Defence products

As a quick introduction, Avon is a technology business that designs, manufactures, and produces life-critical personal protection systems and products for the defence sector. Some of its best-known products include body armour and masks that many armies, security services, and police forces use around the world.

So what’s the current situation with Avon shares? Well, as I write, they’re trading for 948p. At this time last year, the stock was trading for 1,937p, which is a 51% decline over a 12-month period. The shares took a hit at the end of last year when an acquisition went badly wrong as well as the fact that one of its key armour products failed a US army test.

A growth stock with risks

Firstly, I can see Avon has a fair amount of debt on its balance sheet. This can hinder the growth of a business and Avon has had to pull back on research and development (R&D) spending due to this. R&D is a pivotal ingredient for growing any business. This is especially the case in the defence sector.

Next, defence spending is key for many governments throughout the world. However, when the state of the global economy is uncertain and a potential recession is looming like now, demand may temporarily drop. Furthermore, pre-agreed contracts can be delayed and this is a common occurrence in the defence industry. All of these issues could affect Avon’s short-term balance sheet and levels of returns.

The investment case

I always view any growth stock as a long-term investment so I’m willing to accept some shorter-term headwinds. The longer term is where I believe Avon could thrive and provide me consistent returns through growth. Here’s why.

Firstly, Avon has an excellent relationship and ties with the US Department of Defense. This relationship provides lucrative opportunities as the US government is one of the biggest defence spenders in the world.

Next, the defence landscape is changing and this should benefit Avon, in my opinion. Research indicates that global defence spending rose to record annual levels in 2021. Avon also recently confirmed that since the tragic events in Ukraine began, it has experienced heightened demand for its products.

Finally, Avon shares currently pay a dividend that would boost my passive income stream with a current dividend yield of 3.5%. I am buoyed by this but viewing it as a growth stock, I would expect this rate of return to continue to grow. Dividends are never guaranteed and can be cancelled at any time, however.

I do believe Avon could be a great growth stock to buy for my holdings. Analysts believe the future could be lucrative although I am aware forecasts don’t always come to fruition. The recent share price drop has only made it a more attractive prospect for me.

Even as recession approaches, countries will continue to invest in their armed forces. Spain’s £500m order for 20 new Eurofighter planes from BAE Systems in recent weeks illustrates the point. Nations will always spend heavily to protect their borders at all stages of the economic cycle.

Global defence expenditure rose to record annual levels in 2021, and Russia’s invasion of Ukraine since then has raised the appetite for governments to keep spending. This is why I’d consider snapping up Avon Protection (LSE: AVON) shares today.

Demand outlook has improved

This particular UK defence share manufactures body armour and masks that armies, security services and police forces use all over the globe.

Back in May it announced that “there has been a significant increase in expression of interest in our products” following the outbreak of the Ukraine war. It added that it expects to see “a significant shift in demand in the short, medium and longer term.”

I like Avon because of its strong relationship with the US Department of Defense that provides exceptional revenues opportunities. This has been helped in part by its acquisition of 3M’s advanced ballistic protection business in 2019.

Risks to Avon Protection

I’m concerned by the large amount of debt Avon Protection currently has on its books. Net debt jumped to $88.3m as of April from $44.1m a year earlier. The business has been forced to curtail research and development spending because of this.

Trading at Avon has also recently been impacted by bumpy US federal budget discussions this year, an issue that has hit orders. Contract delays are a common problem for defence businesses that can have big consequences for near-term investor returns.

A dirt-cheap UK share

That said, the latter point isn’t a dealbreaker for me. I buy UK shares based on the returns I can expect to make over the long term. We’re talking about a minimum of 10 years and above.

And over this sort of timescale I think Avon Protection could deliver exceptional shareholder profits as the geopolitical landscape evolves.

The threat of a new Cold War isn’t the only likely driver of defence spending this decade. According to the Stockholm International Peace Research Institute, China spent 4.7% more on weapons year-on-year in 2021. Russian spending also climbed 2.9% last year.

In the more immediate future City analysts think the business will see earnings tank 67% in this financial year (to September 2022). But they reckon profits will rebound 250%+ next year. This means Avon trades on a rock-bottom price-to-earnings growth (PEG) ratio of 0.1 for fiscal 2023.

At current levels around £10 I think this beaten-down business could be a steal. I expect the defence giant to recover strongly from recent heavy share price weakness.

