MSI operates in three key specialist areas, but the one that interests me most right now is its defence division where the company is a major supplier of naval equipment to the UK Royal Navy and over 40 other navies internationally. In fact, it's a world leader in the supply of small and medium calibre Naval Gun Systems and has been at the forefront of naval gunfire control technology for nearly 100 years.
These naval weapon platforms, most notably the SEAHAWK family of stabilised naval guns, are operated successfully with 14 navies across the globe, with over 200 systems supplied/ordered to date. The company has been a specialist in the niche area of navigation and command and control technology for more than 50 years, and its latest range of navigational and tactical plotting tables are in service with more than 30 navies. MSI also has the capability to provide a range of steel and lightweight tactical shelters to meet the growing demands of rapid deployment forces involved in conflicts around the world.
What sparked my interest in MSI's fiscal 2015 results, released in mid-June, was the marked profit improvement in the company's defence activities following a disappointing first half. Having posted a first-half loss of £1.15m on revenue of £6.8m in the six months to 1 November 2014, reflecting budgetary constraints disrupting military procurement plans, the defence unit bounced back to post an operating profit of £961,000 on revenue of £10.2m in the second half to 2 May 2015. A new senior management team, the decision to bring new products to markets more quickly, and a breakthrough contract to supply MS-DS 30mm guns for three offshore patrol vessels being built as part of the Royal Navy's shipbuilding programme were the key reasons behind the turnaround.
Moreover, since that award was made in October 2014, MSI has since won a follow-on two-year contract with the UK MoD for the maintenance and support of MSI-DS 30mm naval gun systems and associated ancillary equipment to the Royal Navy fleet. Although the value of the contract is confidential, I understand that it is worth in excess of £12m, a significant sum in relation to MSI's closing order book of just under £46m at the end of April 2015.
New product development programme
MSI's new product development programme is also reaping benefits with first orders won for the company's new MSI-DS 20mm naval gun system. The requirement for three systems - received from a European shipbuilder - will be delivered in the current financial year to 1 May 2016 and installed on new ships for an overseas navy. This is another important breakthrough, and highlights the board's commitment to broaden the range of its product offering directed at the growing international market for small naval vessels. I also understand that other new products will become available to market over the course of the next six months.
So, although global defence equipment markets generally remain constrained, despite the threats to stability from the increasing number of conflicts worldwide, MSI's executive chairman and 28.9 per cent shareholder Michael Bell is predicting an improvement in the level of activity for his business in the second half of the current year. That's worth noting because having posted a modest group pre-tax profit of £71,000 on revenues of £14.3m in the first half last year, reflecting the underperformance of the defence activities, MSI subsequently delivered a pre-tax profit of £1.47m on revenue of £31.2m in the second half, of which two-thirds of the profits in that six-month period came from the defence business alone.
This means that first-half comparatives for the period ending 1 November 2015 will be very soft when the company releases its interim results at the end of November, so we are guaranteed a significant rise in the company's profits given the progress being made by defence activities. But the company is not a one-trick pony as it has other profitable operations too.
Forging profits
These include a division specialising in the manufacture of high quality open die hammer forgings for use within many industrial applications. MSI's modern and well-equipped forges use the latest technology and offer forging, heat treatment, shot blasting, non-destructive testing, and laboratory testing. The division also encompasses fork-arms manufacturing where MSI is a world leader.
Operating profit from these activities rose by 75 per cent to £1.03m on revenue up 7 per cent to £15.1m last fiscal year as both the US operations based in South Carolina, and the UK business in Doncaster, traded ahead of expectations. This performance mainly reflected the benefit of operational improvements, and plant and equipment upgrades.
True, the South American operation, based in Sao Paulo, Brazil, was held back by the negative impact of a weakening market and currency owing to the region's current fiscal difficulties; sterling has appreciated by 50 per cent against the Brazilian Real in the past 12 months. And by their nature albeit lead times on the order book are short and the business is highly sensitive to prevailing economic conditions in its end markets. However, management guidance is that the forgings business should maintain "a relatively stable position". It's also worth flagging up that MSI is expanding manufacturing capacity in the US, a clear indication of market opportunities there.
