Surface Transforms (AIM: SCE) have given DirectorsTalk its preliminary results for the year ended 31 May 2016. The Company’s Annual Report and Accounts for the year ended 31 May 2016, together with a notice convening the Company’s Annual General Meeting at finnCap, 60 New Broad Street, London, EC2M 1JJ on Tuesday 29 November 2016 at 11.00 am will be posted to shareholders in due course. Copies of the Annual Report and Accounts will be available on the Company’s website: www.surfacetransforms.com as from this posting date.
Highlights
· Significant, and continuing, progress with automotive Original Equipment Manufacturers (OEMs) on winning ‘game changer’ contracts, including signing a pre production contract with a major German automotive OEM.
· Continuing progress on the aerospace contract with production still expected to commence in early 2018
· Successful equity placing raised £5.5m to finance the Company’s expansion plans. Negotiations since completed on new 55,000 ft² factory in Knowsley, Liverpool, providing sufficient floor space for the production capacity of initially approximately 20,000 discs per annum.
· Revenues increased by £0.3m to £1.4m (2015: £1.1 m)
· Sales to retrofit and near OEM customers increased by 33.3% to £557k (2015: £418k)
· Gross margin percentage increased to 51.6% (2015: 51.1%)
· EBITDA (including tax credits and excluding share based payments) loss of £640k (2015: loss of £584k)
· Increased research costs of £1,254k (2015:£933k)
· Loss before taxation of £1,154k (2015: loss of £982k)
· Loss per share at 1.44p (2015: loss per share of 1.65p)
· Cash used in operating activities increased by 62.6% to £909k (2015: £559k)
· Cash position as at 31 May 2016 of £4,777k (2015: £829k)
Chairman’s Statement
The financial year ended 31 May 2016 has been transformative for Surface Transforms,
· improvement of the underlying financial performance – offset by increasing research costs;
· excellent, and continuing, progress on the “game changing” aerospace and automotive OEM contracts, including signing a pre-production contract with an internationally renowned German sports car manufacturer;
· completion of negotiations on a new factory site together with supporting local authority grants and interest free loans. Orders have been placed, and deposits paid, on the key items of new capital equipment to support an annual capacity of 20,000 discs which management anticipate would equate to sales of £17m per year; and
· £5.5m placing and open offer which in part will finance this capital equipment.
Sales in the year rose by 28% to £1,362k (2015: £1,066k). This increase was primarily driven by an increase of 55% in sales to retrofit customers of £384k (2015: £247k) and a one-off increase of £142k in aerospace development revenues.
Whilst the loss for the year after tax rose to £848k (2015: £765k), this was largely attributable to increased research costs to £1,254k (2015: £933k) to support both the achievement of the German Automotive Industry standard (VDA 6.3) and the increasing activity on the “game changing” contracts, slightly offset by the subsequent increase in the R&D tax credit to £306k (2015: £217k), albeit this increase in “other income” was less than anticipated as the Company received approximately £100k less research grants than expected. The gross margin percentage and all other costs were broadly in line with the previous year.
However at this stage of the Company’s development, the crucial issue is revenue growth. In this regard, the Company is pursuing both aerospace and automotive customer opportunities.
In aerospace the Company is still expecting to commence series production of a carbon ceramic brake disc package on a US military aeroplane in early 2018. We expect first financial year (“FY”) revenues of £0.5m and future mature production sales of £1.3m. Testing has continued throughout the year with all objectives having been met. By contrast there has been little progress on the civil light aircraft opportunity, solely driven by resource constraints within our customer.
In the automotive market the Company is pursuing two parallel, complementary but in practice, different revenue strategies:
· in the short term, retrofit and “near OEM’s” are important to both demonstrating real road mileage experience and reducing “cash burn”. The Company fits retrofit products to road cars already in service replacing both iron discs and competitor discs. “Near OEMs” are defined as car assemblers who take existing models, pre-registration and customise them for higher performance and/or luxury, as well as companies who build very specialist vehicles. Individual “near OEM” sales volumes are typically between 10 and 200 cars per year;
· the longer term game changing OEM contracts on cars generally costing more than £50,000 where the model volumes (on which contracts are based) are typically between 500 and 5,000 cars per year. These potential customers are typically well known international brands.