BAE is shining

BAE Systems (LSE: BA.) has enjoyed significant share price appreciation due to the uncertain geopolitical backdrop, and this could continue. So far, £104bn of defence spending increases have been announced by seven European countries. BAE is already benefiting from this, with contract wins from the German government. Military equipment such as fighter jets and naval ships made up about half of the group’s sales as of December 2021.

The company is attractive to me both as an income and growth investor. It currently has a 3.4% dividend yield and the continued development of its cyber intelligence units should boost higher margins.

The shares are more expensive than their longer-term average, currently at 15x forward price-to-earnings (against an average of 11x). But I think they could get more expensive as rising tensions between China and Taiwan could be reflected in the price of defence stocks such as this. Regardless of that, general commitment from governments to increase defence spending should benefit BAE and so the company has scope to grow into its valuation. This is a stock I may add to my portfolio soon.

Avon is underperforming

Another large defence player in the UK is Avon Protection. Unfortunately, I can’t be so optimistic about this stock. The shares have fallen 61% over the last 12 months. This downtrend doesn’t appear to be ending any time soon either. The company confirmed plans to wind down its body armour business in December after Avon products failed US Army tests. Alongside this, it was announced that its CEO will leave at the end of this year.

Streamlining operations may lead to a turnaround for the stock longer term, but there’s too much uncertainty today for me to invest. Also, the stock is too speculative for my liking, given the high valuation at 40x earnings.

Software is the new defence

Two other companies I’ve been monitoring are Chemring and Palantir. Chemring supplies the defence industry through its Sensors and Information (S&I), and Countermeasure and Energetics products. The company saw a 27% increase in underlying profit for its S&I business over the past six months and should benefit from the government defence spending mentioned above. Chemring’s steady profits and reasonable valuation mean this could be a quality stock to hold in my portfolio for years.

Meanwhile, a high-growth play in this area is Palantir, an AI data analytics company that makes a digital clone of a business, aiming to improve its efficiency and digital security. It has won several US Government defence contracts and is currently bidding for a £360m contract to control the UK’s NHS IT infrastructure. It seems it has what Warren Buffett would describe as a ‘moat’ around its business because once a company adds Palantir’s clone to its digital infrastructure, it becomes hard to change provider. This could be a great long-term purchase for my portfolio.

Fundamentally, Avon Protection’s figures are promising. With a compounding annual growth rate of earnings per share of 50.48%, this stock has delivered outstanding results for the past five years. Furthermore, its price to earnings ratio of 11.8 suggests that its share price should be significantly higher than where it is currently. In terms of its products, Avon Protection is the only company in the UK and Europe, and one of two globally, that manufactures equipment for all specialised fields: emergency services, military, biochemical protection, and nuclear. While it produces body armour and hazardous material suits, it also manufactures respirators and helmets. The helmet production was enhanced with the acquisition of US company Team Wendy.

While it has a diverse business, the news is not all good for Avon Protection. Suspicions rose in June 2021 when Berenberg cut the Avon Protection price target from 3,335p to 2,955p. The following August, it was announced that the company’s 2022 revenue guidance was being cut from $357m to $320m-$340m. In the same announcement, however, Avon Protection stated its order book was up 21%, indicating the increasing need for its products. Nonetheless, with the pandemic easing, supply chain issues began to nibble away at the share price. Since then, a major flaw in body armour testing has dented investor confidence and the leadership eventually took the decision to wind down this part of the business over the course of the next two years.

These problems have created a rather interesting chart over the past four months. We can see the first price gap on 13^th August and a second, larger gap on 12^th November that took place on extremely heavy volume. These gaps both correspond with the negative supply chain and body armour news stories. While the stock is in an unmistakable downtrend, there is a remote possibility that the price is currently in the head position of an inverted head and shoulders formation. This could mean that a price reversal is in progress and the aforementioned gaps could be filled. There are clear problems with this stock, but these are mainly short-term issues that can be rectified in time. The management has addressed the body armour shortcomings by taking the courageous decision to wind down this part of the business. With solid fundamentals and potentially encouraging price action, I am glad I invested in this stock and will be adding in the near future. I am not surprised this stock is up 10% today.

A closer look at Rolls-Royce shares

Investors who bought Rolls-Royce shares a few years ago are likely looking at a red mark in their portfolio. That’s because, over the last five years, this stock has fallen by around 45%. Most of this decline was seen in early 2020 after the pandemic decimated its aerospace revenue stream. But even if I look at share price performance between December 2016 and 2019, it only climbed by a mediocre 4.6%. That doesn’t even beat inflation on an annualised basis. So, what happened?

