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Follow the smart money

Follow the smart money
February 27, 2017
Follow the smart money
IC TIP: Hold

Bearing this in mind, last month's placing and open offer from Sedgefield-based Kromek (KMK:25p), a radiation detection technology company focusing on the medical, security and nuclear markets and one I have been patiently monitoring for sometime, really caught my eye. The company raised net proceeds of £20m at 20p a share in an oversubscribed placing and open offer not because it needs the money to fund the business - gross cash at the October half-year-end was £3.8m and only £1.7m of a £3m revolving credit facility was drawn down - but because the board wished to bolster the balance sheet to strengthen its position when negotiating contracts with government bodies and OEM customers.

Kromek has done pretty well so far, winning $38.6m (£31m) of orders since the summer of 2015, but some customers have expressed "concerns about its financial strength and ability to supply significant quantities of its core cadmium zinc telluride (CZT) technologies". This has dissuaded them from signing on the dotted line, something that Kromek's directors wanted to rectify given the potential for sales to ramp up sharply.

They have a point as this is an exciting business segment to be operating in right now given the geopolitical backdrop. That's because the company's products provide high resolution information on material composition and structure and are used in multiple applications, ranging from the identification of cancerous tissues to hazardous materials such as explosives, and the analysis of radioactive materials. The business model provides a vertically-integrated technology offering to customers, from the growth of CZT crystals to finished products or detectors, including software, electronics and application-specific integrated circuits.

Sales are starting to gain momentum as Kromek's results in December revealed a near 20 per cent rise in revenues to £3.8m in the six months to end-October 2016. Moreover, with operating costs under control, and gross margins holding steady at 53 per cent, half-year pre-tax losses narrowed from £3m to £1.8m. The order book is robust, so much so that analysts Hannah Crowe and Paul Hill at research firm Equity Development believe that revenues can grow from £8.9m in the 12 months to end-April 2017 to £12.5m next year, an outcome that would mean Kromek hits cash profitability. Interestingly, they calculate that £7.2m of that £12.5m revenue forecast is backed fully by a flow-through of the order book, a further £3m is supported by repeat or expected orders, and only £2.24m is being factored in as new shipments.

In other words, if Kromek can persuade customers that it is fully funded to support much larger orders, then there is potential for an accelerated move to cash profitability. This explains why £17m of the net proceeds of the £20m from the fundraise will be set aside to provide comfort to these third party customers and a further £3m will be used for working capital to enable the company to both support contracts, and continue its investment in product development.

 

Sales momentum continues to build

The decision to tap investors appears to be already paying off as Kromek announced last week that it has been awarded a five-year contract, worth at least $3.1m, by an existing US-based customer that is an emerging leader and global company in the homeland security marketplace. Kromek has developed key components to be incorporated into the customers' new generation security screening system for the detection of explosives. This equipment has regulatory certification and provides advanced capability for screening current threats, and is ideal for the detection of homemade explosives.

There is an even bigger prospect in the US homeland security, too. That's because Kromek has already shipped 10,000 personal radiation detectors (D3S) to the US Department of Defence as part of that body's SIGMA programme aimed at preventing attacks involving radiological "dirty bombs" and other nuclear threats in the US and globally. Having successfully developed and demonstrated a network of these smartphone-sized mobile devices that can detect the tiniest traces of radioactive materials in trials across New York, Washington and New Jersey, there is potential for Kromek to participate in the roll-out of the programme across up to 23 cities in the US. Analysts at Equity Development believe each deployment could be worth somewhere between $10m and $15m. Given that President Trump has made homeland security one of his top priorities in the fight to counter the threat of dirty-bomb attacks from international and domestic terrorists, a roll-out of the programme now looks like a distinct possibility.

In addition, a few months ago Kromek was awarded a $1.6m contract by the US Defence Threat Reduction Agency to build on, and enhance, the technology platform to develop a high performance isotope radiation detector capable of use in military and other harsh environments. This represents a major opportunity to adapt its technology base and supply into the US military and security agencies. Closer to home, the company won a $430,000 contract with the UK Ministry of Defence for the supply of nuclear radiation detection products.

There are strong growth opportunities in medical imaging, too. For instance, Kromek has now commenced delivering on a five-year contract, valued at $12.6m, with a long-standing OEM customer. The company's detector modules, which are incorporated into the customers' systems, produce some of the most accurate imaging to diagnose the strength and health of bones. This allows clinicians to accurately detect, monitor and treat osteoporosis in patients. I also understand that Kromek has been awarded repeat contracts by three of its current OEM customers to supply its CZT-based detector modules. The value of these contracts was double that of the customers' previous orders, highlighting the potential for growth in recurring revenues. Furthermore, Kromek has also entered an agreement for the supply of CZT-based gamma radiation detectors with an existing medical customer, and this order has a minimum value of $560,000 over the two-year agreement.