In respect of the five main automotive manufacturers the Company is working on or is in discussions with:
OEM 1 (British) Start of production (“SOP”) on this limited edition car had been expected to be in mid-2018, with first financial year (“FY”) sales of £0.8m and a further £1.2m in the following FY. For reasons unconnected with Surface Transforms this performance car customer has extended the vehicle freeze date of the first model by six months but has stated that this will not impact the SOP of the car. Self evidently any delay in the SOP dates causes anxiety about the programme itself. At the very least it seems increasingly likely that the SOP will slip by six months and this is now the Company’s planning assumption.
OEM 2 (British) SOP is currently scheduled for late 2020 with first FY sales of £0.7m and future mature production sales of £1.1m. This luxury car company continues to test, however it is a sister company of OEM 3 and is therefore waiting for the OEM 3 tests to finish before contractually committing to Surface Transforms. Nonetheless the size and weight of this vehicle is such that the superior heat dissipation characteristic of the Surface Transforms product is particularly relevant.
OEM 3 (German) As recently announced, the Company has signed a pre-production technology development agreement with OEM 3. As part of this process the customer notified the Company that, after achievement of agreed technical and operational goals, they intend to introduce Surface Transforms onto a different, higher volume, model than previously discussed. This change of model impacts the forecast sales and cash profile. The SOP is now later than forecast (now September 2019) but the effect is a higher forecast of sales in FY 2017-18 (higher volume cars need more prototype parts), lower than forecast sales in 2018-19 (later SOP) but significantly higher sales thereafter. The details of these numbers are still in discussion but the Company’s planning assumptions now include this change of model.
The significantly higher volumes of this different model have capacity implications in Q4 2019 that may require further investment to meet the needs of other customers (above the currently planned total 20,000 p.a. planned disc capacity). However no decisions on capacity to support other customers will be made without contractual customer commitment from OEM 3.
The testing, process is arduous, but progress is in line with management expectations and we expect a final decision, on this model, at the end of Q1 2017.
OEM 4 (German) SOP is currently scheduled for late 2020 with expected initial FY revenues of £1.8m and future mature production sales of £3.8m. As previously announced, this is a sister company to OEM 3 and therefore, the current testing required by OEM 3 should not need to be duplicated. OEM 4 sees all the test data from OEM 3.
It is not clear if the later SOP of OEM 3 will impact OEM 4 but our revised planning assumption is that this could well be the case.
OEM 5 (German) This Company is a competitor to OEMs 2, 3 and 4. SOP is currently scheduled for mid-2019 with expected initial FY revenues of £2.5m and future mature production sales of £2.6m. There has been an acceleration of activity with this customer who is both aware of their competitors’ activities with Surface Transforms and seeking to ensure they get equality of resource allocation. No new issues have arisen from recent testing.
In support of these anticipated contract wins the Company is in the process of moving from its Ellesmere Port site to a new facility in Knowsley, Liverpool, and increasing floor space from 12,000 ft2 to 55,000 ft2. This new floor-space has a footprint which could accommodate machines with a capacity for 100,000 discs per annum. The Company is now in occupation of this site and the planned move is ahead of schedule. In the period to September 2016 the Company has also now ordered and paid deposits of £735k on the key items of plant totaling £2.9m which would support a capacity of 20,000 discs to be located in the new site. Local authority grants and interest free loans to the value of £500k have been negotiated, to be offset against the capital expenditure; the first instalment of the grant income has been received in the new financial year.
The German automotive companies have requested that the Company achieve the German automotive quality standard VDA 6.3 before issuing contracts – this project is well in hand and we expect to achieve this accreditation within the next six months and in advance of any contract award.
This capacity expansion has been financed by an equity cash raise of £5.5m and a loan to equity conversion of £400k. The Company would like to thank both existing and new shareholders for their support in this fundraising.
Strategic Report
Operational Review and Principal Activity
Surface Transforms is a UK based developer and manufacturer of carbon ceramic products for the brakes market. In these industries our products are lightweight, extremely durable and highly refined. They offer better heat dissipation and material strength; resulting in superior wear life, improved brake pad wear life and weight reduction compared to our competitor’s carbon ceramic products in the automotive industry and for the aerospace industry they offer weight reduction, improved brake performance and superior wear life.
