Ultra Electronics is in a replenishment phase, investing in new technologies to embed in programmes that should return the company to growth from FY17. In the current year the spending environment remains flat, but FX and M&A contributions will bolster performance, enabling the company to deliver EPS in excess of 2011’s record level. Our fair value of 2,037p indicates decent upside for the shares should improved order intake and continuing investment deliver expected growth.
Ultra continued to invest heavily during the first half of the current year. Around 19% of sales continue to be spent on new product development. While growth in defence spending has yet to manifest itself in the western world, notwithstanding the apparent increase in support, the investment positions Ultra to generate growth from new contract awards and the strengthening of the longer-term pipeline of opportunities. The £100m order intake shortfall apparent in H215 is being unwound and significant additional contracts appear close to signature. Order cover for 2016 stood at 87% at the end of July, which allowed management to tighten the organic revenue guidance for FY16 to +/-1%. With FX and M&A also making positive contributions, Ultra should experience healthy earnings growth in the current year, despite the dilutive disposal of Ultra ID Systems, with organic growth in FY17 expected to progress towards long-term trend levels in excess of 4%.
Clearly the sharp fall in sterling against the US$ is providing a boost to previous expectations, although recent volatility introduces a degree of uncertainty as to where translation benefits in 2017 will settle. The S3 programme should continue to deliver progressive cost benefits, as should the Herley integration. In addition, recent advance payment consumption and the sizable cash outflows that emanated from the Oman airport contract termination should be complete. Cash conversion is expected to return to the through cycle norm of 80-85% in FY17.
Our estimated fair value for Ultra currently stands at 2,037p, a simple average of our FY17 peer-based sum-of-the-parts and our capped DCF valuation. If Ultra continues to grow EPS in 2017 beyond the range of the last five years, and global defence spending does indeed start to accelerate as western world budgets increase, we feel a moderate rerating is plausible.