Surface Transforms Q&A with Hardman & Co (LON:SCE)

Hardman & Co

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 is Surface Transforms and why should investors in this small company take note?

A1: The company announced a series of orders in June and July of this year, taking its annual sales projection in calendar 2022 to six times its historic sales. This is just step two in this company’s journey towards being a major player in a market set to exceed £2 billion. The company is an auto component manufacturer and has been making an exceptionally technically-demanding product for nearly a decade now: carbon ceramic brake discs.

Step one was taking on the known extreme challenge of chemical-engineering, designing and manufacturing the product then convincing the potential customers, the global auto OEMs, original equipment manufacturers, well known car-makers. They now have become actual customers – that was step two.

And just on their “toe in the water” first orders, it takes the company to cash flow positive and to profits. All manufacturing capacity is fully in place. We shall turn to the potential, but here we look at numbers based on orders secured.

Numbers are still small – £5.8m turnover in 2022 and a profit being registered on that level of sales. Two years ago – in full anticipation of these types of orders – a factory with £17 million revenue capacity was opened. Investors should take note that the customers are global OEMs. These are big players but they also are cautious and deliberate. For these OEMs, it’s been many years of testing their product and a £5.8 million sales rate is just a couple of small models. It always is like this. The global OEMs are very demanding: testing and re-testing, then toe in the water, then much greater volumes.

Q2: You said the company was at “step two”,  can you give us a summary of why “step two”?

A2: Step one was ten years ago – the determination to enter this technically challenging market. That challenge creates the barrier to entry. It takes many years and PhD level expertise in chemical engineering to make the best product. And that is just the product. You then have to perfect manufacturing, test it and then get the OEMs to test it. Each takes years and can only be done sequentially.

For several years, the company has been selling the product to track cars, retro-fits and the smaller OEMs. In the field, this product has been proven and for many years its failure rate effectively nil. Step two was summer 2019.

Step two was that – after a number of years’ testing by the OEM customers – firm orders with firm dates and pricing were secured from two OEMs.

So, step three will be other OEM orders – where testing is well advanced. And also, all these OEMs giving SCE orders in subsequent models. Step two really is the key. It unlocks acceptance of the company as a strong credible volume supplier. The log-jam of the pre-acceptance stages is now gone. It unlocks a market which is huge for a £30m market capitalised company but not overly ambitious in the context of the huge global auto market.

Q3: Just why do we need a new type of brake disc for our cars?

A3: We model 6% of the brake disc market by volume will eventually migrate to this product. It will migrate because the weight is significantly better than iron brakes, by circa 5% of the total car’s weight. This reduces emissions and these environmental regulatory drivers are clear and present. It also eliminates dust – and particulates also are big environmental topics. Performance is much enhanced. Braking is stronger and this enhances safe speed – for example coming into corners. Both environmental legislation and performance criteria move the market to this product.

Q4: What is the company’s market potential? Your report refers to £2 billion and yet the company’s market capitalisation is under £30 million.

A4: If 1.5% of brake disc volumes in Europe alone go to SCE in the coming years, that would be £500 million annual revenue. The current global sales for this carbon ceramic brake discs product is – we estimate – some £150 million per annum, 99% supplied by one competitor to SCE.

There is a significant quantum of growth – many orders of magnitude of growth – pent up here. For example, this is part of a global automotive brake systems market which is approaching $30 billion. We calculate there is an addressable market of £2 billion carbon ceramic brake discs in Europe alone. That number would be generated if around 6% of all brake discs, currently these are grey iron discs, migrate to carbon ceramic.

This assumes that in the relatively near-term, nearly all cars retailing over £100,000 would take these advanced products. That would give a £250 million addressable market – the market available right now, we contend. If only a portion of cars selling for over £50,000 take the product in due course, that gives a £2bn market.

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Q5: Are there any other suppliers? Having just two in the world seems unlikely surely?

