are not in the commodity chemicals business, which allows you to push through prices on an index wide basis. Clearly, we’re also making investment in future opportunities that impact the SG&A line. And we also have to consider the fact that even if we may be quite impacted by energy cost, and significantly so the global competition may not be. So you always have to keep this all in the balance.

I think we’ve shown our ability to recover price, particularly in the last six months or so, six to nine months or so. And I think we’ve also built into our pricing contracts, a mechanism whereby we can react faster in the future when input costs rise of a sudden magnitude and in a certain pace, I think we’re much better equipped to deal with price increases right now.

And I would also say that as pleased as we are with the progress on the pricing front year-to-date, this is a dynamic game that might require us to go further out as time passes. But it’s a complex equation here, and we’re not operating in a commodity environment whereby we push through prices based on an index mechanism.

[Martin Court, Chief Commercial Officer]

And Alex, maybe I can add as well, going back to one of Chetan’s point that for some of these mega programs, we’re getting so close to the inflection point now that we need to make sure we got the appropriate resources to be able to deliver that. So we don’t disappoint our customers after all the effort we’ve got to acquire them. So there is a cost load there, which comes before we get the benefit from that.

[Alex Stewart, Barclays]

Thank you.

[Operator]

The next question is from Andrew Stott of UBS. Please go ahead.

[Andrew Stott, UBS]

Yes. Thanks. Good morning, everybody. First of all, best wishes to you, Martin, in your future. On to my questions. So number one, the CapEx to sales guidance for the mid-term of £8 million to £10 million. If I take the midpoint, so about 200 basis points higher than the pre-China investment ratio, can you remind me what’s behind that increase? I think it says on one of the slides ESG related. So can you just walk me through why your CapEx intensity is effectively going up? That’s question one.

Question two is a bit more straightforward. I think it’s my lack of understanding of accounting here. Medical gross margin down 890 basis points, primarily reflecting currency is the statement in the release. Can you just remind me, Ian, what it is that’s going on with hedging there and why the gross margin is impacted so heavily? Thank you.

[Ian Melling, Chief Financial Officer]

Yes, sure. So let’s start with the CapEx point in particular. So with CapEx, the extra allowance kind of the higher rate than you’d have seen historically in this business is, I think twofold, but one is making sure that we keep our assets up to date and keep invested in our assets to a point where we can drive the most out of them and be as efficient as we can from a capacity point of view.

And the other big piece that we’ve talked about is ESG investment. So we do see, as we go forward, the opportunities to improve our assets from an environmental thought print point of view, and we’re still working through the plans for that. But we do envisage to spend some capital to potentially change sources of energy for some of our clients, for example, moving to electric rather than gas where we can source renewable electricity and that comes with the conversion cost, if you like, that we’re building into CapEx. So more to come on that in the future, but that’s why we’re being a little more cautious than what we saw historically from a CapEx point of view.

In terms of the medical gross margin. So I think what you’re seeing here is you’re seeing the gross profit effectively being hedged by the absolute gross profit effectively being hedged by our currency hedges. So we’re not seeing extra gross profit. But meanwhile, the revenue number is accelerated by currency and a higher proportion of our medical sales are in U.S. dollars than in the rest of our business. So the revenue accelerates, the gross profit – the impact on gross profit is delayed by the hedges. So what you effectively see in the short term is you see a lower gross margin.

[Andrew Stott, UBS]

Okay. So it’s the timing effect?

[Ian Melling, Chief Financial Officer]

To some extent, it’s a timing effect because the hedges effectively hedge the gross profit, absolute number. But as you hedge the gross profit number, the revenue moves with the spot currency, if you like. And so the gross profit takes time to catch up and in the scenario we’re seeing here, you see the gross profit deteriorate in the short-term as the revenue increases and the gross profit as I say.

[Andrew Stott, UBS]

Yes. Thanks, Ian.

[Ian Melling, Chief Financial Officer]

You can see some of that in the adjusted gross margin, which is stronger, the FX adjusted gross margin.

