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

Catalyst