Shares in Surface Transforms (LSE:SCE), a Cheshire, UK, based manufacturer of carbon-ceramic brake discs, trade at 75p. Being a small company with a market cap of £152m, with shares trading on London Stock Exchange’s AIM market for less than a pound, Surface Transforms can rightly be called a penny stock.
Last March, Surface’s penny stock status was even more assured since it was trading at 16p. I have been a shareholder in Surface Transforms since 2018, and I have been delighted with the 388% price rise over the last 12 months. But, I am not cashing out now as I think there are more price gains to come.
Electric vehicles need brakes
Surface’s brakes find use in high-performance vehicles, be they petrol or electric powered. Brake discs are one component that will not become redundant if the internal combustion engine disappears.
Surface has been expanding its brake-disc production capacity from handling £4m worth of sales to circa £20m. The expanded capacity should be available in the second quarter of this year. Surface has raised £20m this year. The bulk of these funds will build revenue manufacturing capacity to approximately £35m per year in 2022. The rest will support the working capital requirements of ramping up to the £20m in expected sales per annum mark.
This is not a build it, and they will come strategy. Surface has been steadily winning contracts to supply brake discs to car markers. An eighth manufacturing supply contract was signed in 2020. A ninth is in process. These will exhaust the capacity of a £35m sales per year facility by 2024 if things go to plan. Surface has a potential contract pipeline that would require something like a £75m facility in 2024, rising to close to £100m by 2026.
Penny to pound stock?
Surface Transforms reported revenue of £1.45m for the 2019 fiscal year. Eyeing revenues almost 100 times higher in six years is ambitious. Given the stepwise progression and the success achieved already in scaling up capacity, I think it is achievable. The potential demand is also there for the taking.
A single highly profitable manufacturer dominates the high carbon-ceramic brake disc market. This manufacturer does ownership links with some carmakers. Surface is a credible alternative, and its position as an independent supplier strengthens its case for continuing to grab market share.
But there are, of course, risks. The market-dominating supplier is powerful and may react aggressively to losing market share. Increasing manufacturing capacity, particularly towards the £100m revenue mark, requires capital. Existing shareholders have the risk of being diluted as funds are raised by issuing new shares. Returns can be gobbled up by interest payments on debt raised to pay for factory capacity.
The coronavirus pandemic might leave lasting scars on the global car market, particularly the luxury segment. Surface’s broader ambitions do rely on the auto market being in fairly good health fairly soon. Increasing sales requires increasing working capital, so Surface will have to manage its cash flows closely when ramping up its output.
Surface’s expansion to £35m worth of sales by 2024 at the earliest seems fairly assured. That would be enough for me to add Surface to my portfolio today. The potential for more growth makes me think this penny stock will be a bonafide pound one someday.
