There's a few of us taking some tough medicine today and offloading Highcom (formally XTek) at a significant loss. Way back when I wrote this about the Company:

"When I look at the history of XTEK that’s what I see; decades of largely loss-making years, dilutive acquisitions, constant cap raises, letters from the longtime Chairman expressing remorse for yet another disappointing year.  But when I look at XTEK today I see something a little different…I see at least the possibility of a company that has new leadership, has cut away the fat, has a very clear strategy going forwards, has the infrastructure to deliver it and finally has tailwinds behind it."

I was wrong. It seems nothing has changed. While we don't know how the half year loss will convert to cash it seems likely that a CR is just around the corner. It's kind of hard to fathom how two months ago they were guiding to increased revenues and profits and yet were just weeks from closing the books on a $13-15 million loss (their market cap at the current price is just $18 million). Either they were lying/delusional or - worse - they didn't know. It's almost like they only look at their own numbers twice a year!

I had rated Scott Basham as an operator. He, along with the Board, now go onto the blacklist. If he transfers to any company I own, I will sell it. Apart from the lack of trust, the capital allocation has been appalling. They deliberately chose to hold increased levels of inventory, which is now being written off. They chose to set up shop in Poland, which is now being abandoned. It makes you question the decision to move the Xclave from Adelaide to the States. They strongly indicated they were close to an acquisition. I now wouldn't trust them with that decision. Fortunately for those that continue to hold I don't see how they could afford to pay for it.

[Sold]

Mixed feelings about today's update. On the plus side they upgraded revenue to $86-88m - not surprising given the previous guidance appeared conservative based on previous disclosures, but still welcome. Also happy to see the opportunity pipeline is also trending up. 'Pipeline' is a bit of a nebulous concept that can mean very little in the wrong hands but I guess $200m imaginary dollars is better than the $175m imaginary dollars they'd previously disclosed.

Less happy about the FY EBITDA guidance of $9 - $10.5 million. This suggests a loss in the second half, although it's hard to reconcile between the unadjusted EBITDA of this disclosure and the underlying EBITDA previously presented. You've got to think that dubiety has a slightly deliberate intent to it. With the Ukraine deal in the rear view mirror the main contributor to 2H was the Australian Army SUAS order, which was always going to be on much lower margins. Possibly even in the teens (that deal I mean, not GM overall), compared to gross margins of over 50% in the previous two halves. But a loss? That's a little disappointing. On a more positive note the awarding of the 5-year maintenance contract for that order is expected to occur in the next quarter. As the equipment supplier you would think XTEK would be in a good position to get it and, if so, it should be on much better margins.

I guess the real unknown is what happens next? I think FY23 may be the highwater mark for revenue for a while. That's ok but how profitable can they be on significantly lower revenue? I still think they're cheap given they're trading around NTA but more work to be done leading up to the FY report.

(Also worth noting they dropped the Purchase Order disclosure given the Ukraine order is complete and the SUAS order in largely done).

[Holding about half of a full position. Was tempted to top up given the opportunity Regal has been giving but will likely wait on the annual report now]

No dollars attached but a promising announcement from XTEK this morning in relation to a partnership with Tata Advanced Systems to (hopefully) supply helmets to the Indian Ministry of Defence (IMOD). Tata Advanced Systems is part of the Tata Group, which is the largest conglomerate in India with almost 1 million employees. A good partner to have if you want to crack the Indian market.

CEO Scott Basham posted a picture on LinkedIn a couple of months ago of an Indian airport boarding gate. He was on a trip back from their new site office in Poland, but the choice to come back via India caused some conjecture, which now makes more sense. Ava Risk (AVA) followers would be familiar with the large IMOD deal they did. Interestingly Scott Basham was the CEO of AVA at the time so presumably has some contacts with/familiarity of IMOD.

[Held as an underweight position]

A very welcome and chunky announcement from XTEK this morning in relation to a new Defence order for aerial drones. Not the highest margin product in their arsenal but it will help absorb fixed costs and the follow on maintenance and support is high margin.

Added to their already stated forecast 1H revenue of at least $47m, this order brings their Technology Division backlog to $35m and so they are now forecasting Group revenue to exceed $82m for FY23. That seems very conservative as it assumes no Ballistics division sales in 2H, which is their biggest growth driver. At the very least they will continue to make retail sales of ballistics armour and so $90m full year revenue looks like the bear case to me (assuming no major delays to delivery) and $100m+ is possible, depending on defence tenders.

