Avon Rubber: a moat business that can keep on growing

The business

Avon Rubber consists of two main businesses: Avon Protection and milkrite/InterPuls. Both are run and managed separately with guidance on strategy coming from the group head office.

 

Avon Protection

Avon Protection is the world leader in advanced chemical, biological, radiological and nuclear (CBRN) respiratory protection systems. It manufactures and sells its products to the world’s military forces, police forces, fire departments and industrial companies. Since the start of 2020, it has also supplied ballistic protection products, mainly to military customers.

The company sells its products directly to its military customers and through distributors and agents to its other customers. The vast majority of the business’s revenues comes from the US and the US Department of Defense (DoD) in particular.

For most of the past decade, this business has been underpinned by a sole supply agreement with the DoD for the M50 general service respiratory protection mask. Not only has the M50 provided a secure stream of revenues for Avon, but the technology used to develop it has allowed it to create and sell other related products.

Avon Protection’s other key products are:

• FM61 filters that are used with the M50 masks.
• C50 masks – similar to the M50, but used by police forces in counter-terrorism tasks.
• Emergency escape breathing devices – hoods used on board ships, but also with commercial applications in areas such as mining.
• MCM100 – underwater rebreathers (pictured) used in long and deep diving situations such as mine clearance.
• Thermal imaging cameras used by fire services.
• M69 – aircrew mask. 
• M53A1 – mask and powered air systems for special services personnel.
• Military protective helmets.
• Body armour.
• Flat armour – used to protect things such as seats, cockpits and engines.

The business with the DoD has some very attractive characteristics. Not only does it give Avon a source of secure and relatively predictable revenues and cash flows, but the products involved are safety-critical and are highly regulated. This creates a significant barrier to entry for new competitors and an impressive economic moat for Avon.

Once a product has been approved by the DoD it is possible to gain exclusive sole supplier status with guaranteed order levels for a specified length of time and often with agreed price increases.

The niche, problem-solving and safety-critical nature of its products with limited competition means that Avon is able to charge decent prices for its products. As the volume of them sold increases, this leverages the fixed overheads of its manufacturing plants, which has allowed it to make very attractive profit margins.

 

Avon Protection: revenues and profits

£m	2013	2014	2015	2016	2017	2018	2019
Sales	93.1	92.8	98.8	100.9	113.8	115.7	128.4
Op profit	16.1	13.6	15.9	15.1	19.8	21.5	26.2
Margin	17.3%	14.7%	16.1%	15.0%	17.4%	18.6%	20.4%

Source: Annual reports

Once a long-term deal on a product is in place the growth in its installed base means that a significant additional revenue and profit opportunity arises from the sale of spares and accessories. You can see how this develops over time by looking at the volumes of products sold under the M50 mask contract in recent years. 

 

M50 Masks: Orders and deliveries

M50 Masks	2015	2016	2017	2018	2019
Masks Delivered	240,000	189,000	150,000	179,000	96,000
Filter spares	92,000	122,000	144,000	150,000	166,000
Received orders	172,000	169,000	169,000	219,000
Closing order book	50,000	30,000	49,000	89,000

Source: Annual report

While the orders and deliveries of the masks have moved up and down a lot, the growth in the installed base has seen a steady rise in the sale and delivery of filter spares. The 10-year M50 contract came to an end in 2018, but Avon is confident of signing a new five-year contract with the DoD sometime in 2020.

Avon’s acquisition of 3M’s ballistic business has further strengthened its relationship with the DoD. It brings with it lots of additional benefits such as the ability to cross-sell its existing products, a well invested manufacturing footprint and very good research and development capabilities.

Avon has been very good at developing new products in recent years to take over from the M50. The M69 aircrew mask and the M53A1 should start producing significant revenues in 2020 to offset the decline in revenues from the M50.

What is particularly attractive about Avon’s Protection business is the potential to widen its military customer base beyond the DoD. For a UK company, Avon has sold little to the UK military in recent years. This will change with a five-year contract to supply general respiratory masks to the UK Ministry of Defence, which saw its first order in 2019 and will see two additional production lines for masks and filters set up.

The MCM100 underwater rebreather got its first big order from the Norwegian navy last year and shows the potential of Avon’s military business to expand its customer base. In 2019, military sales to the rest of the world military soared from £14.4m to £32.4m. The potential of these additional sales to leverage the overheads on Avon’s manufacturing plant is a significant source of future profit growth for its Protection business.

Outside of the military area, the performance of the business has been more patchy. Avon has exited the breathing apparatus market for fire services due to high levels of competition, but has fared better selling its products to police forces in the US. That said, the Law Enforcement business has had its ups and downs, with orders and revenues taking a hit in 2019 due to the US government shut down earlier in the year. Revenues should bounce back in 2020.

There’s a lot to like about Avon’s Protection business. It’s difficult to see defence spending by governments being cut at the moment, especially with the commitment of NATO countries to spend 2 per cent of their GDP on defence going forward. This combined with the scope for Avon to cross-sell products from the 3M business and expand its geographic sales reach suggests that the outlook for future profits growth is very healthy.

