# Surface Transforms plc Now with multi-year, multi million revenue contracts

- Link: https://www.directorstalkinterviews.com/surface-transforms-plc-now-with-multi-year-multi-million-revenue-contracts/412792272
- Published: 2019-09-09T07:12:13+01:00
- Author: Giles Arbor

**[Surface Transforms](https://www.directorstalkinterviews.com/company/surface-transforms-plc/sce.l)**(
[LON: SCE](https://www.directorstalkinterviews.com/company/surface-transforms-plc/sce.l))
has today announced it’s preliminary results for the year ended 31 May 2019. The
Company’s Annual Report and Accounts for the year ended 31 May 2019, together with
a notice convening the Company’s Annual General Meeting at Image Business Park, 
Acornfield Road, Knowsley Industrial Estate, Liverpool, L33 7UF on Wednesday 30 
October 2019 at 9.30am which 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**

**Financial highlights**

·    Revenues decreased £361k to £1,002k (_2018: £1,363k)_

·    Gross margin percentage reduced to 61.6% _(2018: 67.4%)_

·    LBITDA (including tax credit and excluding share-based payments and non-recurring
staff costs) increased to £1,564k _(2018: £1,382k)_

·    Research costs increased to £2,074k (_2018: £2,002k)_ which has been partially
offset by increased R&D tax credit of £921k _(2018: £465k)_

·    Other administrative expenses increased by £431k to £1,514k _(2018: £1,083k)_
of which £150k were non-cash items, primarily share based payments

·    Loss after taxation of £2,059k _(2018: £1,834k)_

·    Loss per share of 1.64p _(2018: 1.66p)_

·    Cash used in operating activities increased by £28k to £2,196k (2018: £2,168k)

·    Cash at 31 May 2019 was £1,925k _(2018: £923k)_

·    Capital expenditure in the year was £175k _(2018: £2,024k)_

·    Raised £3.3m, net of expenses, of equity finance in two successful equity placings
during the year

·    Following a history of successful claims, the Company has accrued research 
and development tax credit relating to the year resulting in a near doubling of 
this figure and reducing the loss by an additional £400k

·    Announced change of financial year end reporting date from May 31 to December
31 with effect from December 2019

**Customer and Operational highlights**

·   Post year end awarded an €11.8m contract over seven years from major German 
automotive OEM 5 with SOP of October 2021

·   Post year end awarded a £6m contract over three years to be fitted onto British
specialist automotive company cars for OEM 6 with SOP end of calendar 2021

·    Won a £300k p.a. contract from Koenigsegg as customer replaced its lower volume
existing model

·    Continuing progress on development activity with OEM 3

·    All the furnaces for OEM production cell one now on site in Knowsley. Expected
to be in production by December 2019

·    On target to achieve 50% reduction in direct production cost

·    Awarded environmental certification ISO 14001

**Chairman’s Statement**

The past 15 months, and more particularly the three-month period of contract awards
since 31 May 2019, have been transformational in the development of Surface Transforms.
The Company now has multi-year, multi million revenue contracts that we expect to
support break even EBITDA (including tax credit) during 2020, positive EBITDA (including
tax credit) in 2021 and profit before tax in 2022.

I summarise the progress made during the last 15 months by each of our key customers
and potential customers below:

**Progress on customers**

**German OEM 5: **This customer is one of the three major German automotive companies.
Winning a contract with one of these key reference OEM customers has been a prime
commercial objective for Surface Transforms since its original formation. The contract
awarded to Surface Transforms is to be the sole supplier of the carbon ceramic disc
option on the front axle of one of the volume cars in their stable; the lifetime
revenue from the contract is estimated to be €11.8m over the expected 6 to 7 years
of the cars production run with start of production (SOP) in October 2021.

Of equal, arguably greater, importance is the commercial understanding and opportunity
with OEM 5 to be selected for further multiple vehicle platforms in the customer’s
portfolio over time. These potential awards could generate revenues many times the
value of this first contract. The Company’s carbon ceramic disc is now part of German
OEM 5’s approved component list and whilst there will always be testing on new models
these tests are now more about sizing and system integration than product evaluation.
Furthermore, pricing has been agreed with the customer providing a link between 
increasing volumes and reduced product pricing.

