February 2011’s Penny Shares to Watch…

This month’s penny shares to watch:

• A thrilling gamble on high tech TV…

NANOCO (NANO)

• The rebound in British manufacturing gathers pace...

Chamberlin (CMH)

A thrilling gamble on high tech TV

(This article first appeared in Penny Sleuth in February 2011. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)

Buying shares in companies that have no revenue and yet are valued at close to £200m is not something I would generally take an interest in. But one company that could be an exception to the rule is Cheshire-based NANOCO (NANO).

Formed ten years ago to commercialise work done at the University of Manchester and Imperial College London, Nanoco moved a step closer to its ambition last week when it raised £15m through a placing of shares.

Nanoco produces something called ‘quantum dots’. These are the next step up in television technology, and before long they could be used by TV manufacturers everywhere.

Here’s how it works: the dots are minute particles of semiconductor material of less than ten nanometers in diameter. When excited either by electrical energy or light, they emit light at a specific wavelength linked to their diameter. By changing the size of the dot you can change its colour emission. Smaller dots emit blue light and larger dots red light.

Quantum dots are not new, but their widespread adoption has been prevented by two things. The first is the difficulty of making them with a consistent specification, and the second is because of EU legislation.

Nanoco seems to have overcome both problems. And the way has now been cleared for it to potentially capture the market, multiplying its share price in the process.

How the way was cleared to start snapping up orders

Most other producers manufacture quantum dots via a high temperature, dual-injection process which works well for small production batches but is difficult to scale up.

Nanoco, though, grows its quantum dot structures using a seed cluster, which removes the need for a high temperature nucleation step. While this process takes around a week, it enables Nanoco to control the growth very precisely, stopping it when the frequency of the light emitted by the dots matches the required criteria.

The second hurdle has been legislation such as the EU’s Restriction of Hazardous Substances directive that bans the use of cadmium in electronics. Quantum dots have historically been made of this toxic metallic element but Nanoco has come up with a way of making quantum dots that are cadmium-free.

Much of the funding for Nanoco’s research efforts has come from Japanese electronics manufacturers, which see quantum dots as the next innovation in television backlighting. Once again regulation is a driver.

In 2009 the California Energy Commission introduced new legislation to lower the permitted power consumption of televisions. One way to improve the energy consumption of televisions is to replace the traditional cathode fluorescent lamp (‘CFL’) backlights with LED backlights. LED TVs are now becoming popular.

The difference is, while a CFL backlight comprises a single light source that is always on, LED backlights use hundreds of LEDs (light emitting diodes) that can be selectively switched off where the related area of the screen is showing black.

Quantum dots offer a further improvement by limiting the energy that is lost through colour filtering. That is the theory. Nanoco has demonstrated it in the lab, and shown that it can produce quantum dots on a commercial scale.

Why Merrill Lynch are predicting a jump to 500p

Today quantum dots sell for $5,000 per gram. Each gram is sufficient for 60-80 LED TVs. But once Nanoco starts producing in commercial volumes it expects to be able to reduce the price to nearer $500 per gram. That’s comparable to the cost of the phosphor that is used in existing solutions.

With a capacity at present to make 25kg of quantum dots per year, that implies annual revenue potential before any further investment of £12.5m. Based on this, Merrill Lynch anticipates a 70% gross profit margin. Nice!

With the cash raised last week, Nanoco is building its sales team. The big question now is the speed at which television manufacturers adopt quantum dots. Merrill Lynch has estimated that the number of LED backlit televisions sold will jump from five million in 2009 to 129m in 2012. It has assumed that Nanoco’s quantum dots will be used in 10% of these TVs by the end of 2012 and 10% a year later.

Yet Nanoco is not without competition from the likes of Nanosys and QD Vision. And I agree with Merrill Lynch hen it says that ‘the adoption of new technologies often takes longer than expected.’ All the same, in a note last September before the latest share issue, Merrill Lynch set a price target of 140p. That’s 50% higher than today’s level, based on the assumption that Nanoco achieves a 20% market share in LED television backlighting in the long term.

But as it points out the actual outcome could be binary – in other words Nanoco’s quantum dots could capture most of the market, or none at all. In the event that it captures 50% of the LED TV market Merrill Lynch sees the shares going to 500p.

