Cube Report (19 July 2021) – Ultra Electronics puts up a strong defence

Cube Report (19 July 2021) – Ultra Electronics puts up a strong defence

Good morning, it’s Roland here with today’s Cube Report.

On my list for today are half-year results from FTSE 250 defence group and possible bid target Ultra Electronic Holdings (ULE). Ultra appears to be another good British business that’s attracted the attention of private equity, following on from FTSE 250 peer Morrisons.

Will this spate of bid interest be dampened down by higher valuations for UK stocks, or reduced expectations? We’ll have to wait and see.

I also plan to touch on a guidance upgrade from Synthomer. Apologies, I ran out of time to cover this.

One other quick note — today’s half-year results from recruiter SThree look strong. However, I covered the firm’s half-year update in June and today’s numbers don’t really seem to add much to this story. I’m not going to cover SThree today, but you can read my thoughts from June (which are unchanged) here.

Ultra Electronics Holdings

  • Stock data should display here.
Market cap £1.7bn
RNS Interim results
Writer disclosure No position

This FTSE 250 engineering group is primarily a tier 3 (sub-system) provider, which means it builds products that are typically used within larger systems/products. For example, Ultra produces de-icing systems for military aircraft, sonar buoys for naval use and various electronics and communications systems. The company also has civilian businesses in forensics (ballistic identification) and nuclear safety.

Ultra recently attracted bid interest from private equity group Advent, which already owns UK rival Cobham. Ultra’s response was fairly hostile, but Advent still has a few more days to make an offer before the Takeover Code deadline of 23 July.

In the meantime, Ultra appears to be putting up a strong defence. Today’s half-year results contain strong numbers and a bullish outlook for the business as a standalone enterprise.

Financial highlights: The company reports a record order book of £1,270m with improved margins and growing ROIC (return on invested capital). The dividend has been increased and the balance sheet is described as “strong”.

The financial highlights for the six months to 2 July 2021 do appear to support a bullish view:

  • Order book organic growth +14.3% to £1,270.2m
  • Revenue +4.7% to £404.5m
  • Underlying pre-tax profit +18% to £56.5m
  • Statutory pre-tax profit +55% to £46.2m
  • Interim dividend +5.2% to 16.2p per share
  • Net debt to EBITDA leverage cut from 1.2x to 0.65x
  • ROIC (return on invested capital) improved from 17.5% to 21.3%

The direction of travel appears to be positive, although I think it’s worth noting that using the firm’s preferred measure of underlying earnings, performance has yet to return to 2016 levels. Ultra Electronics is a turnaround situation, no doubt made harder by Covid-19 disruption.

Profitability is recovering, but revenue growth remains weak — I’ve listed the organic revenue figure above, which excludes currency impact and discontinued business. But on a statutory level, revenue fell by 2% to £404.5m during the first half.

Trading commentary/outlook: Chief executive Simon Pryce says that Ultra is targeting “above market growth and mid-teens margins”.

Mr Pryce says that improved resource allocation, operational performance and increased R&D spending are helping the business move towards these goals.

Defence spending in the core ‘five-eyes’ market (USA, UK, Canada, Australia & NZ) is said to be robust. Recent contract wins include a $52.7m deal for ORION radio equipment from the US Marines and a £31m UK MoD Sonobuoy order.

Underlying profit vs statutory profit: Before I go any further, I want to check the reconciliation between underlying and statutory profits. Clearly there are some big adjustments at work.

It turns out that there are several adjusting factors:

ULE 1H21 profit adjustments

(l-r 1H21, 1H20)

I can see the case for excluding fair value movements on derivatives and profits/losses from discontinued businesses.

However, I don’t agree with excluding amortisation of acquired intangibles. These charges are non-cash today, but they represent previous capital (cash) allocation decisions by management when acquisitions were made.

In my view, we don’t get a true view of a company’s profitability if we exclude these costs from its profits. This is especially true when calculating return on capital employed. How can ROCE be accurate if it excludes costs resulting from past capital employed?

Return on invested capital: Ultra Electronic’s management do not seem to share my view. The company’s measure of ROIC is calculated using underlying operating profit, i.e. excluding amortisation of acquired intangibles.

In my opinion, this is likely to present an inflated view of profitability.

For example, the company’s calculation of ROIC for the past 12 months is 21.3% — a pretty impressive figure.

I’ve recalculated this for the last 12 months, adding back in amortisation on acquired intangibles. My calculations give TTM ROIC of 19.6%. That’s still very good, but it is 8% lower than Ultra’s figure.

My view

Ultra Electronics is a company I’ve followed for a while and nearly bought on several occasions. It’s never quite made it to the top of my buy list, but I do have a broadly favourable impression of this business.

Although revenue was broadly flat (depending on how you measure it) during the first half of this year, broker forecasts suggest a return to growth in FY22, with continued margin expansion.

Despite my comments regarding profitability, the group does appear to offer a decent level of profitability, with double-digit ROCE and operating margins.

Ultra’s balance sheet also looks okay to me, with little debt. Cash generation seems good and Ultra’s dividend has not been cut since the payout was introduced in 1997. A strong record.

The main risk I can see is that the group’s business is heavily dependent on its relationships with the US Department of Defense (24% of revenue) and the UK MoD (7%). These are the company’s two largest customers. I’d imagine that any souring of these relationships might also impact its ability to work with tier one defence contractors like BAE Systems (also a major client).

Bid interest has lifted Ultra Electronics’ share price and the shares now trade on around 18 times FY21 forecast earnings, with a dividend yield of 2.5%. I’d say that is probably fair value for now.

Although I’m not inclined to buy at this level, I might be tempted if the shares pulled back towards the 2,000p level.

That’s all I’ve got time for today, thanks for reading.




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