**British OEM 6: **This customer is one of Britain’s premier high-performance car
brands. The relationship with the customer is through a tier one system integrator.
It is an existing relationship as the Company was nominated for a £2m contract on
a specialist one off car in 2018, as described in last year’s report. Post year-
end, the customer, through the tier one system integrator, awarded the Company a
second £6m contract (plus spares) to be spread over 3 years with SOP towards the
end of calendar 2021.

The SOP on the first contract was originally scheduled for March 2019 but will now
commence at the end of 2019. This delay had cash implications for the Company and
thus the Company sought recognition of the problem from our customer for this issue.
As previously reported in June 2019, we are pleased the situation has been resolved
amicably.

**German OEM 3 **This customer is the performance car division of Germany’s largest
automotive Company. The German parent has given OEM 3 the lead responsibility to
approve the Company’s products for wider use within the Group as two other major
subsidiaries (OEM 2 and OEM 4) also currently use carbon ceramic discs. As previously
reported all testing has been completed apart from a destruction rig test in very
specific environmental conditions, with the successful criteria being the number
of cycles achieved before destruction. This test, unique to this customer, has proven
to be extremely difficult to pass and work has now been going on for a number of
years.

However, it is pleasing to report that considerable progress has been made in the
past six months. The investment in a new type of furnace in Knowsley has facilitated
a different approach to resolving this problem and has led to a significant improvement
in test results. OEM 3 has frequent model selections each year and the development
and testing continues, with the customer sharing the objective with the Company 
of achieving the test requirement for the next model selection.

**Near OEMs**: We use this nomenclature to describe smaller automotive car manufactures,
re-builders or tuners typically producing less than a few hundred cars per year,
sometimes only one or two cars a month. This segment has been growing for the Company
but in the year, three near OEM customers suffered either delayed SOP and/or production
problems. This led to a reduction in revenue in the financial year. Nonetheless 
the business was not lost, and revenue growth is expected to return in the next 
twelve months.

It was particularly pleasing to win both the Koenigsegg and British OEM 6 orders
as they are existing customers and this repeat business is a testimony to their 
experience of our technology, quality and supply chain capability.

**Retrofit and Aftermarket: **Whilst financially a small market the fitting of the
Company’s products to existing cars is particularly valuable in securing real world
track and road experience of the Company’s discs. This experience of real customers
driving real cars on both road and track is not lost on our potential OEM customers.
It is effectively additional product testing and reduces their risk of fitting our
technology to production cars.

This retrofit market is mostly served by distributors and therefore has the characteristic
of relatively large orders at infrequent, and difficult to forecast, periods. This
distributor volatility resulted in a reduction in sales in the financial year ended
31 May 2019, as expected orders were pushed beyond our year-end. This issue of aftermarket
order volatility was part of the reasoning behind the decision to change the Company’s
financial year-end from 31 May to 31 December. We cannot change the volatility of
the Company’s aftermarket sales, but we can at least ensure that the Company’s financial
year-end is not in the middle of the automotive racing season and that our financial
year is aligned with our OEM customers.

**Progress on Operations:**

**Knowsley site: **The relatively new Knowsley facility is a 5,000 square metre 
factory. It is ultimately planned to have five OEM production cells plus the existing
small volume production cell (SVP). The combination of these six cells will have
the capacity for generating revenue in excess of £50m p.a. The SVP cell exists, 
OEM production cell one is fully financed and under construction and the subsequent
four cells would need financing and construction as new orders are won. Naturally
any financing requirement for the subsequent cells would include internal cash generation
and debt as the Company will be profitable long before OEM Cell One reaches capacity
limits.

**SVP Cell**: This cell is the original manufacturing capability transferred from
the old Ellesmere Port site with revenue capacity of approximately £4.5m p.a. dependent
on product mix. The cell has performed well in the year achieving most of its key
measures of performance. Moreover, the team have improved capacity of the cell through
process optimisation and with minimal capital expenditure. The sales from lower 
volume OEM customers (namely OEM 6), together with retrofit and near OEM customers
will be manufactured in this cell and therefore the cell will be close to capacity
in the next 18 months

**OEM Cell One**. This cell is planned to have the capacity to generate revenues
of circa £12m p.a., beginning with German customer OEM 5 (SOP October 2021) and 
then any further large OEM contracts. Clearly with this cell, but not future cells,
the need was to demonstrate capacity well in advance of potential need, to re-assure
the larger OEM customers that we have the capability to supply them.  It takes about
18 months to order, deliver and commission a new cell and generally nomination of
new cars is two years ahead of SOP. Commissioning would therefore be broadly in 
support of known or highly likely orders. A new cell costs about £10m and has a 
payback – when in production – of approximately 18 months.

