Surface Transforms analyst Zeus upgrades forecasts

Surface Transforms plc (LON:SCE) has reported solid progress at H1 but more importantly signalled significant upgrades to our sales and profit estimates for future years. Due to better-than expected demand from OEM 8, and activity with new customer OEM 9, revenue will be c.10% higher each year between 2023e and 2025e. With improved operational gearing, our net profit forecasts are lifted by, on average, around 40% each year through this period. Cash should also improve with anticipated better trading. We have discussed higher energy and other expenses with management; from our analysis of unit costs, we believe we have appropriately reflected these pressures in our estimates. The current orderbook now stands at £190m but for the first time Surface has indicated that pipeline opportunities – good prospects, mainly with existing customers – amount to another £400m of potential contracts. Applying a 20% net margin suggests a further possible £80m of profit, if converted. Our DCF-based valuation, which takes a prudent view of the orderbook, pipeline and rising discount rates, is lifted to 140p from 110p per share (a c.30% uplift), indicating good potential upside.

Solid interims, profitability achieved – Surface Transforms published H1 headlines in a pre-close statement in early July. Revenue increased 137% to £2.9m (H121a: £1.2m, Zeus c.£3m). Gross profit was up 129% to £1.7m (H121a: £0.7m, Zeus in-line) with the margin about stable at nearly 60%. LBT increased to £2.5m (H121a: £2.2m, Zeus in-line) mainly as investments in the platform were made to prepare for higher activity. Gross cash was ahead of our expectations at £6.7m (vs. our £6m forecast). Pleasingly, helped by higher development income from OEMs, the Group achieved profitability for the first time in June and July. Good orderbook growth and large pipeline identified – Over the past year, Surface has added major new contracts, with OEMs 6, 8, 9 and 10. The total order book now stands at £190m, from under £50m a year ago. For the first time the Group has outlined its OEM prospective contract pipeline. This incorporates only active development programmes with existing customers or well-known potential customers and is valued at £400m. If we assume a medium-term net margin of 20% this implies additional profit of £80m – although clearly these contracts need to be secured; indeed, we exclude these amounts from our estimates and make prudent assumptions on order flow and margins beyond those already contracted for our DCF valuation.

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Upgrades to Zeus estimates – OEMs 6, 7 and 8 are now in full (“series”) production. OEMs 5, 9 and 10 will start production over the next year or so. Management now has better guidance from customers, particularly on demand and phasing of deliveries for OEM 8. Shipments for OEM 8 have been slightly delayed and sales for this year (2022e) will be £1.5m lower but gross profit mix effect and tight cost control offset the impact. Hence, guidance for a net profit for the year is maintained. The better news is that higher demand from OEM 8 combined with the new OEM 9 contract increase guidance significantly for 2023e-2025e. Sales will be c.10% higher in each year. Costs will also rise by c.£0.8m to cover additional overheads, and we continue to make prudent assumptions on materials and energy expenses, reflecting the current inflationary environment. No tax will be paid now until beyond 2025e helped by the super deduction capital allowances scheme and carry forward losses. The factory and operations are wellinvested adding to the operational gearing of the business. The net result is that profit should be much higher than our prior estimates – for 2023e-2025e we increase our net profit by an average of c.40% each year. To illustrate, for 2024e (when all current contracts will be in full production) revenue is increased by 10% to £33m and net profit rises by over 40% to c.£7m from c.£5m; a 21% margin from 17%. Cash should improve too; capex will reduce significantly by H223e and working capital should turn more positive as the recent stock build converts to cash. That said, for 2022e and 2023e we expect only about £1m of gross cash at each year-end, before a big ramp-up in 2024e to c.£7.2m, or net cash of c.£6.6m.

Continuing to deliver on medium-term plans – This statement confirms that Surface Transforms is well on-track to becoming the leading supplier of carbon ceramic brake disc technology to OEMs. Following upgrades to our estimates, our DCF-based valuation is lifted to 140p per share from 110p (a c.30% uplift).

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