Interesting! And while I’m not buying in myself, I’ll certainly be monitoring its progress over the next few months.

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The rebound in British manufacturing gathers pace…

(This article first appeared in Penny Sleuth in January 2011. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)

Chinese manufacturers are beginning to lose out to their UK rivals. That was one of the messages that I learned last week when I visited a century-old foundry in Walsall. It’s owned by CHAMBERLIN (CMH) and its Chief Executive Tim Hair told me an interesting story.

Visiting the warehouse of an important German customer during the depths of the recession two years ago he found a suitably small stack of goods supplied by Chamberlin, alongside a vast pile of components shipped from a Chinese supplier. Faced with collapsing sales, the German had asked the Chinese supplier to hold back. The latter simply referred to the small print of the contract and carried on delivering components regardless.

Now the German factory, Hair told me, had enough Chinese components to keep it going for nine months, and that assuming that the factory was running flat out. In fact it was running at about one fifth or its pre-recession volumes. The German customer had had enough.

And this story is being repeated elsewhere. Faced with such inflexibility and faced also with the unreliable quality of Chinese components, Western manufacturers are increasingly looking to local suppliers. Caterpillar, for example, will only accept parts from distant suppliers if they can offer a 30% price advantage, and that is enough to negate the advantage of low labour rates.

But the swing back towards Western manufacturing was not the only reason for Hair’s optimism.

A remarkable recovery story

A turnaround specialist, Hair moved into the formerly family-run company five years ago to find the business, which has foundries in Leicester and Scunthorpe as well as Walsall, in a fair old mess. Having spent two years putting things right, Hair and Finance Director Mark Bache had to endure the recession. But now Chamberlin is on the up.

A contributing factor in its recovery is environmental legislation. Car manufacturers are under legal obligation to reduce emissions, and the only way they can do so is by fitting turbochargers. A turbocharger uses the pressure from the exhaust to create more pressure in the cylinders, enabling them to receive more fuel-air mix. Most diesel engines already have turbochargers, but in petrol engines turbochargers have typically been deployed to boost power.

However, as well as souping up engines, turbochargers can also make them more efficient. The new Ford Focus includes Ford’s ‘Ecoboost’ technology, which basically means that it has a turbocharger, while Mercedes has said that within five years all cars will be fitted with one.

The secret of making turbochargers

Turbochargers need a particular circular metal casing that requires holes inside – a bit like putting a hole in the middle of a donut. These, says Hair, ‘are an absolute bitch to make’ but Chamberlin is one of the few to know the secret.

Walking around the foundry I saw exactly how they are made. A sand and resin core is modelled and placed within a mould. Molten metal is poured around this core and as the metal then cools the resin turns to gas, the sand crumbles away and the component is ready for polishing.

Chamberlin is one of only four in Europe that can achieve this tricky process, placing it in an enviable position in what seems certain to be a strongly growing market. Of the four major manufacturers of turbochargers Chamberlin already supplies BorgWarner and has just started to fulfil a contract with IHI, which is expected to become worth about £5m per year.

A venerable company thrives once again

The extent of the recession is evident from Chamberlin’s trading history. Sales slumped from £39.9m in the year to March 2009 to £28.5m the following year. Now though Chamberlin, which makes lighting and security products as well as running the three foundries, is seeing output back at pre-recession levels. With the benefit of the IHI contract to come this makes broker forecasts that place the shares on a forecast price/earnings ratio of about eight, look conservative.

But Hair believes that Chamberlin is doing much more than just recover from the recession. He argues that Chamberlin is a stronger business than it ever has been, and this comes down to a philosophy that all UK manufacturers could learn from.

His philosophy is summed up in four words – ‘doing difficult things well.’ There is no future in competing at the low specification end of manufacturing. But Chamberlin has a very high level of process know-how, enabling it to make things that others cannot. When he joined the business he found that customers admired Chamberlin’s capabilities but were frustrated by its inability to deliver.

Hair has changed that, the business is now flying and the emerging turbocharger business is, says Hair, ‘a gift’. It is great to see this venerable company thriving once again.

And I’m convinced that this is part of a wider story of recovery in UK manufacturing. There are a few stories I am following in this sector at the moment.

Good investing,

Tom Bulford Editor, Red Hot Penny Shares

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(This article first appeared in Penny Sleuth in February 2011. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)