Excellent progress on bringing this cell into production was made in the year. All
the furnaces are now on site and given their lower production costs and increased
capability some are already being used in production of parts for the SVP cell. 
The other furnaces are in the final stages of commissioning.  The team expect to
be able to release the complete cell for production in December 2019 with initial
capacity of £6m reaching the target capacity limit of £12m progressively during 
2020.

**Capital Markets Day:** The Company intends to hold a Capital Markets Day in Knowsley,
in October 2019 to give shareholders the opportunity to see the new production facilities
in their virtually finished state. Further details, with instructions on how to 
register interest, will be provided in the near future.

**Cost reduction**: Over five years ago the Company set itself the task of more 
than halving the production cost of its discs. It is pleasing to report that this
task is on schedule and is expected to be achieved upon completion of OEM Cell One,
expected in December 2019.

The Company is now confident of its competitiveness, evidenced by the recent contract
awards. However, like all disruptive technologies there is a price elasticity curve
for carbon ceramic discs, indeed we believe that price elasticity for carbon ceramic
discs is currently high. The current high-performance car market for the Company’s
products is potentially £2bn, however if the Company (and indeed its competitor)
wishes to further increase the size of the market, beyond high performance cars,
continuing cost reduction is essential. Therefore, having achieved our initial cost
reduction goal, planning has now commenced on the second phase of the on-going reduction
in direct production costs.

**Environment: **The Company is acutely conscious of its environmental responsibilities.
We are determined to be a good neighbour and to ensure that the unarguable environmental
benefits of using carbon ceramic discs (weight, fuel consumption, brake pad dust
and longer life) are not lost in the manufacturing process.

Accordingly the Company secured approval of its environmental process controls through
the award of ISO 14001 certification.

The Company is still finalising approval of all its environmental permits. As described
previously, as a result of increased scale and the introduction of new technologies
the Company is now operating in a different regulatory environment. There are no
fundamental issues in securing these permits, but the process has taken longer than
originally expected. The permits are expected in time for the new OEM Cell One to
be handed over to production in December 2019.

David Bundred                            

Chairman

8 September 2019

Strategic Report

**Operational Review and principal activity**

Surface Transforms is a UK based developer and manufacturer of carbon ceramic products
for the brakes market for the automotive and aerospace markets. In these industries
our products are lightweight, extremely durable and highly refined.  For the automotive
industry, they offer better heat dissipation and material strength resulting in 
superior wear life, improved brake pad wear life and weight reduction compared to
both our main competitor’s carbon ceramic products and other competitors iron discs.
For the aerospace industry our products offer weight reduction, improved brake performance
and superior wear life.

Our strategy is to be a profitable, series production supplier of carbon ceramic
brake discs to the large volume original equipment manufacturer (OEM) automotive
market and to niche military and small commercial aircraft brake market.   To achieve
this, we work closely with Tier One suppliers and directly with OEMs to meet their
requirements on product, price, quality and security of supply.

In addition, we supply carbon ceramic brake discs to small volume vehicle manufacturing
and retrofit high performance kits for performance cars.

The key features of our business model are as follows:

·   Engineer and manufacture carbon ceramic brake products, which deliver high technical
performance for the luxury and performance brakes markets, which we estimate to 
be, ultimately, a circa £2 billion per annum market

·    Achieve selection and supply to OEM customers with product for multiple models
in multiyear supply agreements

·    Be a ‘Quality Company’ with a culture that lives and breathes its world-class
business processes and management systems.  We surpass the automotive and aerospace
quality standards (IATF16949); and thus, have the confidence that we are able to
pass all customer audits, as evidenced by recent contract wins

·   Protect the environment by minimising the environmental impacts arising from
our activities, products and services and be committed to continuous improvement
of our environmental performance

·    Operate lean manufacturing processes, enabling the Company to produce products
that are competitively priced with good margins

·    Support and manage our supply chain which can deliver to our customers’ requirements
on product, price, quality and security of supply

·    Build manufacturing capacity capable of providing sales of circa £17 million
per annum which is further expandable, with the requisite capital expenditure, to
£50 million sales per annum.