For a long time, the financial state of this enterprise has been pretty dire. Only one out of the last five years have been profitable, which pushed management to take on considerable debt even before the pandemic reared its ugly head. Needless to say, that’s not the sign of a healthy and thriving business. And with Covid-19 only exacerbating the problem, I’m not surprised to see the stock take such a massive hit.

But recently, the situation has improved. The company is undergoing some fairly massive restructuring to cut costs. And its aerospace division is back on the mend as demand returns for its aircraft maintenance services. Therefore, Rolls-Royce shares may be primed to make a rapid comeback in 2022. And if that were to happen, then an investment as small as £1,000 could prove to be quite lucrative. But is there an even better buying opportunity elsewhere? I think there is.

Fallen from grace but capable of rising again

When investigating Rolls-Royce shares, many investors like to focus on its aerospace division. After all, it’s the group’s primary revenue source. However, it also has sizeable operations within the defence industry. That’s a sector in which Avon Protection (LSE:AVON) has recently fallen from grace as far as the market is concerned.

Avon designs and manufactures personal protective equipment for the armed forces as well as first-responders. And until recently, the stock was thriving, reaching as high as 4,650p in early December 2020. However, looking at the share price today, almost all the gains made in the last five years have been wiped out. There are undoubtedly numerous reasons why shares of Avon Protection have collapsed. However, one leading factor is a failed body armour test for the US Defence Logistics Agency, which significantly impacted growth expectations.

Yet the income from its flagship respirator and ballistic helmet product lines remains uncompromised, with double-digit growth still being delivered. That’s why I believe investors may have overreacted, creating a buying opportunity for my portfolio. And with a much stronger balance sheet than Rolls-Royce, these shares look like a better comeback story, in my opinion. As such, I’m not convinced buying Rolls-Royce would be so smart for me. I’d ignore Rolls-Royce and buy Avon for my portfolio.

Key details

Formerly known as Avon Rubber, Avon Protection PLC is a British company with a long history in the manufacturing of rubber-based products. However, 2020 represented the culmination of a decades-long process by which Avon transformed itself into a producer of ballistics and respiratory protection systems for the military, law enforcement, and emergency responders.

Avon had been making personal protective equipment since the 1960s and manufactured the S6 and S10 respirators for the British Armed Forces throughout the latter half of the 20th century. This part of the business became its most profitable wing, particularly after it acquired International Safety Instruments, Inc in 2005 and started selling the M50 mask to the US Department of Defence in 2009.

2020 was a great year for the company. Orders increased by 23%. Revenue was up 30%. Management expanded the business by acquiring Team Wendy, a helmet and protective gear producer.

All of this great news caused the share price to almost double over the course of the year. So, what went wrong?

Overexcitement and setbacks

Avon Rubber completed its transformation into Avon Protection by selling Milkrite, a rubber tubing producer, and using those proceeds to purchase Team Wendy. This final pivot to protective gear clearly excited investors as they pushed the share price to all-time highs.

But this acquisition was costly and the Covid-19 pandemic brought with it the same challenges for Avon that it did for most other businesses. While sales of its M50 mask stayed strong, the 4,490p share price in November 2020 put the company’s value over £1bn. Projected revenue for 2021 was only £186m. A crash was all but inevitable.

This was responsible for the sustained selling off period seen over the course of 2021.

The share price then tanked further when Avon’s new body armour design failed a key US Army test. This denied the company a much needed and valuable contract. Its new helmet design was also rejected, due to a complaint by a competitor. Avon had initially secured this contract in September 2021 but, from what I gather, this rejection is only causing a delay as the design is retooled. But it couldn’t have come at a worse moment for the share price.

Do I buy?

So, what is my outlook? Avon Protection managed to reduce its debt between 2020 and 2021. Delays aren’t good but they don’t mean total failure. Avon’s price-to-earnings ratio is also very low.

But, based on current revenues it could struggle to pay its 2.54% dividend.

Despite this, I will be adding it to my portfolio.

It’s a risky move, but once Avon improves its products, I think we could see a significant share price resurgence.