Petrol stations superstructures
MSI's final business activity is the design, manufacture and construction of petrol station forecourt superstructures, including convenience stores, canopies, retail, food & refreshment outlets and car wash buildings. With a heritage stretching back to the conception of forecourt retailing in the 1960s, this business is a leading specialist in this niche area throughout Europe and is managed from operational centres in the UK, Poland and Ireland.
MSI is also the contractor of choice for forecourt structure alterations; refurbishment, maintenance and damage repair services. By retaining a comprehensive reference library of original drawings and structural calculations for thousands of petrol-filling stations across Europe, the company can offer a prompt response on specification in accordance with local regulations when structures on active stations require modification or repair. In turn, this minimises downtime, disruption and eliminates expensive intrusive site surveys and multiple site visits.
Admittedly, profits from this activity halved to £855,000 on slightly lower revenues of £13.3m in the 12 months to 1 May 2015, as strong growth in the number of forecourt convenience stores completed in the period was offset by a fall in activity of the business in Poland that services many East European countries. Political uncertainty in the region discouraged many customers and potential developers to commit to their plans for new petrol station construction projects and service station upgrades.
However, there are still opportunities to grow this business, non more so than by profiting from the withdrawal of major oil companies from frontline retailing when they sell-off parts of their estates to independent dealers, dealer groups and operators. By providing an enhanced service to these prospective customers, not only in terms of new build, but in relation to station maintenance and upgrades, MSI can use its expertise and substantial library resource to win new business.
In fact, post the fiscal 2015 year-end, the company acquired Petrol Sign B.V., a Netherlands-based company that designs, restyles, produces and installs the complete appearance of petrol station superstructures and forecourts. The acquisition will enables MSI to offer a more complete service package to customers. The deal was sensibly priced with the consideration of around £2.5m equating to 7.5 times pre-tax profits of £330,000 in calendar 2014.
It's worth flagging up that MSI will benefit from a four-month profit contribution from Petrol Sign B.V in its forthcoming half-year results. And because MSI's net interest income last year was only £38,000 on a record closing year-end net funds of £17.15m, a cash pile worth 108p a share, the acquisition will be earnings-enhancing too.
Solid balance sheet
The recovery in the defence markets, and upside from the recent acquisition aside, MSI also offers a rock solid balance sheet and one that is not accurately reflected in the current market capitalisation of £30.1m, a modest 6 per cent premium to the last reported net asset value of £28.3m.
That's because the company also owns freehold property with a net book value of £10.8m and plant and equipment with a carrying value of £1.8m, or 85 per cent less than its original cost of £13m, so there is hidden value in the balance sheet as the replacement cost of these assets is significantly higher than their depreciated book value. This also means that MSI's market capitalisation is fully backed by cash on the balance sheet and property assets.
It's worth noting, too, that last financial year MSI booked a £1.1m non-cash depreciation charge, and a £317,000 amortisation charge in its annual accounts, which helps explain why cash generation is significantly higher than the reported pre-tax profit of £1.54m. In fact, net cash inflow from operating activities has averaged £5.3m a year over the past two financial years.
In turn, this strong cash generation enabled the company to maintain a dividend of 8p a share on the 16.7m shares in issue (the company also holds 1.7m shares in Treasury), even though it was barely covered by an EPS of 8.2p. That payout cost £1.33m and means the shares offer a rock solid dividend yield of 4.44 per cent. It's also in the interests of directors for the payout to be maintained, too.
Furthermore, once you strip net funds from MSI's market value of £30m, the company's enterprise value of £12.85m equates to a modest 9.5 times its net profit of £1.35m last year. And remember, those earnings were depressed by the underperformance of the defence activities in the first half. In other words, the company is being seriously underrated given the potential for a bounce back in earnings this year. I believe the net profits of £2.5m earned in the 2014 fiscal year are more representative of the true profitability of the business in its current state.
Directors interests
It's also good to see that the directors have sizeable financial interests in the company. Non-executive director David Pyle, finance director Michael O'Connell and Mr Bell between them have a 49 per cent stake and have been on the board for over 30 years each. True, they are well remunerated, the six main board directors were paid £1.14m last year, but this is still less than 10 per cent of the company's total wage bill for its 356 staff. And, unlike other companies, share option schemes are modest: four directors have options over an aggregate 214,000 shares exercisable at 194p each and expiring in September 2017. I am comfortable with this arrangement.