·    Succeeding in these activities will generate highly desirable, world leading
quality products, which are price competitive and profitable to the business.

Furthermore, our products and processes are protected by a high level of intellectual
property through a combination of patents but mainly Company process knowhow.

**Delivering our objectives:**

**Automotive OEMs**

Significant progress has been made post 31 May 2019 with contract wins as a tier
two supplier to OEM 6 and tier one supplier to OEM 5.

The OEM 6 contract win is an illustration of how the customer’s demand is divided
over several models with the life of these models spread over many years which overlap.
Once a product is approved for use on the first model, with good supplier performance
the product has the opportunity to then be adopted on multiple model platforms which
run simultaneously over many years and therefore provide long term revenue visibility
and strong growth.

Like OEM 6 this key event of approval for use on the first model has now been achieved
for OEM 5 with an understanding with the customer that further demand can be secured
as new models are launched.

OEM 3 (with OEM 2 and OEM 4 as part of the group) are supporting the Company to 
achieve the same objective of first contract win.  The Company believes the one 
outstanding requirement can be achieved with a combination of product refinements
and process improvements.

As part of being a good supplier we are also focused on achieving certain key operational
objectives:

·    **Quality** – The Company continues to have excellent in-service quality. But
improving quality is a never-ending process, particularly in the automotive industry.
Our measure of improving quality is therefore primarily focussed on reducing the
internal cost of quality; for example, reducing internal re-work, which of course
also reduces cost; good progress is being made but there is always more to do. Additionally,
the award of the IATF 16949 quality approval, reported in the last annual report
is another measure of success in this area. This quality approval process requires
annual re-certification audits. It is therefore pleasing to report that in the year
the Company successfully completed its first annual recertification of both IATF16949
and ISO 9001, with only minor issues arising during the re-audit. Additionally, 
the Company was approved as a supplier by all of its customers following several
appraisals in the year. These customer audits included German OEM 5 who, naturally,
uses the German VDA 6.3 approval process.

·    **Environmental** – The Company is now ISO14001 certified and has the objective
of being responsible for the environment and improving it. The Company has now embarked
on a campaign to reduce its carbon footprint. The plan described some years ago,
to install a CHP plant on the site was never completed due to the failure of the
supplier; however, the Company learnt much from the experience and is now restarting
the project and searching for a more reliable supplier.

·    **Supply chain security** – as with any manufacturing process we are only as
good as our supply chain.  Improvements have been made to our supply chain in terms
of both improving our existing suppliers and adding new suppliers to our approved
supplier list.  Further improvements have been identified and are being addressed
during the year.  We are pleased with progress made and will continue to reduce 
our supply chain risks.

·    **Manufacturing capability, capacity and cost** – the Company operates a versatile
SVP Cell to support OEM development, Near OEMs and retrofit products.  The objective
of improving the capacity of the SVP Cell has been achieved with the cell now capable
of delivering approximately £4.5m revenue per annum. There are additional opportunities
to improve this further and the capacity requirements are continuously assessed.
The new OEM Cell One will be in production before the end of this calendar year 
with all the key equipment (principally furnaces) now on site. The capacity will
have a phased introduction with the first £6m of potential revenue available by 
the end of 2019, with the remaining £6m of revenue capacity planned for 2020.  With
the introduction of OEM Cell One, the cost reduction objectives set a number of 
years ago will be complete.  OEM Cell One is more efficient than the SVP Cell due
to versatility requirement for the SVP; however, cost reductions have been deployed
from the OEM Cell One to the SVP Cell.  The cost reduction plans implemented across
both the SVP Cell and OEM Cell One will have a material effect on both the potential
market and Company margins and as such plans for further cost reduction are being
developed.

