Surface Transforms Analyst Q&A: Embarking on an exciting phase of investment and growth (LON:SCE)

Surface Transforms plc (LON:SCE) is the topic of conversation when Zeus Capital’s Research Analyst Robin Byde caught up with DirectorsTalk for an exclusive interview.

Q1: Robin, we understand that you’ve some new research published on Surface Transforms, can you just tell us what’s new in the research?

A1: To give you a bit of background, the company manufactures advanced carbon ceramic brake discs, manufacturing is in the UK but it’s customer base is global.

As you mentioned, we published a note on Monday on the company, this is the first note following the recent and highly successful £20 million fundraise. The company has raised these funds to accelerate growth, to fulfil new contracts, and allow capacity expansion for potential new contracts and these contracts are with automotive OEM’s.

So, the purpose of this research is to update investors on the capital investment programme.

I think it’s important to say that we think that this year, 2021, will be a year of transition and investment with, we believe, strong profit flows in 2022 and healthy free cash generation by 2023.

So, just a little more detail on that investment plan. The company will build a second production unit at its Merseyside factory, that will take about 18 months, once completed the company will have capacity to make enough carbon ceramic discs to generate around £35 million in annual revenue. The second production unit will cost around £10 million to build.

To support those higher levels of activity, the company will hire more technicians and engineers and add more administrative support, also insurance costs and warranty expenses will rise as the company engages with new customers. So, we’ve built-in significant capex over the next two years, around £17 million of CapEx, we’ve also built in around £1 million of additional OPEX.

Looking forward, around 18 months down the line, the factory will then be well invested and operational gearing for new potential contracts should be high.

I think it’s also worth saying that the quality of revenues and earnings should start to improve, the company are signing up more OEM customers every quarter and that is potentially more stable and visible earnings over the medium term.

In terms of customer contracts, as I say, they’ve been signing up new customers through the past year or so and they’re also making good headway in the electric vehicle market. So, carbon ceramic discs are particularly attractive to EV manufacturers due to their superior heat performance and also weight savings.

Q2: Talking about expansion, has the factory got room to expand further?

A2: Yes, that’s a good point so in around 18 months’ time, the middle of 2022, the company will have two fully operational production cells, as I stated generating around £35 million of revenue, potentially. The Merseyside factory has capacity to build five production cells and we think, with five production cells, over the medium term, that will allow capacity to rise to around 100,000 discs per year or around £75 million of revenue.

I’ve been asked by a number of potential investors about the net profit margin once you get to that level of revenue, over the medium term if you like, we think its sustainable net profit margin will be between 25-30%. So, you can see that at that point of full build-out, the company can probably generate around £22 million of net profit each year.

Q3: What can you tell us about the risks involved?

A3: I think it’s certainly worth mentioning the risks with this business model. As with all supply agreements with large OEM’s, the volume of discs actually delivered are not guaranteed and also the phasing of the drawdown of discs could be delayed if the vehicle development programme itself is delayed.

We think in setting guidance, Surface Transforms has been quite prudent, we think we’ve also taken a prudent view of the pipeline both in terms of revenues, gross profits, OPEX and CapEx but there are certainly those risks with the business.

I think it’s also worth restating that 2021 will be a year of transition and investment. The company has two big contracts with OEM6 and OEM9 which will initiate this year but that will be towards Q4.

So, we’d expect the first half to be fairly subdued with better performance in the second half and then profitability in 2022 and free cash in 2023.

Just to sum all of that up, the company is about to embark on an exciting phase of investment and growth, it’s leading-edge products are now being more widely adopted by the OEM’s and you can see that coming through in contract awards.

I think this is all recognition that the company’s technology is superior to the competition, we do expect more contracts to flow over the next 12-18 months but also the earnings in the near-term maybe be slightly subdued as the investment programme is implemented.

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