A5: There no other suppliers in the world – just two. And we’ve shown that it takes many years for any new supplier – and that is anyone, no matter how well resourced. This is chemical engineering and it takes years’ OEM pre-testing not only of the product but the manufacturing process which is super-complex engineering and baking – down to microscopic levels of surface transformation.

Q6: So, Surface Transforms is second supplier into this market, the sales are growing fast but from nearly nothing. It can be seen that new products gain acceptance and volumes grow a lot but will investors in this small company ever get beyond just a niche player?  

A6: Typically, in nearly all new car components this is what happens. Supplier one grows, but the OEMs remain wary until a second supplier arrives, which secures supply. That in itself is the trigger to substantial market expansion. Supplier two expands to a size not too far behind – or indeed larger. As volumes grow, costs fall and volumes grow further.

This gets us to SCE with a sizeable market share of a £250 million, £1 billion, £2 billion market in the distinctly foreseeable future. As with all OEM sourcing, a dual source is essential. They will not move a product anywhere near the mainstream until there is dual sourcing. T

his £150 million current – 2019 – sales for the whole market is a tiny figure. Within that, SCE sales are only £1.0 million, rising to £5.8 million in 2022 on firm contracts which have been recently announced. But that is simply the crack in the log-jam of these long exhaustive tests. The length of testing provides a kind of economic moat for the two existing players.

Q7: You talked about OEMs moving this product into the mainstream, isn’t this just a high-performance very specialist product?

A7: Both environmental legislation and performance criterial move the market to this product. Just like any new consumer product the more expensive models take it. As volumes rise, prices fall and the market expands further.

Q8: So, what are the risks?

A8: Technical risks a-plenty have been surmounted. The Company has been making the product for nearly a decade and field-failures are statistically non-existent. The production has evolved and for two years has been in a new factory, designed to work in manufacturing cells each identical and further ones being slotted in as demand rises.

Gross margins, at circa 70%, seem high but this is far from unusual for this stage in the market. Costs need to be engineered down in order to expand the market. Costs have halved in the past five years and there are a number of distinct drivers to further falls – certainly not solely economies of scale. At current booked revenues the company only just reaches profitability. That is impressive, on such modest revenue, but more orders need to be secured. No matter how target-rich, this is still prospective.     

Q9: And the numbers? The cash?

A9: One manufacturing cell, in due course the factory could have five, costs £10 million or less to install and commission. Cell one is up and running and has capacity of £12 million annual revenue. In addition, there is a smaller volume cell working and this has a capacity of £4.5 million.

Gross margins in our 2022 calendar year are estimated at 69%. We anticipate 60% as the medium term run rate. With one full-size cell manufacturing product bringing revenue of some £12 million on 60% gross margins, this is medium term, a £10 million capital investment generates 70% return on capital before the overheads. This is the kind of metric driving the next years in the coming decade.

2020 is a transition but our numbers are based solely on revenue from firm orders for specific models. Even so, after the R&D tax credit SCE is EBITDA profitable 2020, just. By 2021 it has achieved cash flow positive status through the year. 2022 we estimate £0.8 million profit after tax which is a 14% profit margin. This we consider an impressive margin based on orders which – in the context of the potential are “toe in the water”.

At some point we do see potential of a £500 million sales as opposed to £5.8m which we see for 2022 estimates. That is a long way off but filling the current factory would take sales to some £50m annual. That would come – we suggest – if just cars selling over £100,000 took this product and SCE carved a share which we see as highly realistic within a short-term addressable market. With cash generation in 2022 expected and with add-on manufacturing cells costing around 18 months’ gross profits, cash generation profiles are good.

In a nutshell, three last points:

1) From 2021 onwards this is an intrinsically cash generative Company, able to reinvest to continually grow the top line

2) There is a clear well-trodden route in the auto industry for the second supplier to secure a strong market share and at this point any third supplier is inevitable many year away. None is visible.

3) Even as a real niche product – and this product will not remain a niche – Surface Transforms should fill its first factory. That would generate gross profits around one times the current market capitalisation.            

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Surface Transforms plc
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Hardman & Co

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Surface Transforms plc

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