**Near OEMs and Retrofit**

These customers make up a relatively small addressable market of up to £2m per annum.
Supplying these customers is delivering on the objectives of product validation 
for large OEM customers as well as establishing the Company’s brand and reputation
as a high-quality manufacturer with a world-leading product. The secondary objective(
as the market is small) to generate growing revenues is only partially being achieved.
The risks associated with forecasting Near OEM sales, relating to SOP and production
delays, have been demonstrated in revenue timing issues this year.  To mitigate 
these risks and grow revenues the Company expects to both expand the stable of Near
OEM manufacturers using its products during the next 12 months, as well as winning
both additional models and replacement models with existing customers. New orders
with Koenigsegg for the Jesko, their new 300mph supercar launched at the Geneva 
Motor Show with annual revenues expected to be circa £300k with SOP 2020 and BAC
launching their new Mono R model with the Company’s ceramic brake as standard are
encouraging examples of succeeding with the latter objective.

We continue to sell retrofit kits for Porsche, Nissan GTR, Aston Martin, Ferrari
and McLaren.      We did not see the expected growth during the year due to order
volatility from the characteristic of a small number of large orders from distributors.
During the year we introduced retrofit products for all the current McLaren range
and will have the benefit of full year sales from these products going forward. 
We therefore expect modest revenue growth going forward.

**Aircraft brakes**

The Company has previously completed the product, quality, environmental, and supply
chain requirements for the customer (a tier 1 supplier).  Realising the objective
of turning this engineering achievement into recurring revenues remains uncertain
as it is linked to programme timing decision between our customer (tier 1 supplier)
and the airframe manufacturer.  Regular discussions with the customer to secure 
financial commitments which are linked to programme milestones are ongoing.

**Summary**

There has been significant investment in engineering work during the year which 
has culminated in the successful contract wins with OEM 6 and OEM 5. The Company
continues investing in engineering with OEM 3 and continues to expect growth in 
near OEM customers both existing and new.  Our work on quality, environment, supply
chain, capacity and cost reduction continue to achieve our goals with further success
expected in the future.

**Financial Review**

In the year to 31 May 2019 revenues fell to £1,002k, this was in large part due 
to the delay in SOP of the OEM 6 hyper car, volatility of demand from aftermarket
distributors and delayed SOP and production problems at three of the Company’s near
OEM customers.

Gross margin deteriorated during the year to 61.6% (2018: 67.4%); driven by lower
volumes of development parts and near-OEM sales mix during the year. Significant
work has been carried out on cost reduction programs, linked to OEM Cell One and
these are expected to start coming on stream in the new financial year and will 
deliver improved margin within our existing retrofit and near OEM markets. These
developments, together with return to more normal sales mix are expected to result
in return to more historic gross margin percentages going forward.

Research and development costs remained flat at £2.1m (2018: £2.0m) primarily driven
by testing for OEM 5 and on-going testing for OEM 3.

Other administrative expenses increased by £431k to £1,514k _(2018: £1,083k)_ of
which approx. £150k were non cash increases in depreciation and share based payment
charges, and approx. £200k due to increased payroll costs as the management team
and mix of staff was strengthened in the year, with the remainder being increased
insurance and facility costs.

Losses after taxation increased by 12.2% to £2.1m (2018: £1.8m) driven by the reduced
sales, decreased margin and a return to a normal level of share-based payment charge.

The result for 2019 includes the research and development tax credit claims made
for 2018 and expected to be made for 2019 reflecting the Company’s history of successfully
making R&D tax credit claims to HMRC. This has the effect of reducing loss after
tax in FY19 by the £400k accrued receivable. This item is non-cash in year and will
not recur in future years.

At 31 May 2019, inventory was £1.2m (2018: £0.9m). This increase has been driven
by the change of supplier of a raw material as well as the processing of materials
to achieve communicated delivery schedules for OEM 6. As previously communicated
the OEM 6 schedule has now been delayed but post year end an agreement was reached
with our tier one supplier to financially support the stock position.

Net cash used in operating activities remained flat at £2.2m, with the increased
stock being offset by an improved debtors’ position and increased R&D tax credit.

The Company had cash and cash equivalents of £1.9m at 31 May 2019 (2018: £0.9m).
In addition to this sum is an expected R&D tax credit of over £400k (expected to
be received November 2019).

Loss per share was 1.64 pence (2018: loss 1.66 pence).

