Surface Transforms DCF-based valuation lifted from 85p to 110p by Zeus Capital

Surface Transforms plc (LON:SCE) has signed a c.£100m contract with existing customer OEM 8. This replaces the previously announced contract from September 2020 which was worth £27.5m. OEM 8 is seeing very good demand for the vehicle variant which will fit the Group’s market-leading carbon ceramic brake discs. Management has indicated significant upgrades to sales for 2023e-2027e. Naturally, additional costs will be incurred with the production ramp-up. Factory capacity is currently at c.£50m of annual sales, rising to £75m in time. Our view is that with more contract wins, Surface may need to consider a second factory.

We are currently in close period for the full year results to be announced in early April. We will publish full updated estimates at that time. That said, for now, we have modelled an earnings scenario to 2025e. We assume, probably conservatively, that by then the Group should generate net margins of c.20% on revenues of £38m, or around £7m of net profit. This excludes any further contract awards. With brighter prospects for Surface Transforms and its disruptive technology, we lift our DCF-based valuation to 110p from 85p.

Major contract award – Surface Transforms has announced a major contract award with existing customer OEM 8. This award is valued at around £100m and replaces the previously announced contract from September 2020 which had a value of £27.5m (i.e., a c.£70m uplift in total). OEM 8 has seen significantly increased demand for this car and has extended the life of the contract to 2027e from 2024e. Other contract terms remain unchanged; carbon ceramic discs will be fitted to the nominated vehicle as standard, and on both axles. Surface is the sole supplier to OEM 8. Start of production is scheduled to begin shortly (i.e., spring 2022) and firm orders have been received. This £100m award lifts the total orderbook, across a range of customers, to £180m. Surface has guided that sales will increase by £4m in 2023e, £11m in both 2024e and 2025e, and by £20m in 2026e and 2027e. The new order has capacity and overhead ramifications.Factory capacity should reach £50m of annual sales in mid-2023e and this will accommodate the extra volumes from the new contract. That said, the Group will need to hire operational and support staff more quickly now, and has said it will accelerate recruitment, leading to £2.5m of additional costs this year.

Forecasts and valuation – We are currently in close period for the full year results to be announced in early April. We will publish full updated estimates at that time, reflecting this major award and costs for the ramp-up, including current inflationary pressures. That said, we have modelled an earnings scenario to 2025e, we assume, probably conservatively, the Group should generate net margins of c.20% on revenues of £38m, or around £7m of net profit. Our valuation for Surface is based on DCF-analysis, building in additional sales and costs, the net impact is to lift our valuation to 110p from 85p, an increase of c.30%. We set out more details of an earnings scenario and our valuation later in this note.

Capital Markets Day in April – Surface Transforms will host a Capital Markets Day at its Knowsley, Liverpool factory in late April, following the full year results statement earlier in the month.

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