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Analyst Q&A with Hardman & Co’s Mike Foster: Surface Transforms (LON:SCE)

Surface Transforms Plc (LON:SCE) is the topic of conversation when Hardman and Co’s Analyst Mike Foster caught up with DirectorsTalk for an exclusive interview.

Q1: What does Surface Transforms do and how is the market placed?

A1: The company is 100% focused on carbon ceramic brake discs. This is currently a luxury-performance market, typically on £100,000 retailing cars. However, that is set to be revolutionised, moving rapidly out of the market niche. Ceramic brake discs are here to stay because their benefits span a variety of environmental categories; for example, the fuel efficiency which derives from significant weight reductions in not only the discs but the whole assemblage of the braking system on the chassis. There is also pretty much total avoidance of microparticles from these discs compared with the dust created by traditional iron discs. These are the types of legislative-related considerations that will eventually take these discs into a very large segment of the new car market, especially perhaps in the EU and UK. This market in 2018 totalled 19.2 million, or a size which could equate to £5bn for this carbon disc market, even if just one axel is fitted and assuming costs continue to be engineered down and the cost savings passed on to the consumer. We estimate a £2bn market ‒ predominantly in Europe but also some for the US ‒ as a realistic medium-term target. This compares with the current £150m annual sales of one supplier and £4m from the company next year. 

Q2: There are a couple of points which stand out. Are there only two suppliers and why does the company make up barely a couple of percent of the market?

A2: They have been perfecting the chemical engineering and tooling of the product, perfecting its manufacture, and progressing extensive tests ‒ lasting years rather than weeks ‒ with several global OEMs. OEMs and original equipment manufacturers: car makers. With such a new and initially challenging-to-make product, it takes time. The company has been selling to a real niche of racing track cars and into retrofit for several years and has built an enviable track record of product excellence. Having effectively ‘gone through the gears’ of opening a factory, testing with several OEMs, and getting designed into upcoming OEM models, in 2019, the company won its first OEM orders. This was a real ‘coming of age’: The company won new orders for four global OEMs in 2019. Prior to this, only the one competitor supplied the whole global OEM market. OEMs were thus wary of relying on only one supplier ‒ they always seek resilience and hence more than one component maker ‒ so the market grew slowly to the current £150m a year. This is tiny. Around 1% of European cars being sold have these type of brake discs. OEMs now have the desired second supplier, so the market will get much bigger. It is only starting from 1%: there is a real and immediate target-rich marketing environment. So: a tiny market share because this is the year the company has cracked the market.

Q3: So how big are they going to get?

A3: In the short term, the answer is that it will get bigger. Our estimates are for 2020 to be slightly greater than 2019, despite COVID-19: more on that later if I may? Then, our estimates are for sales to more than double in 2021 and for just above 40% growth in 2022. Remember, this is just the start. 2021 takes it to cashflow-positive and 2022 to profits. These are 70% gross margin products so top line has a dramatic effect on the bottom line. 40% growth is nearly nothing at this stage of the game. Our estimates take in only existing contracts. We would be shocked if no new were contracts announced well before then. Management indicates there are currently several live trials with OEMs, and that one in particular is the most advanced. So, our 2022 sales estimate is £5.7m, versus £1.0m achieved to May 2019. The company has capacity in place and commissioned to achieve £16.5m revenues. It is not guaranteed that is for sure, but it has every chance of reaching well towards capacity in not too many years’ time.

Q4: What would reaching capacity mean in terms of profits?

A4: We estimate £0.85m post tax profits in 2022 on £5.7m revenue. Even on 60% gross margins (we reckon up to 70% is the broad range) and even were overheads to expand a little ‒ for example, this company frequently spends £1m a year on R&D ‒ over £5m post tax profits would be on that horizon. That is more than 3.5 pence of earnings per share. Now, while this is not a forecast for any particular year, it is clear to us that the market opportunity for this company is much greater than simply filling the current capacity. Indeed, the Board has illustrated confidence that an order pipeline of £50m a year within maybe five years is much more than simply an aspiration.

Q5: So, this is a major growth market and SCE is one of only two suppliers in the world. Won’t a third and a fourth supplier turn up?

A5: The tests they have been undertaking with specific OEMs have lasted years, and that is after years of these OEMs being involved in calibrating their products working on track cars and retrofits, being involved in checking SCE’s manufacturing procedures and supply chain. This literally takes many years. No other competitor is visible as even having started that multi-year journey.

Q6: Yet the share price has fallen in the past couple of months from a recent peak of 28 pence to around 15 pence now. What has happened?

A6: They are cashflow-positive on OEM orders it holds now. These OEMs are household names. But the production of these orders only gets properly underway in 2021, with a modest ramp up later this year. There is a base-load on top of that, namely retrofit and track cars. The COVID-19 restrictions have put a halt to the season in both these markets and left a pause in sales for a few months at this critical stage. The company has raised £1.4m (gross) in a Placing of new shares at 13 pence. These is an Open Offer to existing shareholders. This is frustrating but the success of the Placing secured the cash through to that positive cashflow next year. The company has no debt. The dilution is 10%.

Q7: Are there other risks?

A7: If the 2021 track season halves, then we expect 2021 to see a flat cash position: no inflow or outflow. If no more OEM orders are won, the company will be profitable but merely to the tune of £0.85m a year and the orders run through several years but start to taper meaningfully in 2026. The smallest order runs to 2022. So, we see the market growing and both players growing within it. Some kind of product failure would be a large negative but they have been selling into the niche market for nearly a decade now and the OEMs are happy with what they see: a product which has statistically nil failure outside specification and a product which is better than the competitors’ (especially better designed-in heat dissipation and consistency). Growth in environmentalism helps. Legislation has already helped. Growth in electric cars would help too.  

Q8: Is there a risk that the OEM orders could be pulled or delayed?

A8: The OEMs ‒ there are three live orders here, starting in late 2020 and in 2021 ‒ are putting SCE’s discs onto specific models which are already launched and with pre-orders. The whole run of cars for the order starting at the back end of this year is already sold out. At the moment, these are luxury cars and they pre-sell. Why would pre-sold cars have manufacturing delayed? The only reason is COVID-19 and the first is due to commence back end 2020, so the risk on timing is very low indeed.

Q9: Can you explain to me why the company valuation looks so favourable to you?

A9: The company makes highly technically demanding-to-make products, but products which are just at the start of a very typical auto-component demand curve. In auto-component terms a £2bn market is still quite niche. It is one of only two suppliers and the barriers to entry are huge ‒ more in terms of time than money. That means Surface Transforms shares the next several years of market growth with just one other. Gross margins are 70% and any erosion should definitely be modest. Capacity is in place for sales, which would lead to very attractive profits relative to the current share price. The Placing has been a success but 2020 has seen an impact from COVID-19, which has been reflected in the share price. It would take a macro-situation in 2021 (as opposed to simply 2020) forcing OEMs to pull out of manufacturing cars, which are pre-sold for our numbers to be blown materially off course. The company’s position is robust and the market position benefits from a huge ‘economic most’. Downside seems to be pretty much covered off to us, while the upside is a protected position as one of two globally in a global market of circa £100m a year gross profits and growing fast. This is a company with a market capitalisation of £21m and has never had any debt.

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Disclaimer: Statements in this article should not be considered investment advice, which is best sought directly from a qualified professional.