[Held]

I thought this morning's announcement was worth posting given I've commented a couple of times in the past week that I wasn't a huge fan of a couple of decisions by the now departing CFO (nice guy though). It can be difficult to assess the impact of a CFO on a business from the outside - when it works best, they're a key contributor to strategic decision making. However, that's not always the case.

I think where they describe the new CFO as having "a proven track record of success in providing advice to boards for decisions relating to M&A, capital development projects, risk management, and financial performance of subsidiary companies" as being indicative of where the board is actively giving their attention.

The experience of the new HighCom CEO is also extremely impressive including being alumni from West Point, Duke University (completing an MBA), Safran University and Stanford Graduate School of Business. Nice to see XTEK are bringing two women into senior roles in a sector that is traditionally dominated by men, in addition to adding Adelaide McDonald as a non-executive director back in August.

[Held]

-         Probably the biggest risk is just the uncertainty and number of moving parts. They are not easy to forecast and the valuation does assume a permanent step change in this company’s performance. It is entirely possible that they have gotten a one-off benefit in 2022, mainly from Ukraine, and then go back to being the pretty ordinary company they have historically been.

-         Peace breaks out in Europe, China decides it doesn’t need to go all imperlialistic, Americans give up their guns and the world puts on their tie dyes, puts flowers in their hair and we all live happily ever after. It could happen!?!

-         A XTEK/Highcom product is failed by the National Institute of Justice. Thus far they have not had any products rejected. It’s not the end of existence if that happens but it currently appears to be a significant marketing plus for them and a differentiator from some of their competitors.

-         Someone comes up with a better material that is a game changer for ballistic armour. Plastic armour is a thing that some companies are working on – it has some drawbacks but the big advantage is its low weight. From what I can tell they’re more of a serious retail option than defence option but worth pointing out.

-         Both the Ballistics and Technology divisions rely on continuing to win tenders, which obviously is not certain.

-         Daft acquisitions.

Let’s face facts – this company benefits from conflicts. That doesn’t mean we want them to happen but the reality we can’t wish them away. Clearly, there’s no shortage at the moment, with the war in Ukraine and Russia’s actions making the rest of Europe anxious. Likewise many analysts are predicting a likelihood China will invade Taiwan in the next five years. The result of that is many countries are vowing to increase the size of their armed forces. Poland is on the record as saying it will increase its defence force from 150,000 to 400,000. Germany is doubling its defence spend. Closer to home Australia will spend $270 billion over the next 10 years and Japan is spending a similar amount over five years.

In addition to that some economists like Russell Napier are flagging defence as one of the few areas that will benefit in what will otherwise be a multi-decade period of muted growth. Putting that together I think you at least have to look at defence given the tailwinds that are present. I guess there’s an argument they could be screened out on an ESG basis, and I’ve no issue with those who do, but doing so won’t prevent conflicts.

It has been a transformational year for XTEK but the rapid growth can make it tricky to analyse the financials. It ended the year with net cash of $35 million, having generated free cash of $23 million. With a market cap below $55 million the multiples look crazy low. However, included in the cashflow was full payment for a large order they received in the year (widely speculated to have been from Ukraine but this hasn’t been confirmed), that was only partly fulfilled. The balance in unearned revenue was around $30 million at year end.  For some reason that has been included in Trade Payables. I did speak to the CFO and although he had a reason for showing it this way, it’s not what I would have done and at the very least there should have been better disclosure in the Notes to the financial statements. 

Anyway that order has subsequently been fulfilled and thus the $30 million of unearned revenue has now been recognised as revenue in FY23. Costs to fulfill the order would also have been incurred in FY23. Again it’s not easy to estimate those costs given the substantial increase in gross margin percentage in FY22 but let’s assume that those costs represent half of the revenue, it brings net cash down to about $20 million ($35m disclosed minus half the value of unearned income of $30m).

Historically this has been where the investment case has fallen over with management and Board over promising and under delivering. However, in the past 18 months they have undertaken a complete refresh. CEO Scott Basham commenced in the role in July 2021, coming across from AVA Risk (ASX:AVA), where he had led a transformation and brought the company back into profit.