 

Follow the money

It's reassuring to see the board have significant skin in the game, including chief executive Dr Arnab Basu MBE, who owns 1.14 per cent of the share capital. Mr Basu has a PhD in physics from Durham University, specialising in semiconducting sensor materials, and previously held senior management positions in his family business, which manufactured materials for the electronics industry serving major telecom and consumer electronics manufacturers, including Siemens.

Non-executive director Dr Graeme Speirs is clearly confident of the company's prospects as he subscribed for 7.5m shares in the placing, a cash investment of £1.5m. Mr Speirs is an experienced entrepreneur and owner of an investment company focused on UK start-ups in the technology, life sciences and energy sectors. He has a PhD in molecular physics from Aberdeen University, and is an expert in the design and manufacture of polymer composite products. Including beneficial interests, Mr Spiers owns 9.2 per cent of the 259m shares in issue.

It's noteworthy, too, that funds controlled by Gervais Williams' Miton Group (MGR:38.5p) acquired 31.25m of the placing shares to take its stake to almost 19 per cent. I rate the company's fund managers highly, and so too do other investors, which is why its profits have been rising strongly. Indeed, I recently upgraded my target price on Miton's shares to 50p ('In the ascent', 23 January 2017), having first advised buying at 23p ('Poised for a profitable recovery', 4 April 2015). I also note that funds controlled by Katie Potts' well regarded Herald Investment Trust picked up 10m shares to take its stake to 5.35 per cent, and Diverse Income Trust acquired 8m shares for a stake just over 3 per cent. Funds controlled by Schroders and Killik own around 9 per cent of the equity between them.

It's only fair to point out that Kromek is not averse to tapping shareholders, having raised £15m in a placing at 51p a share when it came to the market in October 2013, and a further £11m in a placing and open offer at 25p in the summer of 2015. The fact that the share price is half the listing price is a reflection of investors' caution until they see firm evidence of a move towards profitability. However, the growing traction in new contract wins and a bullish order book suggests that possibility is now on the cards. It's also worth flagging up that a major stock overhang resulting from a sell down by Amphion Innovations (AMP:2.38p), a tiny Alternative Investment Market (Aim)-traded investor and developer of medical and technology businesses, has almost been unwound. The company was an investor in Kromek prior to the listing and owned 12.4m shares when Kromek started trading on Aim in the autumn of 2013, representing 11.6 per cent of the share capital at the time. Amphion's shareholding is now only 4.1m shares, or 1.6 per cent of the share capital.

 

Risk assessment

Of course there are risks involved, the most obvious of which is that Kromek is at an early stage of its commercial development, and there is absolutely no guarantee that revenues will grow as analysts predict. Indeed, as the raft of contract wins highlight, awards can be lumpy by their nature and, as a consequence, hard to forecast. Any contract loss would have a far higher greater financial impact, too. Moreover, even if future orders do ramp up, as analysts predict, the company still has to increase production substantially to fulfil them, so there is execution risk.

The business also has to invest heavily in product development and this isn't cheap; research and development spend (R&D) was £1.7m in the latest half year, albeit a R&D tax credit of £900,000 for the previous financial year helped offset this cash burden. There is also the cost of protecting its 265 patents, although given the high barriers to entry into this market, and the company's leading edge technology, I don't see competitive pressures or patent challenges as an issue. In fact, gross margins look sustainable given there are only four recognised producers of CZT globally. As analysts at Equity Development rightly point out, two of them - Siemens and General Electric - are not really independent, so may refrain from supplying CZT to medical imaging rivals Toshiba and Philips.

It's worth considering, too, that leading edge technology isn't always adopted by customers as quickly as the bullish management of companies predict, albeit in this case I feel the board's confidence is well placed.

 

Target price

So, having considered all the above risk factors, and the fact that Kromek's share price appears to have bottomed, I strongly feel that the current offer price of 25p is an attractive entry point. The company has a pro forma net asset value of £44m post the placing, of which net cash accounts for £22m, which gives a reasonable price-to-book value ratio of 1.5 times.

Importantly, the company should still retain £17m of cash, a sum worth 6.5p a share, by the time it becomes self-funding assuming all goes to plan and it moves to cash profitability in the 2017-18 financial year. If that happens, Equity Development's target price of 34p a share, based on a discounted cash flow calculation, looks achievable to me and could even be conservative if the raft of contract wins gathers pace.

For good measure, the chart set up is very bullish. Having tested the 20p lows three times in recent months, and following news of the successful placing and last Wednesday's bumper contract win, Kromek's share price has bounced strongly to the 25p resistance level that previously capped progress in January and December. From my lens, the bottom is now in place and a break-out above the 25p resistance is highly likely, suggesting a sharp move to the 30p resistance level that halted progress last summer. Beyond that analyst's 34p a share price targets come firmly into play.

Offering a minimum of 36 per cent share price upside, I rate the Aim-traded shares a strong buy.

 

MORE FROM SIMON THOMPSON...

A comprehensive list of all the investment columns I have written in 2017 is available here.

The archive of all the share recommendations I made in 2016 is available here

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