I covered the pre-close trading update from Pennant (PEN:65p), an Aim-traded supplier of products and services that train and assist engineers in the defence and civilian sectors, in quite some detail after the company announced delays to some contracts, which prompted house broker WH Ireland to cut its 2019 pre-tax profit estimate in half to £1.8m on revenue of £20m (‘Pennant’s recovery potential’, 12 August 2019). Chief executive Philip Walker remains comfortable with that forecast, and so am I, having seen the contract schedule for delivery in the second half.
The major reason for the profit reversal is because Pennant was carrying £1m in additional costs in advance of starting work on a significant contingent contract (worth £28m in revenue 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 in 2018. However, the effective contract start date has been pushed back to 30 June 2020, so in light of the delay the company has made £430,000 of annualised operational cost savings, and should achieve a further £170,000 in savings, all of which will be seen in the 2020 budget.
Of far more importance at this juncture is the potential for a strong recovery in Pennant’s profits as the company delivers on a healthy order book that has increased from £31m to £36m year on year. Of this sum, £11.5m is scheduled for delivery in 2020 (excluding the aforementioned single-source major contract), thus underpinning half of WH Ireland’s 2020 revenue estimate of £22.3m and significantly higher annual pre-tax profit of £3m and earnings per share of 7.7p. The higher profit margin not only reflects the aforementioned operational cost savings, but a record contribution from Pennant’s integrated logistic support (ILS) division.
This unit has long-term contracts with the Canadian and Australian defence departments, which use Pennant’s Oracle-based software product to reduce the support cost of major capital equipment in the defence, aerospace and transportation markets. The true cost of ownership of a major asset such as a train, tank or aeroplane is much more than the purchase price. Therefore, the speed and frequency of maintenance and repair has a substantial impact on overall cost. ILS is a methodology used by Pennant that identifies and minimises life cycle costs.
Mr Walker also noted during our results call this morning that he expects to report positive newsflow with regards to complementary acquisitions and partnerships in the next three to six months, both of which will underpin and diversify revenue streams away from lumpier contracts. The board has ample firepower to make bolt-on acquisitions, so as net borrowings of £400,000 are well within a £3m facility keenly priced at 1.75 per cent a year with Barclays. Also, Pennant has a further £1m bank facility, and owns unencumbered freehold property worth £5.5m. Moreover, its contracts are scheduled so that they are cash positive from day one, thus reducing working capital build.
It’s worth flagging up too that a potential £5m contract to supply trading aids to a new academy in Saudi Arabia that is due to open in September 2020 is not factored into WH Ireland’s 2020 revenue estimate even though the prime contractor is a longstanding partner of Pennant's. Nor for that matter are three other smaller government contracts worth £2m that were deferred (due to budgetary issues) until 2020. The point being that these potential contracts and the £11.5m of contracted revenue in the order book for delivery in 2020 cover 83 per cent of WH Ireland’s 2020 revenue estimate, meaning that the ‘bridge’ is actually a lot smaller than it first appears. Moreover, analysts have yet to factor in a contribution from the £28m contingent MoD contract into 2020 estimates, thus offering potential for Pennant to outperform.
Trading on a 2020 price/earnings (PE) ratio of 8.5, I continue to see strong recovery potential in the shares. Buy.
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