Sedgefield-based Kromek (KMK:25.5p), a radiation detection technology company focused on the medical, security and nuclear markets, has announced a placing and one-for-65 open offer, at 25p a share, to raise £19.9m net of expenses after it was awarded a massive $58m (£44m) seven-year medical imaging contract. In the past three years, Kromek has won $138m of new contracts and analysts estimate that its current order book exceeds $100m.
Kromek moved to a state-of-the-art medical-grade facility in Pittsburgh last year that has the design, engineering and technological capabilities needed to produce commercial quantities of cadmium zinc telluride (CZT) crystals. The move was well timed as demand for the company’s CZT-technology is really taking off in nuclear detection, medical imaging and security screening. The primary reason for the equity raise is to fund the extra capacity required in the medical imaging business.
That’s because Kromek has developed a range of CZT-based detectors for use by original equipment manufacturers (OEMs) in CT scanners. These detect photons emitted from radio-pharmaceuticals injected into patients which concentrate at sites for identification of diseases including: cancer, Alzheimer’s, Parkinson’s, dementia and osteoporosis. CZT-based detectors are smaller and are lighter than scintillator detectors, and have higher resolution, superior specificity and lower scan time, resulting in improved and earlier diagnoses, better patient outcomes and a reduced cost of healthcare. Kromek’s chief executive, Arnab Basu, believes that CZT-based detectors are set to replace the prevalent scintillator-based detectors, a view given credibility by the massive seven-year contract Kromek has just been awarded. He also believes the market here is worth $100m a year.
Furthermore, as one of only four companies that can manufacture and supply CZT worldwide, Kromek is ideally placed to win further contracts as more of its customers commercially adopt and launch next-generation CZT-based products. So, in anticipation of winning further major contracts, the directors want to increase Kromek’s medical imaging production capacity further and have earmarked £10m of the equity raise for capital expenditure in expanding facilities in this operation. Dr Basu says this will give Kromek critical mass in production. He also reassures investors that the incremental capital expenditure requirement of servicing another huge contract win can be funded through internal cash flow and, more importantly, as the business expands the company will not need to return to shareholders for the incremental working capital and capital expenditure requirements these contracts will create. Moreover, during our lengthy conference call, finance director Derek Bulmer said that £5m-£7m of the company’s current working capital position will normalise and unwind by April 2020.
Sales and marketing efforts to ramp up
Kromek’s nuclear division’s flagship product, the D3S ‘dirty bomb detector’, is gaining contract momentum too. This is a portable, nuclear detection device used by counter-terrorist agencies to protect civilians and key infrastructure in cities, including ports, borders and transport hubs. The product is 10 times faster at detecting gamma and neutron radiation, and at a tenth of the cost of conventional detectors.
It’s proving popular, as Kromek has delivered more than 10,000 D3S units as a sole supplier to an agency of the US Department of Defence under its SIGMA programme. The product is being deployed and field tested by US government agencies in North America and by a number of customers in Europe and Asia. Kromek is also working with the US government to develop a ruggedised dirty bomb detector for use by the US military. Dr Basu believes the market in nuclear detection is also worth in excess of $100m a year.
So, to capitalise on the increasing traction that the D3S product is experiencing, Kromek plans to invest £3m-£4m to expand its sales and marketing capability. Of this sum, about £500,000 will be spent in the 2019-20 financial year. It’s worth noting that this business has significant capacity to scale up production without additional capital requirement.
The £6m balance of the equity raise proceeds will be used to strengthen Kromek’s balance sheet and target new contracts as they emerge.
Balancing risk and reward
Clearly, there is execution risk, but given the directors say that the “pipeline of new opportunities is extremely robust”, then the decision to invest extra capital in facilities, and have a cash buffer to target new contracts, is sensible. It also allays concerns over the company’s cash position as prior to the equity raise analysts had forecast Kromek to end the financial year to end April 2019 with net funds of £2.7m, down from £6.5m a year earlier. These figures exclude the operating liability on the lease on the Pittsburgh facility.
The important point being that with the benefit of the $58m OEM contract, expectations that Kromek can lift revenues from £15m to £18.5m in the 2019-20 financial year have been de-risked, and help support a near-doubling in Kromek’s cash profits to £3m as analysts predict. Furthermore, if the flow of contract wins continues to gain traction, then expect revenues and profits to ramp up sharply as the operational gearing of the business really kicks in.
To put the current valuation into perspective, based on an enlarged share capital of 374.5m shares post the placing and open offer, Kromek has a market value of £95m, or 1.6 times pro-forma net asset value (NAV) and 2.3 times tangible NAV. Its enterprise value of £71m equates to 24 times cash profit estimates for the 2019-20 financial year. However, earnings multiples will drop sharply if the company continues to win contracts at the current rate, and moves into operating profitability.
True, the shares are back at the 25p level at which I initiated coverage ('Follow the smart money', 27 February 2017), and retail investors will be dismayed that only £1m of the equity raise is through the open offer, so institutional investors now have more of the economic interest in the company. I personally feel that a placing price north of 30p a share would have been appropriate too. However, that issue aside, the investment case for Kromek is even stronger now than two years ago when I first recommended the shares as the commercialisation of the company’s technology is clearly gaining traction and is highly supportive of acceleration in Kromek’s profits in the coming years. In the circumstances, I would advise taking up the open offer and continue to rate the shares a buy.
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