[Operator]

The next question is from David Farrell of Jefferies. Please go ahead.

[David Farrell, Jefferies]

Yes, good morning. A few questions from me, please. Just going back into some of the end markets, the price to see energy volumes down 6% and also medical volumes down 4%, given kind of A, positive background for energy spending; and B, in Medical, you talked kind of very positively about it. So I was just wondering what’s going on there.

And then my second question, which may or may not be able to ask is, I think I saw that Petrobras sort of awarded another EPC contractor, a contract to deliver titanium rises as a way of addressing their corrosion problems. Is that in direct competition to what TechnipFMC is doing? And how certain can we be that contract comes through over the next couple of months? Thanks.

[Martin Court, Chief Commercial Officer]

I’ll start with the macro one maybe. So that contract wasn’t awarded. It’s for a very specific part of the riser architecture, which is not in competition with what TechnipFMC are bidding forward Petrobras, the solution would be way too heavy and also way too expensive or more broad application.

[David Farrell, Jefferies]

Okay. Thanks.

[Jakob Sigurdsson, Chief Executive Officer]

And on the energy side, I think we are seeing the impact here of delayed CapEx, to be honest, even the rig count has increased slightly. I think we’re seeing the impact here of reduced CapEx or maintenance on the energy side primarily. And as it delays for medical, under medical, we report medical implantable and medical that goes into other medical applications outside of the body, be it inhalers and/or other delivery devices that are outside of the body, and that’s primarily where the volume impact has been showing up. That’s clearly higher volume than the volume that goes into implantables. So that’s why we see the volume drop there even if we’ve seen a significant revenue growth for medical overall.

[David Farrell, Jefferies]

Okay. That’s clear. Thanks.

[Ian Melling, Chief Financial Officer]

Thank you, David.

[Operator]

The next question is from Kevin Fogarty of Numis. Please go ahead.

[Kevin Fogarty, Numis]

Hi there. Thank you for taking my question. First one, just a little bit more color on the medical side given what you’ve seen in terms of kind of volume and revenue progress. Is there anything out there that you’ve seen that might kind of derail that progress in the second half of the year, just sort of the commentary on that?

And just secondly, on energy costs. Is there any way of sort of calling out what you think this sort of potential tailwind might be in H2 given where energy prices are currently?

[Jakob Sigurdsson, Chief Executive Officer]

So on the medical side, the answer is no. I think we’re seeing good momentum in the business and our operating assumptions are that we will continue to see that momentum in the same direction for the remainder of the year.

[Ian Melling, Chief Financial Officer]

Yes. And just on energy costs specifically. So I think we said at the start of the year that we could see energy and raw material inflation in COGS being up to £20 million. That number is now significantly lower and is less than £10 million. Most of that reduction is energy and we should start to see that come through the P&L in the second half of this year. But bear in mind that we’re carrying quite a lot of inventory at the moment, and most of that energy cost is going into inventory.

So we’ll see the start of the reductions we saw in the later parts of the first half flow through in the second half. And then the benefit from the second half of this year will mainly come through the P&L in the next financial year.

[Kevin Fogarty, Numis]

Sure. Okay. So mainly a timing issue in terms of seeing that coming through. I get that. Okay. That’s great. Thanks for the clarity.

[Ian Melling, Chief Financial Officer]

Thanks, Kevin.

[Operator]

[Operator Instructions] The next question is from Matthew Yates of Bank of America. Please go ahead.

[Matthew Yates, Bank of America]

Hey, good morning, everyone. A couple of questions, if I can. Just the first one around inventory. I think you said earlier on the call, you are in a position to be ready to meet a demand recovery. But when you look at that inventory position, just how elevated is it? If we don’t see that demand coming back in the VAR channel soon, is there a risk here that you’re going to have to cut production run rates for a while?