Product failure leads to volatility

While the Avon Protection share price might be up today, it was only last Friday when the business lost almost half its market capitalisation. I’ve already explored what happened last week. But as a reminder, management released an update on its body armour business. The firm has recently signed a contract with the US Defence Logistics Agency to supply its new Enhanced Small Arms Protective Inserts (ESAPI) armour plates.

However, these plates failed during early-stage testing. Consequently, the approval process has been significantly delayed and is now expected to be completed by mid-2022. This was the catalyst that sparked the massive sell-off last week, as a sizable chunk of the group’s 2022 revenue guidance was based on this contract. As a result, management expects full-year performance to be at the lower end of expectations. And to make the necessary corrections as well as complete additional auditing work, full-year results have also been delayed.

There has yet to be any confirmation as to when its next annual report will be released. But in my experience, investor frustration and a lack of information is not a good combo. So, seeing the Avon Protection share price plummet on this news was hardly surprising. But why is it now climbing again?

The rising share price

After reading the trading update last week, my conclusion was that the market had seriously over-reacted. Avon Protection’s revenue stream is far from compromised since most of its profits are actually generated from its respiratory devices and ballistic helmets. What’s more, the potential income from its new ESAPI plates isn’t lost, merely delayed.

The Avon Protection share price has long been trading at a lofty premium. This is undoubtedly a contributor to the high degree of volatility seen over the last few days. But after having the weekend to process the information, it seems the market is starting to agree with my conclusion. So today’s upward momentum appears to be driven by investors taking advantage of the low price.

Final thoughts

Despite this recent speed bump, I still believe Avon Protection and its share price has enormous growth potential over the long term. With the stock now being priced at a far more reasonable valuation, even after today’s boost, I remain tempted to add some shares to my portfolio.

Avon Protection’s share price crashes on product failure

As a reminder, Avon Protection is a designer and manufacturer of personal protective equipment for the military and first-responders. It has a reasonably diversified product portfolio, including respirators, ballistic helmets, and ceramic body armour. And it’s this latter category that’s the cause of today’s turbulence.

Management had recently secured a contract with the US Defense Logistics Agency to provide its Enhanced Small Arms Protective Inserts (ESAPI) body armour plates. However, before this new product can be put into service, it must be rigorously tested to verify its effectiveness. And during the First Article Testing round, the ESAPI plates failed.

Consequently, approval of this product has been delayed to the second quarter of its 2022 fiscal year that runs to September 2022. This is undoubtedly frustrating for shareholders. Even more so, since $40m of its 2022 guidance was dependent on this product. With this delay,  performance next year will likely be below previous expectations. What’s more, the company has also decided to postpone the release of its full-year results for 2021 as additional auditing work is now required.

With no new release date confirmed, and the severity of this product failure remaining largely unknown, seeing the Avon Protection share price crash is hardly surprising.

Taking a step back

The loss of expected income from its body armour business is undoubtedly disappointing. However, I’m personally not too concerned. Management has already begun taking action to rectify the situation. And at the moment, revenue from these armour plates is merely delayed rather than lost.

In the meantime, the rest of its operations seem to be running smoothly. Looking at its half-year earnings, sales of its respiratory devices have grown 23% year-on-year, while its ballistic helmets have more than doubled. And given respirators represent around 70% of the revenue stream, with helmets mainly making up the rest, the company’s income is by no means jeopardised.

Is this a buying opportunity?

Throughout 2021 I’ve looked at this business in February and August, respectively. And both times, I’ve concluded that Avon Protection is a great company but has an inflated price tag. This seems to have been an accurate interpretation given where the shares are trading today compared to then.

Mixing a lofty valuation with bad news is often a recipe for extreme volatility like the kind seen today. However, now that the firm’s market capitalisation stands at a far more reasonable £590m, this stock finally looks relatively cheap. With that in mind, I am now considering pulling the trigger and adding it to my portfolio today.

Product fail and delays

This morning, the mid-cap respirator and ballistics protection supplier revealed that its Enhanced Small Arms Protective Inserts Vital Torso Protection (VTP ESAPI) body armour plates had “encountered a failure” in testing. As a result, the company expects a significant delay in approving this product.

The bad news didn’t end there. To make matters worse, Avon also announced that it had faced further delays in getting final approval for its US Defense Logistics Agency ESAPI plates. This process is now expected to complete in Spring 2022. 

Naturally, none of this is great for Avon’s top line. It previously expected its body armour division to generate $40m in revenue in FY22. However, the company now believes this contribution will be “significantly reduced“. Worryingly, the Melksham-based firm concluded that the full extent of the damage would depend on the outcome of a strategic review management has now instigated.

