Chemring is primarily a defence group that currently focuses on countermeasures, counter IED, pyrotechnics and munitions.
These four areas take advantage of the company’s three core competencies of energetic material expertise, high product safety and reliability and high volume manufacture of explosive products.
They’ve managed to grow earnings and dividends in 9 out of the last 10 years and just as importantly, that growth has been consistent. The compound rate of earnings growth in the last decade is around 27% and nearer 40% in the last 5 years. Return on equity has averaged over 19% and return on capital employed is typically over 30%. Free cash flow has been generated in all of the last 8 years and capital expenditure has been just over half of total cash flow, leaving plenty of extra cash for dividends and more growth.
In a nutshell the company has been growing like crazy and is expected (by the company and analysts alike) to keep growing at a somewhat lesser pace for at least the next few years. Of course, we all like a bit of growth, but what about the price?
At 693 pence the price to earnings ratio is around 14 and the current earnings yield is 7%, which is just above the level of a basket of investment grade corporate bonds. That’s not great, but it’s not terrible either. The dividend yield is low at less than 2%, so that’s not fantastic, but with a historic growth rate of 27% it starts to look more acceptable. The PE is well below the price/earnings/growth ratio using historic growth, and it is also well below the level suggested by a proxy of a 15% discounted cash flow calculation (6.5 + ½ of growth). The current PE sits at its historic average which isn’t helpful, although that hasn’t stopped past investors earning fantastic returns.
In order for me to expect a decent return, Chemring is more reliant on future growth than any of my other holdings. If earnings stay close to where they are now for the next few years there seems little reason for the share price to increase and with a 2% dividend, that’s not much to look forward to.
On the assumption that the growth does continue in some form, if I project book value into the future growing at the rate of retained returns on equity (14%), add in dividends at the historic payout ratio (26% of earnings) and finally calculate the share price using average returns on equity (19%) and the average price to earnings ratio (14), I get a 5 year total return of 49%, while I’m typically looking for 100% as a ballpark. This low figure comes from the low growth rate of 14%, given by removing the dividend from the average return on equity of 19%. In Chemring’s case, they actually grew earnings by around 27%, so this projection comes out somewhat ‘pessimistic’. It also comes from calculating earnings at the 10 year average return on equity, which is 19%. More recently ROE has averaged 26%, so by assuming it will be 19% in the future I’m saying in this case that current earnings are abnormal and that for the next couple of years they will go down (and therefore in this projection I ‘expect’ the share price to be down for the first couple of years).
Projecting earnings growth using the actual historic growth rate (27%) and paying out the dividend at the historic rate and pricing the company at the historic PE, I get projected 5 year total return of 237%. Much better of course, but remember to take a quick cold shower as these are projections and nothing more.
So now that I have my projections, one of which is not good enough and one of which is very good indeed, what should I do? Perhaps take the middle road and say that total returns might be in the middle of 49 and 237, which is 143%. That’s a pretty good return and if I close my eyes and make a wish it might come true.
Now that I think Chemring might be able to give me the returns I’m after, what kind of events might happen to make things turn out less rosy then I expect?
The first thing is the current level of debt. With net debt at some £300 million, the company has a net gearing ratio of 95%, which is pretty high. It also means that interest is covered only 7 times, which is okay but not fantastic. More positive is debt to earnings, which is about 3 times, and my general guideline is no more than 5. So debt is a bit on the high side but not catastrophic.
What about risks to their markets? Looking at the last 3 years it’s obvious that the recession had no impact whatsoever, but that’s not so surprising when you consider that their major clients are governments. So what about US and UK spending cuts? That’s where it gets a bit more interesting. In simplified terms, it’s pretty easy for a government to make capital spending cuts in the military, you just don’t build any new aircraft carriers, or you make the army keep using the tanks they’ve already got rather than upgrading to some shiny new ones. On that basis it would hurt the tank manufacturer. But Chemring makes disposable products, things that get fired out of something to either blow something else up or to stop something else blowing you up. It’s easy to not buy new tanks but it’s not so easy to not buy new ammunition for those tanks. It’s probably even less easy to not buy the defensive countermeasures that stop the enemy killing your chaps inside those old tanks or the counter IED technologies that the company develops.Using that logic it seems that Chemring’s earnings may be relatively well insulated from any spending cuts.
Okay, what else? In the 2002 annual report earnings fell from 5p to 2p, which was the last time earnings didn’t grow. Why? Sadly, a worker was killed in Kilgore, Tennessee, in an incident in April 2001. This seems to have led to the rebuilding of the whole plant at significant cost, although by 2004 much of those costs had been recouped through insurance. The negative growth in this case was an infrequent, one off survivable catastrophe.
I’ll try not to get too excited though as Chemring does not have a low cost durable competitive advantage. They probably do have some advantages in expertise and management and organisation, but these are grist for the mill of capitalism. The nearest thing they have to a low cost durable competitive advantage is their position of global leadership in the countermeasures market. Being the market leader at anything typically means you have many advantages including economies of scale and being ‘known’ as a leader when tendering for contracts, even in markets outside the one where you are the leader. They are looking for most of their growth to come from further expansion into larger markets outside countermeasures and it’s likely that this will be aided greatly by being the global market leader and largest supplier of countermeasures to the US and UK air forces.
I think Chemring has earned a place in my portfolio and so I’ve put in 1/20th of my pension at around 680-690p. I expect to hold for as long as the projections suggest that the future returns will be good, or when peace breaks out across the face of the Earth; whichever comes first.