Velocity Composites (LON:VEL) Sees Revenues and Profits Lower, Shares fall 25%

By | 4th September 2018

Velocity Composites, a manufacturer for carbon fibre aircraft parts today announced in a trading statement that revenues and profits would be below expectations for this year. Shares reacted by tumbling by roughly a quarter in early trade which could be considered a fairly modest drop considering the small-cap status of the company, but set against the share performance this year it is rather dismal:

I am not really familiar with this company at all and have read some of their previous reports as well as comments on forums. But no special analysis is needed to realise that this has been a turbulent roller-coaster ride for investors. Having only being recently admitted to trading, the initial story was of growth – and lots of it. You can see from the chart that only as recently as the start of this year, the markets bought into it, reaching a price of almost 140p. Today we are at less than a third of that, so we can presume that some things in the past year have given rise to some doubts.

First of all, a bit on what the company does, which is succinctly put as ‘is that of the sale of kits of composite material and related products to the aerospace industry’. It is easy to see that this potentially could be a great market: there will always be a growing number of aircraft in the world, and the benefits of composite materials over the traditional metals are not in doubt. Furthermore, utilisation of specialists such as Velocity can improve the supply chain: they can be more agile and responsive to demand. Velocity has already demonstrated this, as it has set up a facility specifically to be near one of its clients: a win-win situation all around.

Best of all, only a few manufacturers of aircraft are really prevalent throughout the world. This standardisation of airframes potentially allows Velocity to have a global reach. To that end, they have established an Asian subsidiary in Malaysia, to benefit from the rapid growth of airframe demand in the region. The company were also looking to set up a global R&D department to further develop their products.

Somewhere along the line, the market seems to have lost patience with this. And checking previous updates there seems to be several weaknesses in the model that have been uncovered. The first hiccup came on 27th Feb in the trading statement which said:

 In recent months there have been some demand reductions with some platforms (e.g. A330, A380 and A400M) decelerating faster than anticipated. The Board has also identified a potential contract which was initially determined to be profitable, on the basis of a stable rate of build. However, the customer recently advised a rate reduction and, as such, Velocity has declined the contract on the basis of significantly reduced profitability.

It does make sense that Velocity would be slightly at the whim of the larger purchasing trends. And given the discrepancy of size of company, supplier squeezing is not unknown, and the fact that the customer didn’t return says there are other alternatives.

Another issue came in to play on the 30th April update:

at the time of the last trading update, the Company had included approximately £3 million in relation to one of Velocity’s largest customers who have subsequently undergone a significant degree of corporate change. These contracts remain in final negotiation and, if they had been signed on the timescale initially expected, would have been worth approximately £5 million in revenues for the current financial year and are expected to be worth £8 million in revenues on an annualised basis.

In the context of the yearly revenues, £8m is a significant amount. There has to be caution advised in assessing the quality of revenues when it is dependent on a few large customers. Given the industry there are likely to be very few small players; there can’t be many small companies that own an Airbus.

Today’s trading update was more or less on the same lines:

The Company continues to make progress towards its year end targets. However, a number of factors, which are set out below, mean that revenue in the year is now likely to be lower than current market expectations with a consequent impact on profitability at the EBITDA level. The adverse factors include longer lead times in customers finalising the contractual position, delays in the placing of production orders where contractual terms have been agreed, delays following requests for configuration changes by contracted customers, and in one case the loss of a programme by a customer.

As we can see, there has been little good news here, and it seems that the year end will not provide any more respite:

Gross margins in the second half of FY18 have now recovered to over 19% on a monthly basis from the previously announced lower than expected levels in the first half year. Given the continued investment in sales and business development, including on-going work in relation to opening a new European facility, partly offset by the recovery in gross margins, the Company now expects to report a low single digit EBITDA margin (%) loss for the year ended 31 October 2018.

As a result, the share price has declined to a all-time low of 40p.

Comment

I like the idea of the business, and the directors seem invested: they own almost 50% of the shares; the share price could be volatile either way. Although that in itself doesn’t make it a good investment. The profit warnings from this year have pretty much shown the pitfalls of this type of business: reliance on a few big customers, the axis of power in the relationship lying with the purchaser, little control over the timing of revenues, all of which have significantly affected Velocity. It seems that in some cases they have been ready to go, but contractual delays end up stringing out the project. Slack on the customer side is therefore transferred to Velocity.

Balance sheet-wise they appear fine for now. As a recent IPO you would expect them to have cash; and of the c.£10m net raised from it, there was £5.75m left at the last year end, some of the proceeds being used to clear an invoice discounting facility and on capex. The cash position has deteriorated slightly:

The Company currently has a net cash position of approximately £4.0 million and has access to a pre-agreed debt facility of approximately £5.0 million when needed, of which a maximum of £1.0 million has been utilised at any one point in time over recent months.

Reading on Stockopedia, one of the concerns raised was the levels of mark-up the company made on its product. This was touched on in today’s trading statement:

Gross margins in the second half of FY18 have now recovered to over 19% on a monthly basis from the previously announced lower than expected levels in the first half year. Given the continued investment in sales and business development, including on-going work in relation to opening a new European facility, partly offset by the recovery in gross margins, the Company now expects to report a low single digit EBITDA margin (%) loss for the year ended 31 October 2018.

This sounds better than it actually is, as all expenses have to be paid from that gross margin. The previous years margin was 15.2%, but this was all swallowed up by administrative expenses which gave rise to an almost £1m operating loss last year. But it is the case that assuming the same expenses, the route to being profitable either involves ramping up operations, or increasing pricing power, neither of which seems to have happened as yet.

The cash position has also declined somewhat:

The Company currently has a net cash position of approximately £4.0 million and has access to a pre-agreed debt facility of approximately £5.0 million when needed, of which a maximum of £1.0 million has been utilised at any one point in time over recent months.

This is not altogether surprising given the nature of the business and the losses. I wouldn’t say the business was in danger at this stage.

In my view there are too many uncertainties here to invest. Velocity has virtually no diversification outside the UK as yet, so Brexit could potentially throw up some gremlins. Visibility of revenue is also poor and dependent on other factors, and they could be bargained down into marginally profitable contracts if a year was poor. With another slim loss looking likely this year, it may take a while to turn around. One of the brighter spots is the opening of a new European centre to assist with sales and business operations, although one must presume there will be stiff competition in the sector.

Let us not forget its intended strategy:

In my view the route to success has to be via a superior product, which could be developed in-house. But given the market reaction, this doesn’t seem like a realistic prospect at the moment. I tend to agree with the market, and that in fighting the current battles, cash might run out.  One distinct advantage of the low share float and lower price is that this might simply be taken back into private hands after a period of time.

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