All told, it’s hard to imagine a worse update than this one. Yes, products failing tests is nothing new. However, we’re talking about life-saving products here. If any company needs to get things right first time, it’s Avon. 

Any positives?

Not really. I suppose one crumb of comfort existing holders is that only Avon’s body armour business appears to be suffering issues. By contrast, the company has said that its respiratory and helmet divisions were “unaffected“. 

Having fallen 73% in value from where it stood just 12 months ago, one might also argue that the risk/reward trade-off is now even more attractive.

Then again, there’s nothing to say that the Avon share price can’t keep falling. Management’s decision to delay the release of full-year results until December could induce further selling in the weeks ahead. Even when it does report these numbers, it’s clear that the earnings outlook will be a lot worse than previously thought. This is before we’ve even considered the impact of headwinds previously highlighted by the company (supply chain issues and a “tight” labour market in the US).

Avon share price: bullet dodged?

Today’s fall in the Avon share price looks excessive to me. Nevertheless, the frustration felt by investors isn’t unwarranted. I must say that I’m shocked by just how quickly things have unravelled. This was once a high-quality company with a leading position in a niche market. I was a holder of the stock myself until the valuation began to look too rich.

My takeaway is that these problems are fixable and that the stock could recover. However, it’s clear that this will require a lot of patience from shareholders who may feel they can make far better gains elsewhere. Or perhaps a suitor may race in and snap up the company on the cheap, preventing a full rebound. Notwithstanding the prospect of further delays in the approvals process, I think that’s now one of the biggest dangers if I was considering a buy.

Avon stays on my watchlist as a potential buy though. But my goodness, it needs to start protecting its owners more.

Quality… but at a price

Belfast-based IT solutions provider Kainos (LSE: KNOS) is down to report interim numbers on 15 November. Having more than doubled adjusted pre-tax profit to £57.1m in the previous financial year, it’s not unreasonable to think that the good times have continued. After all, the need for organisations to digitally transform their operations has never been greater.

This could be good news for the KNOS share price which has already climbed 61% in the last 12 months. I say ‘could’ because this really depends on whether the company is able to meet investors’ (lofty) expectations.

Kainos ticks many of my ‘quality growth’ boxes. High margins? Check. Strong returns on invested capital? Check. Low/no debt? Check.

The problem is that all this comes with an exceptionally high price tag of 53 times forecast earnings. So the risk here is that any slight misstep or loss of trading momentum might be poorly received by the market.

As things stand, that’s not an ideal risk/reward trade-off. Hence, I’ll be watching next month’s activity with interest.

Ticking time bomb?

I’ll also be following FTSE 250 member Watches of Switzerland (LSE: WOSG). Like Kainos, investors in the luxury timepiece retailer have enjoyed a brilliant run of late. Its stock is up a little over 180% since the end of October 2020.

Based on its Q1 update, I think there’s a chance this momentum will carry on when H1 results are revealed on 9 November. Back in August, the company said trading in the UK has been “exceptionally strong” and that the US business was seeing “excellent, broad-based growth”. Group revenue hit £297.5m — more than double that achieved over the same period last year.

WOSG shares currently trade at 33 times earnings. While still pricey, that’s far more palatable than its FTSE 250 peer’s valuation. Then again, operating margins in this line of work aren’t exactly massive (9% last year). It makes you wonder what might happen to investor sentiment if consumers begin to tighten their belts again as lockdown savings run out. 

Could this growth stock actually be a ticking time bomb? We’ll soon find out. 

Contrarian pick

Also on my watchlist is respirator and ballistics expert Avon Protection (LSE: AVON). Of the companies mentioned here, this is the one I’d be most likely to buy next month.

Labelling Avon as a ‘great’ growth stock may seem odd. The shares have plunged in value recently following news of order delays, supply chain disruption and a “tight labour market“.

To me, these issues are temporary. Even so, external forces could impede Avon for a while yet. As a result, I don’t expect a quick rebound when full-year results are revealed on 23 November. That’s despite the company saying it possessed a “strong order book” earlier this month.

Still, shares trade at under 20 times forecast FY22 earnings. This looks reasonable for a leader in a niche market with significant barriers to entry. Contrarians are also being compensated with dividends, although the yield is just 1.7%.

Taking into account this margin of safety, I’ll be hovering over the ‘buy’ button next month.