Chairman Mark Stevens commenced earlier this year, taking over from the previous long time Chair, after having led a strategic review of the company in 2021. He served as an army officer for 10 years before moving the private sector in 1995 as a defence-industry consultant and advisor.

In addition to capital markets specialists the Board also includes other former defence force officers and industry experts, including former Minister for Defence Christopher Pyne. Having worked in an area that submitted grants and tendered for work from the Department of Defence, I don’t think the importance of having people that can open doors can be under-estimated. Reputation counts for everything in this business – much more so than what you’re trying to spruik in my opinion.

The relative newness of management does mean insider ownership is relatively light and I’m yet to find any decent disclosures about incentives to align management with shareholders. It should be said here that XTEK’s Annual Report is lacking in a number of areas. The remuneration report barely reaches two pages and gives little or no information about the ST and LT incentive plans (other than they exist). Interestingly, despite the record year the company didn’t issue any performance related payments or options to any Key Management Personnel.

The company recently issued a capital management policy. This might seem a small thing and is the norm for larger cap companies, but it’s not often a priority for the smaller end of the market.  At the same time the Board expressed their intention to commence dividend payments in FY23.

The beef I've always had with defence industry suplliers (and other small gadget companies generally) is too often insiders always seem to let the possible get in the way of the profitable. I get it too – the tech is cool, the gizmos are amazing, the temptation to push boundaries and pursue moonshot projects is hugely tempting…and wallet draining. When I look at the history of XTEK that’s what I see; decades of largely loss-making years, dilutive acquisitions, constant cap raises, letters from the longtime Chairman expressing remorse for yet another disappointing year.  But when I look at XTEK today I see something a little different…I see at least the possibility of a company that has new leadership, has cut away the fat, has a very clear strategy going forwards, has the infrastructure to deliver it and finally has tailwinds behind it.

What does XTEK do?

Historically XTEK had a finger in a lot of pies. It made ballistic armour, various parts for rifles, spacecraft, built aerial drones and ground robots and sold software to enable real time aerial mapping. 

In the past year or two it has slimmed its focus, ceased producing lethal products (i.e. gun parts), stopped talking about building bits of satellites and lined up under just two divisions. The Ballistics division manufactures and sells body armour, rigs and helmets and the Technology division builds and sells surveillance drones and mapping software. As you would expect the customers for both divisions are generally DoDs or state/municipal authorities. The ballistics division also sells to retailers.

Ballistics looks like being the main focus going forwards. In FY21 Ballistics accounted for $16 million of the $28 million XTEK earned. In FY22 Ballistics grew exponentially to $47 million of XTEK's total of $58 million. Based on the backlog and pipeline it looks likely Ballistics will continue to earn the lion’s share in FY23, notwithstanding the CEO has flagged a possible doubling of the Technology business this year. You could ask why they don’t just focus on Ballistics and sell/exit Technology altogether. When asked they state the Technology business is an excellent lead generator for the Ballistics business.

XTEK is headquartered in Canberra but manufactures at two sites, Adelaide and Columbus in the US. The CEO likens the Adelaide site to a Ferrari factory. It houses their proprietary equipment XTclave, which is essentially a vat of oil, which uses heat and extreme pressure to mold high end ballistic armour and helmets. Whereas much of the armour and helmets you see on TV are pistol-resistant, they claim you could be shot in the head by a rifle at point blank range and wearing their products require nothing more than a Panadol – a claim I haven’t tested (but the National Institute of Justice do so it’s all good). XTclave enables more complex shapes to be molded, which is useful for helmets and female body armour.

If Adelaide is a Ferrari factory, Columbus is the Datsun Sunny 180B factory. It’s the base for the Highcom business they acquired a couple of years back and is where they produce high volume armour, selling to armed forces, government agencies and retail distributors. In the past the majority of their product was produced on an agency basis and so would leave the factory with someone else’s label on it, but part of their new strategy is to push the Highcom brand, avoid the middle man and maximise margins.  They appear to be getting some good traction in this and based on product reviews look like being a trusted player in supplying the armour needs of your whole family!

Or how about this one:

I can’t say I’ve ever thought about buying ballistic armour for my family – I guess Americans love their kids more than we do.