**Change of year end date:**

The Company has announced that it intends to change its year-end reporting date 
from 31 May to 31 December. This brings the Company into line with its major OEM
customers who all have calendar year financial years, whilst also avoiding having
a year-end in the middle of the automotive racing season

The issue of this report will be the last to cover a twelve-month trading period
ending on 31 May. The Company will then report:

–     Unaudited interim results for the six months ending 30 November 2019 by 28
February 2020

–     Audited results for the seven months ending 31 December 2019 by 30 June 2020

–     Unaudited interim results for the six months ending 30 June 2020 by 30 September
2020

–     Audited results for the twelve months ending 31 December 2020 by 30 June 2021

**Key performance indicators**

The Directors continue to monitor the business internally with several performance
indicators: order intake, sales output, profitability, supply chain capacity, health
and safety, quality and manufacturing cost of automotive discs. A set of business
milestones has been agreed and are discussed as part of the monthly board meeting.

The Company produces an annual business plan and full monthly forecasts detailing
sales, profitability and cash flow to help monitor business performance going forward.

Management meetings are held on a weekly basis, all senior managers attend and discuss
production, engineering, financial and quality issues.

**Risks and uncertainties**

As in previous years the principal risk faced by the Company is considered to be
the speed at which our customers and potential customers adopt the new carbon ceramic
product technology. The post year end contract awards indicate the strengthening
desire from a number of volume automotive OEMs to incorporate the Company’s product
in their respective platforms. This risk is constantly assessed by regular customer
review meetings but is now clearly much reduced.

The risks associated with the factory move are no longer a concern. The risks associated
with bringing the newly purchased furnaces into production are being managed by 
both a project team that has the experience and skills to deliver this type of project
as well as pre-delivery testing at the supplier’s premises.  Regular weekly and 
monthly reviews are held and the project’s progress is communicated across the entire
company on a regular basis.

The Company has an exposure to exchange risk however this is partially mitigated
through natural hedging activities.

In terms of uncertainties, product sales are still expected to grow with future 
OEM projections now supported by contracts. Sales growth is expected to be modest
in the retrofit market with an increasing number of distributors and the Board expects
continuing growth with Near OEM customers. This uncertainty is constantly assessed
by regular customer meetings and monitoring the level of enquiries and orders for
both the Company’s products and industry wide.

In addition, the Company faces the continued uncertainty created by the global economic
and political climate, particularly Brexit. The Company has assessed the risks surrounding
this issue and, whilst the outcome is still unknown, the Company believes that the
timing of the proposed exit from the EU, when considered alongside supply timescales
required by our German OEM 5 customer, mean that any initial disruption should be
avoided. The Company has identified methods of coping with a changed customs environment
and will continue to monitor the situation and will react as necessary.

In summary, the Company has made satisfactory progress in its automotive projects
and is progressing well with its expansion plans. Please refer to note 22 for information
on financial risk management and exposure.

**Directors and Staff**

During the year the Company appointed Steve Harvey as Senior Operations Manager,
Steve joins the Company from the OEM tier 1 environment and the Board believes that
his knowledge and experience will drive excellence in our production processes as
we begin supplying to volume contracts.

We would like to thank all our colleagues, management and staff alike, for their
hard work and dedication over the past year.

**Outlook**

The Board now has a high degree of confidence in accelerating sales growth, the 
timing of which now being underpinned by contract awards.

The underlying sales for the new “rump” reporting period of seven months to December
2019 will be in line with previous guidance – roughly half of the previously expected
sales for the twelve months to May 2020.

For the following twelve months to December 2020 this year will now capture the 
bulk of the sales of the first contract from OEM 6, and, slightly higher than previously
foreseen, development revenues from OEM 5. These combined revenues, together with
return to modest growth in Near OEM and retrofit sales, approximate to the point
at which the Company expects to achieve positive EBITDA (including tax credit) during
the course of the year.

These OEM contracts and Near OEM and retrofit sales continue into the year December
2021, a year that will now include the SOP (in the last quarter) of OEM 5, the second
contract from OEM 6 and the higher volumes as the Koenigsegg Jesko replaces the 
Regera. The effect is that revenues are then expected to get to the point where 
the Company is generating modest levels of cash from operations.

The full combined effect of the contract wins on OEM 5 and OEM 6 are seen in the
first full year of production being 2022, whereat the Company is expected to be 
profitable.

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