 

milkrite/InterPuls

This business sells its products into the dairy industry. It has high levels of profitability, but has struggled to grow in recent years.

Avon’s core line of products in this business are based around selling clusters and liners that are used on milking machines to milk dairy cows. They have been called Interface products because they are ones that come into contact with the cow. They are sold on their ability to promote the cleanliness of the milk extracted and the welfare of the cow. These products are consumables and need to be replaced regularly, which gives Avon a source of regular sales and cash flow.

With the acquisition of InterPuls in 2015, Avon moved further up the value chain by offering farmers more advanced products. These include pulsators (automated milking machines) and milk meters that can analyse the quality of a farmer’s herd. These products are categorised as precision, control and intelligence (PCI).

The third revenue stream of Avon’s dairy business is Farm Services. Here, the farmers outsource the replacement of liners and clusters to milkrite/InterPuls in a service known as Cluster Exchange. This service has been extended to pulsators and animal tags as well. It has built up nicely in recent years, but was only just over 10 per cent of divisional revenue in 2019.

Avon’s Interface business is the global market leader and makes the bulk of its revenues from North American and European markets. It has been trying to expand into emerging markets and has had some success in places such as China and Brazil, but growing profits has proved to be very difficult in recent years.

 

milkrite/InterPuls: revenues and profits

£m	2013	2014	2015	2016	2017	2018	2019
Sales	31.7	32	35.5	42	49.4	49.8	50.9
Op Profit	5.2	5.7	6.4	7.2	8	8	7.5
Margin	16.4%	17.8%	18.0%	17.1%	16.2%	16.1%	14.7%

Source: Annual reports

The economics of the dairy farm industry are best summed up as horrible. Revenues are determined by the price of milk, which tends to move up and down a lot. Animal feed is the farmers’ biggest cost and so the relationship between the milk price and the feed price essentially determines their profits and with it, how much they are likely to spend on Avon’s products.

What tends to happen is that when farmers’ profits are squeezed – as they are regularly if the milk price goes down – they don’t spend as much. They make their clusters and liners last longer and lengthen the replacement cycle. Investment in milk meters and pulsators also tends to take a back seat.

This is bad news for milkrite/InterPuls as the lower sales volumes tends to see the operational gearing of their manufacturing plants work in reverse, as was seen in 2019.

In the longer term the outlook for this business is modestly positive in my view. The demand for dairy products across the world is increasing. This will have to be met with higher milk yields along with a modest increase in global cow and buffalo herds. Big markets such as India still see the vast majority of cows milked by hand and are ripe for automation.

There is also a continued shift towards mega-farms – with more than 20,000 cows – where the focus on animal welfare and efficiency are all important. 

This should increase the demand for milkrite/InterPuls’ products but the underlying economics of dairy farming are unlikely to change, so investors should continue to expect a bumpy ride with this business.

 

Excellent financial performance

Avon has been able to keep on growing its profits while maintaining very impressive levels of profitability and free cash flow generation. These show that the sizeable economic moat in its Protection business can produce excellent financial returns for its investors.

 

Avon Rubber: key financial performance measures

Avon Rubber (£m)	2014	2015	2016	2017	2018	2019
Revenue	124.8	134.3	142.9	159.2	165.5	179.3
Op profit	17	20.2	20.9	25.8	27.3	31.3
Profit after tax	13.05	16.9	21.8	21.5	23.5	28
Capital employed	71.8	83.8	96.2	110	124.8	137.2
Capex	6.8	6.2	6.9	5.5	8.9	7.9
Op cash flow	25.5	21.3	32.4	35.6	37.9	23.2
Free cash flow	15	10.9	23.4	27	22.5	7.9
Net debt	-2.9	13.2	-2	-24.9	-46.5	-48.3
Op margin	13.6%	15.0%	14.6%	16.2%	16.5%	17.5%
ROCE	23.7%	24.1%	21.7%	23.5%	21.9%	22.8%
FCF margin	12.0%	8.1%	16.4%	17.0%	13.6%	4.4%
Opcf cov	150.0%	105.4%	155.0%	138.0%	138.8%	74.1%
FCF conv	114.9%	64.5%	107.3%	125.6%	95.7%	28.2%
Net debt/opcf	-0.11	0.62	-0.06	-0.70	-1.23	-2.08

Sources: Annual Reports, Investors Chronicle

If we look at key measures of profitability such as operating margins, return on capital employed (ROCE) and free-cash-flow margin, Avon has all the hallmarks of an outstanding business. Free cash flow took a hit in 2019 due to a delay in the receipt of cash from a rest of the world military mask contract to the tune of $16.6m (£12.8m). Excluding this then, the company’s excellent free-cash-flow margins and impressive ability to convert its profits into cash would have been maintained. With the $16.6m to be received in the first quarter of 2020 Avon’s prowess in this area should be restored.

The growth in revenues and profits has all been achieved without taking on any debt until the acquisition of the 3M ballistics business. This will see a net debt position in 2020, but the company’s free-cash-flow generation is expected to see a net cash position in 2021.

One of the keys to Avon's success has been its ability to generate new products from its research and development (R&D) efforts. What’s been even better is that the DoD has helped to fund them.

