Underpinned by growing momentum in its order book, Pennant (PEN:116p), an Aim-traded supplier of products and services that train and assist engineers in the defence and civilian sectors, has reported a 75 per cent rise in 2018 pre-tax profits to £3.18m on 16 per cent higher revenues of £21m. That is much as I had anticipated when I suggested buying the shares, at 109p, in my August Alpha Report ('Pennant International: Poised for a return to growth', 13 Aug 2018).
A key bull point is the potential to convert a bumper £100m pipeline of contract opportunities. The news on this front is rather good. That’s because last autumn Pennant landed a £10.2m contract to supply training aids (mainly off the shelf equipment) to a Middle Eastern customer. In a results call this morning, Pennant’s directors revealed that £8m of the contract will be booked in 2019, split £500,000 in the first half and £7.5m in the second half.
They also revealed that the Canadian government contract (potentially worth £17m over five years) that was landed in November 2018 will cover £4.5m of house broker WH Ireland’s 2019 revenue estimate of £21.5m. The contract involves supplying Pennant’s OmegaPS suite of software that provides analytics around logistics support and asset life cycles and is the product of choice for the Canadian Department for National Defence.
Moreover, the company will also book £4m of revenue this year from the extended contract with General Dynamics UK, one of the country’s leading defence companies, that it was awarded as part of a £3.5bn deal to deliver 589 Ajax fighting vehicles to the British Army. General Dynamics sub-contracted the army’s requirement for electro-mechanical trainers and computer-based training to Pennant, and last year the contract was increased in value from £8.5m to £12m.
This means that in aggregate these three contracts, and four smaller ones, cover £19.4m of WH Ireland’s 2019 revenue forecast of £21.5m, thus underpinning the vast majority of the broker’s 2019 pre-tax profit and earnings per share (EPS) estimates of £3.7m and 9.7p, respectively. These forecasts also take into account a projected £150,000 operating profit contribution from January’s bolt-on acquisition of Aviation Skills Partnership (ASP), an organisation that delivers aviation skills training across the UK, promoting the establishment of, and then managing, aviation skills academies. The first such academy, International Aviation Academy, operates from Norwich International Airport and three more academies are in the process of being established and are expected to come online from 2020.
It’s worth noting that in the notes to the 2018 annual report that Pennant is budgeting for £2m total consideration payable to the vendor over the five-year earn out agreement, the implication that Pennant would earn £4m of operating profit given the terms of the agreement, so the acquisition would be self-financing. Chief executive Philip Walker told me during our call that the board are considering other complimentary bolt-on deals.
A major contingent contract
The directors are also very confident that Pennant will conclude negotiations relating to a potential contract for the design, build and delivery of training equipment for which it has been down-selected. The prime contractor has already won its contract and it’s anticipated that the customer, the Ministry of Defence (MoD), will formally award the contract in the first half of 2019. The potential value of Pennant's contingent contract is £25m to £30m, deliverable over 2019, 2020 and 2021. If landed this would almost double Pennant’s order book from £37m to £67m.
Bearing this in mind, and having taken into account the costs involved of fulfilling this major contract as well as £0.5m of efficiency savings that management has identified, WH Ireland’s models imply that Pennant could book £6m of revenue and make a £1.5m gross profit in the second half of 2019 on this contingent contract if landed. That equates to an operating profit of £600,000 after expensing all costs.
In other words, there are real prospects of analysts pushing through a 16 per cent earnings upgrade for this year and one that would lift fully diluted earnings per share (EPS) from 9.1p in 2018 to 11.3p based on pre-tax profits rising to £4.3m in 2019. It would also result in some hefty upgrades for 2020 and beyond.
Importantly, the company is well funded to fulfil the growing order book. Net cash increased from £1.5m to £1.85m over the course of 2018 and this was after expensing £5m on investment including expansion of production facilities. Operating cash inflow pre-working capital movements improved from £2.4m in 2017 to £3.8m in 2018, and was buoyed further by £1.33m of net positive working capital movements. Pennant raised £2.1m of cash through a placing of shares, at 110p, in late January this year, partly to fund the ASP acquisition, which has boosted the cash pile to £4m. In addition, the company has a £3m untapped loan facility, and a further £1m of facilities above that, so should have ample headroom to meet the increased working capital requirements of fulfilling all its contracts. The interest rate on this credit facility is only 2 per cent above Bank of England base rate, so it is keenly priced.
Second half weighting
It’s worth flagging up that there will be a seasonal weighting to this year’s forecast revenue of around one-third in the first half and two-thirds in the second half, reflecting that under IFRS15 reporting the company is unable to book the revenues under the Middle Eastern contract until full acceptance by the client has been received. This will fall in the second half given the timing of the scheduled deliveries.
That’s not an issue as Pennant will still book revenues and profits for the year as a whole in line with the planned budget, it’s just timing. It also means that the company could have a working capital outflow in the order of £5m for the first half as it delivers on these large contracts, which will then reverse by the first quarter of 2020. Expect a first-half operating loss of around £1m and a second-half operating profit of £4.7m to produce WH Ireland’s full-year pre-tax profit estimate of £3.7m (excluding a potential £600,000 profit contribution from the MoD contingent contract).
The bottom line is that Pennant is incredibly well placed to continue growing its order book both in civilian and defence markets, a factor that’s not priced into the shares which are still only trading on a forward PE ratio of 11 even though over 90 per cent of this year’s sales forecast is in the bag and there is scope for a massive earnings upgrade. So, having suggested buying the shares at the current price ahead of the annual results (‘Pennant’s repeat buying opportunity’, 5 Feb 2019), I have no hesitation reiterating my buy advice and 180p target price. Buy.
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