Surface Transforms – Profound Transformation?
Surface Transforms (SCE) is an AIM listed micro-cap with a great story and an all-too predictable record of disappointment that is exemplified by their full-year 2019 forecast history:
Writer disclosure: long SCE.
The company manufactures ceramic disc brakes and has been trying to break into the enormous but cut-throat volume car market with products they claim are both superior and significantly cheaper than the competition.
In common with SCE’s motorsport origins, this has proven an expensive pastime with several fund raises since 2016:
Brokers with a sense of humour
Current broker forecasts are for continuing significant losses over the next two years followed by a small profit for the year ending December 2022.
Joint broker finnCapp’s research is available for free from their website and of course the reason they are able to do this is because it is paid for by their clients. Writing continually upbeat research while keeping a straight face must be hard work, but the research team at finnCap
As demonstrated by the earlier chart, the research team at joint broker finnCap have one of the harder gigs on AIM, and understandably they have developed a keen sense of humour. For example, after a June 2017 update with no redeeming features reporting that 4 of 5 programmes had been considerably set back, finnCap wrote, entirely deadpan, “In many ways, this update is disappointing.”, while slicing revenue forecasts in half fully two years out. Happily just a few weeks later their drinks were on finnCap’s Capital Markets division after they helped raise £3.5m in yet another placing.
While equity investors have been queued up to fund the company’s losses, lenders have apparently steered clear. It seems that not even Rishi Sunak would lend them money – in Surface Transform’s words:
The Company did apply for a government backed CBILS [coronavirus] loan but understands that historic trading performance renders the Company ineligible.
Yet, despite this history the share price is approaching 5-year highs and it is rated at 25x FY 2020 forecast sales. The company hardly constitutes a “hidden gem”.
Before I summarise why I think this company is nonetheless worth a look, let’s look in more detail at the last year or so.
A very mixed year
Just three weeks before their 31st May year-end, the company reported further delays, leading to revenues for the period being half of prior expectations. Expectations that had already been cut in half.
But two months later they announced the breakthrough investors had been waiting for:
Contract Award from German OEM 5
“Specifically, the selection is for Surface Transforms to be the sole supplier of the carbon ceramic brake disc option on one axle of a new edition of an existing well-known model of German OEM 5. The existing model already uses carbon ceramic discs as an option and therefore the forecast production volumes reflect this experience. The lifetime revenue on this specific car model contract is estimated to be approximately €11.8m commencing in October 2021. Annual revenue is estimated to be approximately €2.0m per year before tapering off during 2026…
This award is the culmination of fifteen years of technical innovation and shareholder support.”
The company was already looking cash constrained in March when coronavirus struck, and in any case this was the first time SCE had gone a whole year without a placing for quite a while. In April a further £2.4m was duly raised.
Then, as part of a move to calendar year reporting, SCE confirmed revenues for the 7 months to December 2019 of £1.5m, nearly triple the same months a year earlier, and higher than any earlier 12-month reporting period.
Reasons to be cheerful
finnCap has been at pains to point out that their FY2020 forecasts are “very conservative”, and with the company well funded for the next 12 months, now would appear to be the time to build long term confidence rather than exaggerate short-term prospects. Therefore it is reasonable to assume these will indeed be beaten.
It is notable that none of the revenue expected to be delayed has been added to FY2021’s unchanged forecasts, and so either every car manufacturer’s product schedule has slipped back by around 6 months, or FY2021 could pick up some of the remaining shortfall from FY2020. In any case, the forecasts appear to be better supported by established contracts than ever before.
Management have been buying, both in the recent 13p open offer and more recently in the market at up to 23p a share.
Still, the question remains, what are the fundamental reasons for SCE being so consistent in missing forecasts thus far and why would investors expect this to change in future?
The journey of an innovator from making sales to many small customers to a situation where the bulk of revenues come from far larger contracts with a few customers is rarely an easy one. Even the best run and most capable companies such as Beeks (BKS) have found it hard to break into the “big time”, significantly underestimating the extra time due diligence and implementation take with larger customers. However once the ball starts rolling the momentum can be considerable, with a snowball effect as each contract gives further confidence to other potential customers.
Often a “land and expand” strategy is described whereby initial contract wins lead to further work down the line, but with Surface Transforms there is potential for growth in even more dimensions:
- New OEMs (car manufacturers)
- New car platforms with existing OEMs
- New models on existing platforms
- Increased specification of ceramic brakes within a model.
Surface Transforms stands to benefit from the longest running trend in the automotive industry. The first in-car radios were available as an aftermarket purchase in the 1920s, after which OEMs started fitting them as a costly extra, before including them as standard in luxury models and quickly making them ubiquitous in the 1940s.
The same pattern of introduction has been seen repeatedly – taking the braking system, there has been a shift to disc brakes then ABS and now AEB (automatic emergency braking), each first debuting on top of the range models and/or as expensive options before becoming standard equipment. There is every reason to believe that ceramic brakes will be next.
Carbon ceramic brakes are cleaner, quieter, lighter and far longer lasting as well as more efficient. This makes them potentially applicable to all cars, yet their use has previously been limited by high pricing from a single supplier. Surface Transforms claims it is unique in having the technology to change that.
As detailed in their recent update, SCE will be providing an online presentation with the opportunity to ask questions on 24th July. In my view investors should be wary of getting too tied up in the story, focusing more on uncovering the detailed assumptions behind current forecasts and the risks inherent in them.
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