Pennant’s recovery potential

Around a quarter of the profit shortfall resulted from a rescoping of the company’s contract for the provision of electro-mechanical trainers for the Ajax armoured vehicle. Pennant’s contract is with General Dynamics UK, one of the country’s leading defence companies, 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. Pennant had budgeted £4m of revenue from the contract in its 2019 forecasts, but the customer has requested additional functionality for the training devices, so £1.5m of the 2019 planned revenue will be deferred until 2020. Based on a 30 per cent profit margin, the deferral accounts for £450,000 of the company’s profit shortfall this year.

I would also flag up that the contract has previously been extended from £7m to £12.3m. Bearing this in mind, the £3.6m of revenue that Pennant now expects to earn from the contract in 2020 doesn’t factor in a likely multi-million pound increase in its overall value in light of the rescoping. Also, when the customer last rescoped the contract in 2017, Pennant successfully claimed for compensation. Any compensation payment is not included in WH Ireland’s forecasts either.

The other major reason for the profit shortfall is because Pennant is carrying £1m additional costs in advance of starting work on a significant contingent contract (worth £28m in revenue to the company over three years, according to Mr Walker) for the design, build and delivery of training equipment to the Ministry of Defence (MoD). Pennant was down-selected as supplier of training solutions by the US prime contractor last year, and I understand that the award has an effective contract start date of 30 June 2020. Given the delay, the company has made £500,000 of annualised operational costs savings in the meantime, although these will only show up in the 2020 accounts.

Please note that this £28m contingent contract is not included in Pennant’s three-year contracted order book of £36m, nor is a £4m secured MoD contingent contract for an aircraft upgrade. Pennant training solution was part of the prime contractor’s bid and forms part of that potential contract award. The company is working towards a formal contract award before the December 2019 year-end with all the £4m revenue likely to be delivered in the 2020 financial year.

I can also reveal that the prime contractor on a new academy in Saudi Arabia, which is due to open in September 2020, is a longstanding partner of Pennant for the supply of training solutions. This potential contract is worth £5m for the supply of a suite of training aids and is not factored into 2020 forecasts either. Moreover, three other small overseas government contracts, worth around £2m in aggregate, have only been deferred this year, rather than postponed indefinitely. It was a case of the timing of the start date due to budgetary issues.

The point being that £12.7m of Pennant’s contracted order book of £36m is due for delivery in the second half of 2019, followed by £11.5m in 2020, £7.9m in 2021 and £4m in the first half of 2022. However, these orders exclude any contribution from the aforementioned £28m UK MoD single source procurement contract, and exclude the other £4m MoD contract and the £5m Saudi contract. Given we can expect news flow on progress on these any other awards before the year-end, then expectations that Pennant’s profits could recover strongly in 2020 are being underpriced.

Indeed, based on revenues rising from £20m in 2019 to £22.3m in 2020, WH Ireland expect pre-tax profits to rise from £1.8m to £3m to deliver fully diluted earnings per share (EPS) of 7.7p. There are no debt concerns as net debt is currently £300,000 and Pennant has a £3m Barclays overdraft facility keenly priced at 1.75 per cent p.a., a further £1m bank facility, and owns unencumbered freehold property worth £5.5m.

I would also flag up that contracts are scheduled so that they are cash positive from day one. Indeed, given the training solutions for the aforementioned £28m MoD contingent contract are front-end loaded, Pennant will receive an upfront payment of 10 per cent of the contract value as and when work commences.

True, investors have marked down the shares heavily following Friday’s news and the share price has  fallen by 40 per cent since I last suggested buying at 105p (‘Pennant repeat buying opportunity’, 9 May 2019). However, I can still see the company landing the three major contracts I have outlined above to double its three-year contract order book to £72m and underpin a step change in profitability in the years ahead. That possibility is simply not being priced into Pennant's market capitalisation of £23m. Recovery buy.

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