Avon compares favourably with other successful problem-solving, manufacturing companies such as Halma (HLMA) and Spirax-Sarco (SPX), which tend to spend around 5 per cent of their revenues on R&D each year. Avon benefits from having the DoD fund a large chunk of its R&D and so it gets to benefit while keeping its actual spending on this measure lower.

 

Avon Rubber: R&D costs

Year (£m)	Total R&D	Less customer funded	Company spend	Capitalised	Against revenues	Amortisation	Total income statement	Profit effect
2015	7.1	-3.9	3.2	-2.6	0.6	1.9	2.5	0.7
2016	8.3	-4.3	4	-3.1	0.9	2.4	3.3	0.7
2017	8.4	-4.6	3.8	-2.7	1.1	3.5	4.6	-0.8
2018	9.7	-3	6.7	-5.5	1.2	2.5	3.7	3
2019	8.2	-2.5	5.7	-3.7	2	3.3	5.3	0.4

Source: Annual reports

You always have to be a little wary of companies that spend a reasonable amount of money on R&D. Development costs can be capitalised – the money spent becomes an asset on the balance sheet rather than an expense on the income statement – with the cost expensed over a number of years through the income statement. There is scope for aggressive accounting here and lots of capitalised development costs being used to boost profits.

Avon capitalises some of its development costs, but there’s nothing to suggest that it is using this to boost its profits every year.

We can see that Avon spent £8.2m on R&D last year, of which £2.5m was funded by customers. Of the £5.7m spent by Avon, £3.7m was capitalised, with the £2m left over charged as an expense in the income statement. On top of this £3.3m of amortisation (the spreading of previous capitalised development costs) was expensed against revenues. So of the £5.7m spent by Avon on development, £5.3m in spending on amortisation was expensed against revenues. This boosted profits by £0.4m compared with expensing all the annual cost.

In some years, such as 2018, the profit boost can be significant. You need to keep an eye on this and take it into account when comparing profits made against those forecast by analysts – did a company meet its forecasts by capitalising development costs?

It’s best to look at the impact of capitalisation over a number of years. Since 2015, Avon’s expensing and amortisation has boosted cumulative operating profits by £4m compared with fully expensing its annual development costs. There is nothing material or untoward going on here.

Another thing to keep an eye on with growing manufacturing businesses is their working capital performance. Rising stock (inventory) levels as a percentage of sales can be a sign of overhead capitalisation and profit manipulations, whereas rising trade debtors (receivables) can be a warning sign that a company’s revenue growth is declining in quality.

 

Avon Rubber: working capital as a percentage of revenues

Year	Stock/inventories	Trade debtors	Trade payables	Working capital
2015	12.7%	12.7%	12.8%	12.6%
2016	14.4%	14.0%	16.9%	11.5%
2017	13.7%	14.9%	18.9%	9.7%
2018	13.9%	14.6%	20.8%	7.7%
2019	11.5%	19.7%	17.3%	13.9%

Source: Annual Reports & Investors Chronicle

With the exception of a delayed payment (increased trade debtor) referred to earlier, Avon’s working capital position has been improving. Stock levels are down while payables have reduced the working capital requirements of the business compared with 2015.

 

Forecasts and valuation: an expensive share that might be worth paying for

Avon Rubber: forecasts

Year (£m)	2020	2021	2022
Turnover	228.5	255.2	264
Ebitda	50.7	56	59.6
Ebit	39.2	45.3	47.5
Pre-tax profit	36.8	43.4	45.8
Post-tax profit	30.3	34.2	36
EPS (p)	95.7	112.2	117.2
Dividend (p)	27.1	34.8	39.4
Capex	9.6	8.8	10.5
Free cash flow	29.9	30	33
Net borrowing	17.2	-0.5	-17.8

Source: SharePad

2020 should see a nice uplift in revenues and profits with nine months of contribution from the acquired 3M business. The protection business has got off to a good start, with order intake up 12 per cent in the first quarter while the second quarter should see orders for the M69 mask and M53A1 mask and powered air systems. A new M50 contract could also provide upside to current profit forecasts. Law Enforcement revenues should also recover from a weak 2019.

The favourable milk price environment has seen dairy orders increase by 10 per cent in the first quarter of 2019-20, which suggests that profits should grow in the year as a whole.

Free cash flow should be strong and the company should be back in a net cash position next year. This gives it plenty of firepower to make more acquisitions.

Shareholders should also continue to expect dividends to grow faster than profits as the company takes dividend cover down from over four times to two times over the next few years.

I think Avon is a very high-quality business with good growth prospects. The stock market seems to think so as well as its shares have more than doubled in the past year and are up by more than a quarter since the start of 2020.

This means that the shares look very richly valued on a one-year forecast rolling price/earnings ratio of 26 times at a share price of 2,645p. Yet, compared with similar businesses and supported by excellent fundamentals and an impressive economic moat, this does not look excessive in the current stock market. The scope for profit upgrades from protection is significant in my view as new orders combined with operating leverage could see some nice uplifts. Hence there still seems to be plenty of attractions for long-term investors.