Our strategy is to firstly manufacture and sell high quality engineered products into the automotive retrofit market and ‘near OEM’ market. Although these markets are relatively small it allows the Company to generate revenues/cash and importantly reduces the product and supplier risks for the main part of our strategy. The Company’s primary focus is to work closely with major Tier 1 suppliers and OEMs and introduce our products into these large volume original equipment manufacturers (OEMs).
The key features of our business model are as follows:
· we engineer, develop and manufacture carbon ceramic brake products, which deliver high technical performance for the demand in luxury and performance brakes markets, which we estimate to be, ultimately, a £2 billion per annum market;
· our product technology offers highly desirable technical advantages over our competitors and our process technology offers a highly competitive low cost manufacturing route making our products price competitive with good margins;
· to sell a new disruptive product technology the risks need to be managed. These risks are addressed in partnership with Tier 1 system suppliers and OEMs and through adoption of our products in the retrofit and niche vehicle car manufacturers;
· we have an industry recognised high quality product that has been validated by our strategic partners/customers to support product adoption in the key ‘game changing’ volume markets;
· our quality management systems follow the automotive and aerospace quality standards (TS16949 and AS9100); and through continuous improvement we are developing our system to be compliant to the German automotive industry quality standard (VDA6.3); and
· we are building a new advanced manufacturing plant with a capacity of approximately 20,000 disc/annum that becomes operational during 2018 that will then supply the large volume OEMs.
Our products are protected by a high level of intellectual property through a combination of patents and mainly Company process knowhow.
Delivering our objectives:
New product engineering and sales have expanded in the retrofit and niche vehicle markets. We continue to offer retrofit products for Porsches, Ferraris and Nissan GTR’s. We have added three new kits to our Porsche range, three new kits for Ferrari 458 and 430 models and our first kit for Aston Martin V8 Vantage.
In addition our tactical objectives relating to the key automotive market differentiators are advancing well:
· Product – Engineering support to British OEM 1 continues albeit with delays to programme. Refinements have been introduced to delivery to German OEM 3 environmental requirements. Progress is good and is anticipated to meet the customer’s requirements during the next financial year.
· Quality – We have maintained our automotive quality standard (TS16949) and aerospace quality standards (A9100) during the year and are focused on further improving our business and manufacturing systems to comply with the German automotive industry quality standard (VDA6.3). The Company has invested £200k towards this objective, is pleased with the progress made and is on track to become compliant within the next 6 months. These activities have also begun to yield significant improvements in the cost of manufacturing non-conformance. This has been very encouraging and has also confirmed that further significant improvements can be made during the next 12 months.
· Supply chain security and manufacturing capability – Our expansion plans are progressing well with the Company expecting to move from its current Ellesmere Port location to its new Knowsley factory before the end of 2016. The new factory has been designed using lean manufacturing techniques and will initially have three manufacturing cells. A small volume production cell which will continue to support our existing automotive customer and additional ‘near OEM’ customers. A series production cell which is being designed and built during 2017 and will supply the first large volume OEM customer model. An Aerospace cell which will supply our aerospace customer for their US military aircraft programme. The factory then has the floor space to support a further four similar sized series production cells to support future demand. In total the three manufacturing cells provide a capacity of 20,000 discs per annum, with the capability to expand the factory to a capacity of approximately 100,000 discs per annum.
· Cost – our cost reduction programme has now been fully incorporated into the series production cell process and is expected to achieve the target of reducing the cost to manufacture by over 40%. With the introduction of the series production cell we will then have completed the cost reduction programme to reduce the cost to manufacture by over 50%.
In terms of the manufacture and supply of aircraft brakes we continue our targeted strategy of working with an international aircraft brake system supplier on an exclusive basis. The two companies have continued to work together with the aircraft manufacturer and US Military to progress the qualification, certification and approval process. Progress has been made and is expected to continue during 2017 to commence series production in early 2018.
There has been a large amount of engineering work completed during the year to support the good progress made for both the OEM customers and the new factory. The demand for engineering time has increased further particularly in terms of the quality and manufacturing requirements for our automotive OEM customers. As part of the additional £200k investment previously mentioned we are increasing our engineering resources further. The expanded team will ensure the delivery of:-
· The new factory in terms of design and building the manufacturing capability; and
· Series production manufacturing cell meets our automotive OEM customer requirements, our cost to manufacture target and supply chain security plan.
By focusing the Company on these key medium and long term objectives the Company will have the manufacturing capacity to produce approximately 20,000 discs per annum.