I would also point out that the five main shareholders own 69 per cent of the shares in issue, including Cavendish Asset Management which has a 16.2 per cent holding. This reduces liquidity in the shares, but they are still easily tradable on a bid-offer spread of 172p to 180p. In the past six trading days, bargains of 5,000 and 10,000 shares have traded between the spread.
Of course, liquidity works both ways as it can lead to share prices moving sharply lower on bad news, just as it can lead to sharp re-ratings on good news. But with MSI set to report a marked uplift in first-half profits at the end of next month, and the share price marking time since the full-year results in mid-June, I feel that a move through the 12-month high of 195p towards the 2007 bull market high of 240p could easily be on the cards. Needless to say, I rate MSI's shares a strong buy.
MORE FROM SIMON THOMPSON...
I have published articles on the following 39 companies in the past four weeks:
■ Trakm8: Run profits at 195p, target 220p; Character Group: Run profits at 518p, target 575p; Marwyn Value Investors: Buy at 220p; Global Energy Development: Speculative buy at 30p; Software Radio Technology: Buy at 27p, target range 40p to 43p; Globo: Buy at 33p, target 69p; Pittards: Hold at 105p ('Cashed up for cash returns, 22 Sep 2015).
■ KBC Advanced Technologies: Buy at 112p, initial target 142p; K3 Business Technology: Run profits at 298p; Cenkos Securities: Buy at 177p; Netplay TV: Buy at 10p ('Small cap value plays', 23 Sep 2015).
■ Miton: Buy at 26.5p, target 35p; 32Red: Buy at 73.75p, target 90p; Stanley Gibbons: Buy at 138p; Vislink: Buy at 40p, target 70p ('Building momentum', 29 Sep 2015)
■ Moss Bros: Buy at 97p, target 120p; GLI Finance: Buy at 52p, target 80p; Town Centre Securities: Buy at 315p, target 350p; Globo: Buy at 39p, target 69p ('Platforms for success', 30 September 2015)
■ Safestyle: Run profits at 255p; Epwin: Run profits at 138p; Manx Telecom: Buy at 188p, target 210p ('Income plays with capital upside', 1 October 2015)
■ LXB Retail Properties: Buy at 86p, target 99p ('Bag a retail property bargain', 5 October 2015)
■ Creston: Run profits at 162p, target 171p; Fairpoint: Run profits at 184p, new target range 200p to 220p; Trifast: Buy at 114p, target 140p; 600 Group: Buy at 16p, target 24p; Renew Holdings: Buy at 315p, target range 350p to 375p; Stanley Gibbons: Hold at 105p ('Engineering ratings upgrades', 6 October 2015)
■ STM Group: Buy at 71p, target 80p ('Riding small cap winners', 7 October 2015)
■ First Property Group: Buy at 39.5p, target 49p ('In pole position for re-rating', 7 October 2015)
■ Tristel: Run profits at 99p, target 110p ('Cleaning up with superbug buster', 7 October 2015)
■ Equity market strategy ('Bull market pointers', 8 October 2015)
■ Gresham House: Buy at 320p, target 450p ('A mandate for strong growth', 12 October 2015)
■ Tristel: Run profits at 123p, new target 130p to 135p ('Cleaning up', 13 October 2015)
■ AB Dynamics: Run profits at 267p ('Under-promising, over delivering', 13 October 2015)
■ Trakm8: Run profits at 245p ('Motoring ahead', 13 October 2015)
■ PROACTIS: Buy at 102p, new target 130p ('Secured growth for re-rating', 13 October 2015)
■ Avation: Buy at 148p, target 200p ('Flying higher', 14 October 2015)
■ Cohort: Run profits at 400p ('Cohort on a roll', 14 October 2015)
■ Vertu Motors: Buy at 68p, target 80p to 85p ('The virtue of Vertu', 15 October 2015)
■ Urban&Civic: Buy at 274p, target 325p ('Plotting a break-out', 15 October 2015)
■ MS International: Buy at 180p, initital target price 240p ('Making waves', 19 October 2015)
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
