A below the radar recovery play

Pennant (PEN:29p), an Aim-traded supplier of products and services that train and assist engineers in the defence and civilian sectors, reported a small underlying operating profit in the first half of 2022 despite reporting a decline in revenue from £7.4mn to £6.9mn, a reflection of the shift to higher margin software activities and the wind down of an onerous loss-making legacy armoured vehicle contact with the MoD.

Since the start of the year, the group’s software and services business has grown its first half revenue by 40 per cent to £3.6mn, accounting for more than half of group revenue for the first time. This explains why two-thirds of revenue is now recurring in nature, thus removing the lumpiness of contracts that have dogged Pennant in the past.

In addition to offering two proprietary software product suites, OmegaPS (a sophisticated logistics data tool) and R4i (a dynamic technical documentation solution), the group provides repeat consultancy, support and maintenance services on both software suites to many customers, including the Canadian and Australian defence departments and their respective supply bases.

During the summer, Pennant booked £1mn of software and equipment upgrades, lifting the total order intake to £12mn during 2022. The closing three-year order book of £27mn includes £12.2mn of revenue for delivery in 2023, more than half of which is for software related activities. The directors note that the sales pipeline for this side of the business now exceeds £20mn, highlighting multiple opportunities in the United States, Canada and Australia.

Pennant’s technical training business line, focused on the design and build of generic and platform-specific training technologies, is showing momentum, too. Having landed a three-year contract worth £8.8mn to supply simulated training systems for the British Army’s new Apache AH-64E helicopter fleet, the directors note that defence procurement activity continues to increase this year, particularly in relation to new and upgraded vehicle platforms in the UK.  In fact, chairman John Ponsonby says that in the “prevailing global security situation, we are seeing real signs that defence procurement programmes are unlocking in our key regions, with several new opportunities already being pursued.” This aligns well with Pennant's training systems engineering capabilities, and prospects to convert some of the £30mn contract opportunities in its sales pipeline.

The group’s balance sheet is looking in better shape, too. Since the half-year end, the disposal of surplus property has raised £2.1mn, which halved net borrowings to £2mn, and net debt will be cut in half again to £1mn once recently issued invoices are settled within their 30-day payment terms. House broker WH Ireland expects Pennant to have net cash of £0.2mn at the end of 2022, thus allaying concerns that some investors may have about its financial position.

For the second half of 2022, WH Ireland expects Pennant to deliver an underlying operating profit of £0.3mn on revenue of £7.1mn; the second half order book materially de-risks these estimates. On this basis, expect pre-tax profit of £0.2mn on revenue of £14mn for the 12-month period.

Moreover, without the drag of the armoured vehicle contract next year – group gross margin would have been around 45 per cent in the latest six-month period without it – then WH Ireland sees a step change in 2023 profitability, predicting pre-tax profit of £1.2mn on revenue of £16.5mn. Pennant has the benefit of £6.7mn of historic tax losses, so forecast earnings per share (EPS) of 3.1p could accelerate sharply if the ongoing contract momentum is maintained and the group continues to win higher margin software contracts. The business has higher operational leverage, too, having terminated the lease on its Stevenage office, and management is planning to rationalise more properties to realign the cost base to requirements in the post Covid-19 world.

Admittedly, investors have yet to cotton onto the upturn in Pennant’s fortunes: the share price has underperformed the London junior market by nine per cent since the annual results (‘Poised for a profitable recovery’, 25 May 2022) and only trades on a 2023 price/earnings (PE) ratio of 9.5. However, there is solid earnings recovery story unfolding here, and one that should reward bottom fishers. Buy.

Simon Thompson was named Journalist of the Year at the 2022 Small Cap Awards.

■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com at £16.95 each plus postage and packaging. Details of the content can be viewed on www.ypdbooks.com.

Promotion: Subject to stock availability, the books can be purchased for £10 each plus £3.95 postage and packaging, or £20 for both books plus £5.75 postage and packaging.