Surface Transforms Plc Pipeline increases

Surface Transforms plc

Surface Transforms plc (LON:SCE) provides the following updates on operations, progress with potential OEMs, and pre-close trading update for the year ended 31 May 2017.

Customer and Operational Highlights

· Knowsley factory: move is now fully completed, albeit with certain production interruptions incurred during the move. Except for the ceramic furnaces, all the new equipment is on order, at prices broadly in line with budget. Deliveries start late June and will continue over the next year.

· Aerospace: continuing delays on commencement of aerospace revenues originating from the airframe manufacturer; management discussions with immediate landing gear customer for a commercial response to offset the consequences of this airframe delay.

· German OEM 3: now expected to introduce the Company’s products earlier than expected – on racetrack cars – in 2018. However, extended testing of road cars means volume sales delayed by one year.

· German OEM 5: confirmed programme for introduction in late 2019 and continues to test with positive feedback.

· Engineering work on the Aston Martin order (won in the financial year) continues to plan.

· British OEM 1: delayed first models understood to be due to challenges they are having with brake system integration – unrelated to the discs. Accordingly, management has substituted the Aston Martin Valkyrie for the first model of OEM 1 in its planning; with minimal impact on total sales.

· VDA 6.3: first “trial run” of VDA 6.3 quality approval standard resulted in an agreed shortlist of outstanding items to address before approval will be granted, expected by Q3 2017.

· Phase One cost reduction programme: will complete when all new equipment delivered. In addition, further significant cost reductions identified from the new Combined Heat and Power Plant and increased purchasing power on gas supplies.

Financial highlights

· Sales for the year at £702k, were lower than expected, as during the period of limited capacity, management took the decision to switch saleable parts into test parts for the extended OEM 3 test programme.

· However, these sales have not been lost, at 31 May 2017, total firm orders and customer commitments are for sales of £889k in the new financial year, the highest visibility of future sales the Company has ever had.

· Cash at 31 May 2017 was £1.53m. In addition to which is an expected R&D tax credit of over £450k (receivable December 2017) and claimed but not yet received grants of £118k (receivable Q1 of the new financial year).

Progress with potential OEM Customers

Since the last update on 13 February 2017, the Company has met with most of its potential customers confirming continuing progress on the fundamentals but with changes in the expected profile over the next three years.

The significant developments are:

German OEM 3: The Company is pleased to announce the customer is now expected to introduce the Company’s products earlier than anticipated – now in 2018 – albeit on a limited edition race track only car. Contractual details are in final discussion, and one relatively straightforward regulatory approval test remains to be completed (note: the Company has already passed this particular test on other cars for OEM3, as well as many other customers). Revenues from this car are expected to be £500k in the 2018 race season – which typically runs from March to October. The customer is able to accelerate this introduction because the product requirement, testing and quality accreditations are different for track cars than road cars. The Board considers this decision further validates the customer’s confidence in the core Surface Transforms product.

In respect to the road car, the Company and the customer are now planning a revised introduction route to the previously announced mainstream, volume, vehicle range. The vehicle range is unchanged but the introduction variant is different to and later than previously announced. This has the effect of giving the Company a further six months to complete and replicate the outstanding product testing which moves volume revenues (excluding race car) back twelve months. However, as this is solely a different entry point to the same model range it does not impact medium term sales.

Testing on meeting the product requirements is on going and the Company believes it can meet the customer’s requirements by Q3 2017. However the Company and customer have agreed that Surface Transforms needs to replicate these results and this could take until the end of the calendar year – consistent with the new road car nomination date.

British OEM 2 and German OEM 4: OEM’s 2, 3 and 4 are sister companies in the same group. German OEM 3 has re-iterated that their testing programme covers the requirements of other group companies. Completion of product testing with OEM 3 will therefore complete testing for OEM’s 2 and 4.

German OEM 5: This is a different German automotive group. The customer’s testing is going well; they have slightly different test requirements to German OEM 3 although the Company believes that it can also meet these. The customer has re-iterated the target model with a 2019 start of production date with mature run rate volumes of £2.5m per year.

British OEM 6: In the year, the Company won an order with Aston Martin – now described as OEM 6. Engineering work on the Aston Martin order continues to plan and the launch date of January 2019 is unchanged with development revenues for the Company expected before that date.

British OEM 1: Delay with the first model for OEM 1 is understood to be due to challenges they are having integrating their brake system and unrelated to the discs. The customer’s solution appears to have been to ask the Company’s competitor for a holistic caliper and disc system offering. As a result, this latter project has been deleted from the Company’s internal forecasts and replaced by Aston Martin. The net effect of these changes is minimal. The Company continues to include the second model for OEM 1 in its planning as it will be offering a joint caliper, disc and pad solution to the OEM, replicating the success of Aston Martin.

