An undervalued micro-cap on the road to recovery

Pennant (PEN:30p), an Aim-traded supplier of products and services that train and assist engineers in the defence and civilian sectors, is well on course to recoup all its first half adjusted pre-tax loss of £1.05m in the second half, and move into sustained profit in 2022. Indeed, chief executive Phil Walker is comfortable with WH Ireland’s full-year pre-tax profit estimate of £0.1m on revenue of £16m given that £7.2m of the £26m order book is slated for delivery in the second half.

The loss was flagged up three weeks ago in a pre-close trading update, the major issue being the company’s longstanding contract to provide electro-mechanical trainers and computer-based training for the Ajax fighting vehicles to the British Army. Supply chains issues, workplace restrictions and engineering complexity in emulating a vehicle (which itself is undergoing review and development) means that the planned schedule will not be completed until the first quarter of 2022. When Pennant reported its annual results in late April (‘Exploiting companies under the radar, 28 April 2021), the board had expected to book £2.1m of revenue from the contract in the first half of this year and a further £0.6m in the second half. Instead, Pennant booked £1.8m in the first half and a further £1m is slated for the second half, the shortfall effectively accounted for the company’s first half operating loss. However, there are strong grounds for optimism.  

Reasons for optimism

Firstly, Pennant’s integrated product support (IPS) division is growing beyond its traditional defence base with new customers being acquired in new sectors including commercial aviation and space exploration. The unit already has two valuable government multi-year contracts (£5.4m of annual revenue) with the Canadian and Australian defence departments to use Pennant’s Oracle-based OmegaPS software product (reduces the support cost of major capital equipment).

Pennant is now reaping the upside from its 2019 acquisition of Absolute Data Group (ADG), a Brisbane-based software company that assists clients to manage vast quantities of maintenance and training data (military aviation, commercial aerospace, and marine, rail, nuclear and automotive sectors). ADG has a high margin (90 per cent gross margin on software license sales, and 50 per cent on maintenance work) sales pipeline worth £14m for clients in Canada, USA, Australia and India. It is converting it, too. Since the half year-end, it has been awarded a £1.5m contract of which £1.2m will be delivered in 2022. Effectively, this means that the division, which traded at break-even in the first half on flat sales of £2.6m and is “on track for revenue of £5.8m for the full-year”, will enter 2022 with a £7.8m order book for delivery next year and that excludes any further potential contracts that could be converted into firm orders.

Secondly, the board is addressing the challenges faced in its technical training division and the lumpiness of orders by targeting a greater proportion of revenue derived from Software-as-a-Service (SaaS) activities. This makes sense given the focus on smart technologies amongst training providers and Pennant’s ability to deliver innovative software-based training solutions including virtual reality and sophisticated vehicle platform emulations. The strategy is working as Walker revealed during our results call today that Pennant has won a six-figure contract to develop a prototype simulation for a major national railway infrastructure provider and the follow-on contract for around 800 devices could be worth £4m.

Quality of earnigs improving

The repositioning of the group will not only improve the quality of earnings, but means that Pennant could reduce operating costs by around £0.5m in 2022 given the higher weighting of software in the mix. Bearing this in mind, WH Ireland’s expectations that pre-tax profit will rise from £0.1m to £0.6m on £1m higher revenue of £17m in 2022 looks far too conservative to me given the far greater proportion of high margin software sales next year, and a potentially lower cost base. Chairman John Ponsonby and Walker both highlight an “air of optimism in business activity, client discussions and contracts.” It is worth noting.

From my lens, Pennant has now turned the corner after a difficult couple of years, a point that is certainly not reflected in its market capitalisation of £11.5m. The IPS division alone is worth more than that as a standalone operation given the high multiples of sales being paid for SaaS businesses. Moreover, unrealised tax losses of £4.5m carried forward will benefit future taxable profits to accelerate the earnings recovery. The share price could easily double and more from this point if the contract momentum continues to build. Recovery buy.

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