And then the second question, on the Trauma business, the agreement you’ve announced today were Paragon on the toll manufacturing in China. Can you talk a bit about what that does to the economics of Trauma to say this agreement is designed to help you scale up the business, but how much you have to sort of pay a way by going down this partnership group? Thank you.

[Ian Melling, Chief Financial Officer]

Yes. Okay. So I’ll start on inventory. Thank you, Matthew. So we do have significant inventory, but we are going into a period of asset improvement in the UK, which will involve us shutting down some of our clients over the coming months that will probably run from the later part of this financial year into the first months of the next financial year, and that will allow us to burn through some of that revenue over that period. We don’t expect it to significantly move in terms of absolute value by the end of this year as we build up ahead of that – of those shutdowns and they start to burn it off in the last few months.

We do look at our production plans for next year. And clearly, some of that will depend on where the demand returns to. But as Jakob said, we’ve got a long history of strong recoveries from depressed periods in this business. So we are confident that volumes will return, and we will use that inventory in due course. We’ll talk more about our plans for next year and what our P&L looks like at the end of the year with our full year results.

[Martin Court, Chief Commercial Officer]

On the trauma question. When we looked pretty carefully at the way the value chain constructed there, and we believe that we’re definitely best served by having a toll manufacturer, particularly of the scale and the capability of Paragon. We recognize that while we bring lots of technology and lots of IP to this, we don’t bring a huge amount of parts manufacturing capability and in terms of automation and scale. So we think actually, we will be better served in terms of the returns we make on the business by partnering with somebody who can more rapidly automate than we can.

[Matthew Yates, Bank of America]

Thanks for taking the questions.

[Ian Melling, Chief Financial Officer]

Thanks, Matthew.

[Operator]

We don’t have further questions at this moment. That concludes the Q&A session. And I will now hand back to Jakob for closing remarks. Please go ahead, sir.

[Jakob Sigurdsson, Chief Executive Officer]

Yes, I think it’s worth putting this into perspective. It’s clear that we are going through a demand trough right now. And very much driven by the value-added resellers that are seeing a strong bullwhip effect going through their operations these days. We know that after such demands trough, we do recover quite sharply, and we are mindful of being prepared for that. And at the same time, clearly, obviously, using all the self-help that one would use to make sure that we deliver as good bottom line as we can.

But I think it’s really important to also take a look in two or three quarters into the future. So when we will be selling out of this, we will have a really, really well-invested business, as I said before, a business that has kept going and kept investing in future opportunities through at least sort of three tough cycles. And at the end of this trough, we’ll be very well positioned to meet demand as it returns back, but we’ll also start to reap some of the rewards of the longer-term investments like I referred to, such as in Trauma, in Magma and e-mobility as well.

At the same time, we will be coming into a period of much lower CapEx than we’ve seen in the past three years or so, with pricing at strong levels as well. I think this clearly will translate into a strong cash generation and returns from the business and growing returns from there onwards.

I think that – with the things that we have doing both in terms of infrastructure and talent, we are well placed and well positioned to meet the demands of the future to grow the business. And as I alluded to before, where many of our efforts, for instance, on the Mega programs have been characterized by what you could call almost an evangelical push for a long time, we’re now starting to see the signs of adoption and commercialization. And those signs are the facts that we’re starting to see blue chip OEMs lining up against each and every one of them and starting to devote their own resources to adopt our technology and our contributions into their own parts, forms, vehicles and equipment.

So I think that’s our stronger testimony to the program – the mega programs as one can have. And I do think it’s ever more important to keep that in mind as we’re going through a cyclical turn in the global economy that is clearly impacting our business in the short-term. Bottom line is we’re seeing prices at strong levels. Margins are improving.

As we sail out of this, we should expect continuation of that. And as I said, with the added leverage on the bottom line from volume growth, but clearly from contributions from the mega programs as well. And it’s important that we keep that in mind.

That being said, thanks for your excellent questions during the conversation. Apologies for dropping out there, technology betrayed me for a second, but I’m pretty sure that my colleagues covered it well in my absence. Thanks again. Take care.