Aerospace: As previously reported, testing has been completed and the only outstanding issue is formal sign off by US Naval Air Command and the aeroplane manufacturer. However, this “sign off” continues to be delayed, for reasons the Board believes to be the result of the aeroplane customer wanting to “package” a number of changes at the same time. The Company is in discussions with its landing gear customer with regard to the financial implications of this airframe delay, as the launch date was a fundamental feature of the original commercial agreement. These discussions include continuance of development income if production income is delayed for reasons within the customer’s responsibility.

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Operational Update

Knowsley facility: The previously notified problem with the gas supply has been resolved although this distraction did result in certain production delays. However, the Company is now in full production, on all processes, at Knowsley. The new site, (five times the size of the old site) has been designed using “lean manufacturing” principles and is now, after initial start-up problems, performing better than the old site. The Company fully vacated its old Ellesmere Port facility on 30 April 2017.

The current capacity of the new site is sales of £4m in two cells: Small Volume Automotive Production providing £2.5m and Aerospace providing £1.5m. When the current investment programme is complete, total capacity is expected to be £16m, although given the site footprint £50m sales could be achieved, albeit this would require additional capital expenditure. This £50m sales target reflects the pipeline of the current customer discussions.

VDA 6.3: All German customers require this quality standard. At the Company’s request, OEM 3 recently completed a “potential survey analysis” aimed at evaluating our progress and calibrating the Company’s perception on the closeout actions needed before final approval of VDA 6.3. The survey achieved this objective and the customer confirmed Surface Transforms is close to being approved. An action list with a relatively small number of items has been agreed and management expect to address these by Q3 2017. This timeline is consistent with the new road car nomination date. Racetrack cars however do not require VDA 6.3 approval.

New capital equipment: The new equipment is on order at prices broadly in line with budget. Delivery of the new equipment starts in June 2017, a three month delay but with no impact on any internal or customer critical path milestones.

Changes to the production process from meeting the further product requirements of OEM 3 (the testing issue noted above) could require up to a further £750k of capital equipment on automation of the process and additional ceramic furnaces. The Board are currently evaluating the necessity for such capex including the potential return on investment and were the Company to proceed with the capex, financing options available.

Production cost reductions: The Phase One cost reductions were always in two parts, those associated with detailed engineering changes and those associated with the new equipment. The former is now almost complete; the latter are on target for completion as the new equipment is delivered. There have also been cost increases arising from currency movements on imported materials and sub-contracted processes but these will be more than offset as processes are brought in house.

Additionally, further cost reductions have been identified from both the establishment of a Combined Heat and Power Plant on the new site and increased purchasing power on gas supplies.

Grants and loans: At 31 May 2017, the Company had expended £2.5m of its capital expenditure and thus triggered the final release clause on the £500k grant and loans. £382k has now been received leaving £118k expected in June.

Impact on Trading Results

2016/17 financial year: As part of the process of securing the race track and road car business with OEM 3, the Company has spent approximately £350k on extra development costs which will impact FY16/17 results, partially offset by an increase of £120k in the R&D tax credit expected to be received and credited to the income statement in FY17/18. Additionally, the combination of switching capacity from revenue generating product to test parts together with the problems with establishing gas supply has reduced expected sales in the year to approximately £700k.

However, these delayed sales have not been lost. At 31 May 2017, the Company had retrofit and near-OEM customers orders of £770k and customer commitments for sales for delivery in the new financial year for £119k. This £889k total pipeline is the highest visibility of next year sales the Company has ever had (31 May 2016: £427k).

Future years: The new race track business is a welcome short term boost to revenues but the uncertainty over aerospace revenues and the later starting date for the OEM 3 road car could potentially delay total planned revenues by a year, each year, for the period to financial year 2020/21 returning to the previous notified run rate thereafter.

Year-end cash: The Company cash balance at 31 May was £1.53m to which can be added an expected tax credit of more than £450k in the first half of the new financial year and the above-mentioned outstanding grants and loans of £118k (claimed but not yet received).

Summary

Kevin Johnson, Surface Transforms plc CEO, said: “We are serving a potential £2bn market where a monopoly competitor has current sales of over £100m. Our customers want us to succeed in providing a second source supply to the industry.

Against this background it is encouraging to report the completion of the factory move with continuing cost reductions so we can now focus fully on securing VDA 6.3 and, perhaps above all, that OEM 3 is advancing the introduction of the Company as a supplier, initially on their race car products.

The ongoing delay of the aerospace contract and extended testing on the road car are frustrating, but these programme delays are typical of the industry which are not fully in our control and do not change the end game.

We continue to look forward with confidence and providing further updates on the fit out of the new cells at the Knowsley facility, VDA 6.3 and progress with OEMs, in both the automotive and aerospace sectors.”

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