Avon Protection's rebirth has been a painful one

In September last year, the Wiltshire-based company, which began life in 1885 producing everything from pneumatic tyres to conveyor belts, exited one of its oldest businesses making rubber tubes for milking machines. It sold Milkrite for £180m to DeLaval – £130m of which was booked as a one-off gain for the year ending September 30, 2020.

It spent $130m (£95m) of the proceeds on Team Wendy, a US-based manufacturer of head protection systems used by the military, law enforcement officers, search and rescue teams and people involved in adventure sports.

This fitted more neatly with its now-core offering of making body armour and masks providing breathing protection.

Investors clearly bought into the company’s transformation, which involved a name change from Avon Rubber. Well they might. Its protection business had long been a source of dependable sales and high profit margins, reflecting Avon's specialist knowledge and deep client relationships. The performance of the milking division, which had accounted for about one-quarter of sales, was historically less impress. The pivot to protection saw the share price more than double from 2,065p at the beginning of 2020 to 4,650p last October, valuing the company at £1.44bn.

To say this was a stretch proved something of an understatement. The valuation peaked in late 2020 at almost 37 times next-12-month forecast earnings. Then a disappointing trading update in December led to a sustained sell-off.

The company reported two pieces of bad news – firstly, body armour plated designed for use in the US failed a key testing process. Secondly, a contract it had secured in September 2020 for a “next generation” head protection system for the US army had been objected to by a competitor, creating an unspecified delay to its delivery.

More than half of Avon's value has since been wiped off and it now trades at just above £600m. The question for investors, though, is whether the company's value has further to fall or if it rebounds from here?

A momentum trader wouldn’t be too sure. At 1,915p, the shares trade marginally above their 50-day moving average of 1,896p, but well below their 200-day, 2,700p a share average. The share price has experienced a couple of brief rallies this year, but any serious signs of momentum were extinguished in August when Avon reduced its revenue outlook for the year ending 30 September, citing delays to orders, supply chain disruption and a “tight” US labour market.

No sure thing

The decline in its valuation may seem extreme, but it is a reflection of new uncertainties about the way in which the company now makes its money when previous confidence was sky high. In the first six months without milkrite, nearly nearly 80 per cent of the company’s revenue came from North America and 60 per cent from military customers. This no longer seem to be the sure thing investors were betting it was at 2020 highs.

Uncertainty or delays to US military contracts therefore have a much more significant impact on forward earnings. What's more, the high level of fixed costs associated with the company's manufacturing base means the impact of sales disappointments on profits are magnified.

Supply chain pressures have also affected cash flow. In the first half, Avon moved from a net cash position (excluding leases) of $147.7m to net debt of $12.9m. The bulk of this ($135.5m) was used for the Team Wendy acquisition, but $10m was taken up in working capital to build inventory levels and almost $16m was spent on capital expenditure – mainly on product development and IT infrastructure costs.

Some $12m also went to dividends and share buybacks. Avon Protection has a progressive dividend policy and increased its half-year payout by 30 per cent to 14.3¢.

Full-year results are due on 23 November and the company has indicated that revenue will come in at about $250m. This is a 17 per cent increase on the same period last year, but at the lower end of the $245m-$260m guidance range provided in August. Sales have been affected by procurement “bottlenecks” and delays to existing orders as lead times for parts have lengthened.

Cash profit (Ebitda) margins are likely to fall to 15-16 per cent, which is lower than previous guidance given by the company of 17-18 per cent and a decline on its five-year average of 20.6 per cent.

The lower forecast is due in part to a non-cash inventory write-down in its ballistics protection arm relating to the purchase of 3M's ballistics protection business and the Ceradyne brand acquired from 3M in 2019.

Given the frequency of issues that have occurred over the past 12 months, it is perhaps understandable that some investors have lost faith.

From dark skies...

Things appear to be looking up, though. The contested helmet contract for the US army was superseded in September by a new deal worth up to $87.6m over two years. The company has also said it expects approval for the body armour product that initially failed testing in the first quarter of its 2022 financial year, with initial deliveries expected in the second quarter.

Avon also reported a strong intake of new orders – up 34 per cent year on year to $280m. This bodes well for a bounce back in profitability.

Although the past 12 months have been “a year that neither management or investors were hoping for”, its year-end net debt forecast of $27m was better than expected, joint broker Jefferies said in a recent note.

With consensus earnings forecasts of about 66¢ (49p) for the year just ended, Avon ’s price/earnings ratio of 40 times earnings may seem a bit rich. However, the average estimate for next year is a 91 per cent increase in basic earnings per share of about 126¢ (92p), valuing it at 21 times earnings, which is in line with peers. What's more, Avon's profit fight back is not expected to lose steam quickly. While some way off, brokers think the company could produce earnings of 161¢ (118p) come 2023. It is easy to feel cynical about forecasts after the last 12 months, but before its annus horribilis Avon was better known for beating expectations rather than falling short of them.

Cash conversion increased from 53 per cent at the half-year stage to 80 per cent by year-end, and much of the investment the company needed to make to ramp up production of both helmets and body armour fell into the year ended on 30 September.

Although it has suffered a series of setbacks, the rationale for the Avon's transformation still makes sense. It has developed a strong niche, serving the most important customers in its field – the US Department of Defense, the UK's Ministry of Defence and a framework contract with the NATO that allows member countries to buy from it. 

The US military is obviously a key customer, and although there have been contract and delivery delays, it has not lost work and still has the faith of the world's biggest spender on military equipment. 

The US increased defence spending for the third year in succession in 2020, with its 4.4 per cent budget increase outpacing the global market growth rate of 2.6 per cent, according to the Stockholm International Peace Research Institute. 

Avon's chief executive, Paul McDonald, seems confident that the company can regain its footing. He bought almost £40,000-worth of shares in late September at 2,069p a pop. Although he can't guarantee a bullet-proof performance for investors, he'll clearly be hoping that the year ahead will prove less of a minefield than the one it has just negotiated its way through. If the company can avoid stepping on any more of those mines, the current price should prove a good entry point.