Back in 2005 - repairs from the fun and games of the late 1990s over, and under the leadership of a new chief executive - Chemring went on an acquisition spree that, as is so often the case, looked good for a while. Certainly, sales and profits were transformed. From revenue of £121m in 2004-05, Chemring sped to £740m in 2011-12. In the same period, pre-tax profits from continuing operations rose from £19m to £70m.
Almost needless to say, these figures flattered performance. Include the effect of what the company euphemistically labels 'non-underlying items' and pre-tax profits were just £13m in 2011-12. And why exclude them? After all, the 'non-underlying items' seem to underlie the business firmly. At least, they are a constant in the income statement. In the five years 2007-08 to 2011-12, Chemring shunted £140m-worth of these charges - much relating to overpayment on acquisitions - under this very helpful heading. However, these charges represent value destruction from the past so they should not be ignored. Include them, then work down the income statement to basic earnings from continuing operations and, for example, Chemring made just 6.8p per share in 2011-12, well short of the comparable figure for 2004-05 - 9.3p.
The chief executive who took Chemring all the way up and then all the way down paid a price of sorts when he departed swiftly a year ago. Chemring's bosses now acknowledge that the group expanded too quickly on too many fronts. In January, its chairman, Peter Hickson, said that most of the problems that affected the group's performance stemmed from "operational issues within the business", which is corporate speak for saying: "We really didn't have a clue what was going on in much of the group."
Naturally, Chemring's new chief executive has a plan - a five-point plan, in fact - to address these shortcomings. It includes conventional stuff such as simplifying management structure, merging operating units and - this is where we came in - focusing on cash generation. Even in 2011-12, before this plan was formulated, declining capital spending meant that Chemring turned more of its accounting profit into cash. Its cash-conversion ratio topped 70 per cent, the best ratio Chemring had managed since 2006-07 and above its seven-year average of 65 per cent.
A big exercise in 'kitchen sinking' by the new boss means the current year's basic profit will be blown to pieces, so the cash-conversion ratio won't mean much. Longer term, however, it is likely to rise further, if only because Chemring's heavy capital spending will be reined in. As an indicator, 'cap-ex' for the first half of 2012-13 was just £7.6m compared with £21.8m in the previous first half.
Combine better cash generation with falling levels of debt and Chemring will look a less risky proposition. That should help its share price if only because investors will be content with a lower risk premium for holding its shares. To the extent that the premium is inferred by the beta co-efficient of a company's share price to its stock market, Chemring's has leapt recently. In turn, that raises its cost of capital and depresses its value.
That said, there remain operational issues within the group's countermeasures division. Chemring is the world leader in supplying decoys, flares and related equipment, so was always likely to feel the effects of the withdrawal from Afghanistan of the US and its allies. Nor is this division - or, come to that, the whole group - helped by the ridiculous tit-for-tat cuts in US public spending that fall under the heading of 'sequestration'. However, the pace of decline in countermeasure sales is accelerating - from 8 per cent last year to 25 per cent in the first half of 2012-13 to 32 per cent in the third quarter. In addition, there are clearly quality control issues within the US arm of countermeasures that management can't quite solve and - as of October's profits warning - are hurting the group. They need sorting once and for all.
Despite all this, net debt is on a downward trend. At the end of the first half, it was £275m, 12 per cent lower than a year earlier. Couple that with Chemring's leading positions in supplying defence consumables and you have a business with the potential for resilience and eventual recovery. That also applies to its share price. Even with a sky-high cost of capital it is feasible to value the equity in the existing business at over 200p per share. Maybe it's too early to buy the shares for recovery, but Chemring is clearly one to put on the 'watch' list.
