AB Dynamics: Passes The Test

AB Dynamics is a London AIM listed provider of products and services that test automotive vehicles. Founded as the consultancy service Anthony Best Dynamics in 1982, AB Dynamics went on to introduce a variety of automotive testing products and driving robots, alongside acquiring other similar businesses to derive the £500m market cap that it is today.


Buying AB at the peak of the pandemic was an easy move for me; its strong track record for growth, decent operating metrics, sturdy balance sheet and a loyal investor base (including a 26% shareholding from founder Tony Best himself) were all ticks in the box for an opportunistic investor such as myself. However, the subsequent run-up in the share price has left my holding at a 102% gain, and the results today didn’t exactly flatter the market. So, let’s check back in on its long term story and examine whether it is worth holding on to AB Dynamics or whether deploying the capital elsewhere would make better sense.


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AB Dynamic’s Business


AB’s business is split into two segments, which are then further broken down by product line. The main segment of AB’s business is Track Testing, which is accountable for roughly 84% of revenues. This segment includes products that test ADAS (Advanced Driver Assistance Systems) and autonomous vehicle systems, as well as vehicle dynamics testing solutions such as suspension effectiveness testing. Until recently, AB Dynamics was solely a products supplier to manufacturers and track testing facilities. However, through the acquisition of both Dynamic Research Inc and Vadotech, two automotive testing companies, AB Dynamics has acquired some physical testing track space, which it will use to provide its services.


The second segment of AB Dynamics business is Laboratory Testing and Simulation, which represents a much smaller 16% of revenues. This segment houses products that simulate environmental effects and their impacts on the vehicle such as noise, weather conditions and light conditions, as well as simulating the performance of specific parts of the vehicle. This segment houses physical equipment that automotive manufactures can use to test production or motorsport cars with, as well as software packages that provide simulation, an area AB recently built into their product offering with the acquisition of fPRO.


AB Dynamics sells these products and services mentioned above to track testing facilities, also known as ‘proving grounds’ such as Millbrook in the UK or the new example of ZalaZone, a Hungarian government testing facility that recently named AB dynamics the exclusive supplier of ADAS testing equipment.


ZalaZone


AB also sells products to automotive manufacturers themselves to serve the prototyping and post-production testing process, alongside automotive parts manufacturers such as Goodyear Tyre and Rubber and GKN.


Source: AB Dynamics FY Investor Presentation



The Growth Opportunity


AB Dynamics is still a relatively small company; it typically pays only a token dividend of 4p per share. Therefore, investors looking to buy into AB Dynamics are doing so for growth. Over the last five years from 2015 to 2020, AB has grown revenue by 32% per annum, a punchy level for a company servicing automotive markets.


However, in 2020, growth slipped to 6% as the impact from the pandemic was felt in H2, and the interim report published on the 28th of April suggests that H1 2021 has shown little improvement, with revenue down 21% versus the year prior. This result does paint a blemish on AB’s enviable track record of successive growth, but we need to keep in mind the impact Covid-19 has had on testing facilities, automotive manufacturers budgets and capacity.


When considering the long term view, AB Dynamics does have several pillars to grow revenues. I will aim to detail below some of the key opportunities available to AB Dynamics in the coming years.


Regulation


Regulatory bodies such as the Euro-NCAP and the US National Highway Traffic and Safety Administration constantly put pressure on the automotive industry to improve road safety standards. In 2019, the UNECE announced a new regulation that all new vehicles sold in 40 countries worldwide, including the EU and Japan, would have to be fitted with a minimum set of ADAS systems, including Automatic Emergency Braking (AEB). Since 2014, Euro-NCAP has used a star rating scheme for active safety and this has driven significant changes and investment in vehicle ADAS systems.


This push towards forced installment of ADAS systems to improve road safety requires a significant amount of testing to prove effectiveness. The Euro-NCAP has published a roadmap to add to safety and ADAS requirements over the coming years, and this will only add to the need for advanced safety testing products, which companies like AB Dynamics supplies.


Automotive regulation is typically very strong in more developed markets. However, the safety of citizens is a key issue for countries that are emerging into a higher standard of living; you would only expect regulation from developing countries to continue to grow, especially if they intend on exporting vehicles to developed markets as well.


Market Trends and Market Share


In terms of growth, AB Dynamics benefits from a twin propulsion of both a growing overall market and an ability to grow market share within the addressable space. AB Dynamics considers its total addressable market for the products it currently has to be roughly £1.2 billion. Whilst there are no official numbers to state how fast this market is growing, AB notes in its 2020 annual report that the market for ADAS systems is likely to grow at a compound annual rate of 16% to the year 2025 and for the simulation market to grow at a CAGR of 17% over the same period. This data was arranged from multiple sources, including ADAS manufacturers and market research agencies. AB’s revenue in 2020 would stipulate that it has a 6% share of this market, showing that there is a clear expanse for AB to grow into.


The reasons for the structural market growth in AB Dynamics' end markets primarily relates to a few critical trends in the automotive industry (of which we have already considered regulation). I have listed the other trends below.


Firstly, the automotive industry is undergoing a revolution. The consumer interest in green solutions and electric vehicles has created a boom in innovation and allowed space for a wave of new entrants into the automotive sector. Financial markets have added fuel to this non-combusting fire; the rapid rise of EV stocks such as Tesla and NIO have created large allotments of investor capital to the sector and the addition of venture capital and SPAC involvement in the sector means new innovators are rarely short of capital. This has resulted in what seems like an infinite number of EV start-ups — almost every day I hear of a new company in the space! Smaller startups like Rivian, Lucid motors, Nikola and Arrival are all electric vehicle pioneers. However, they themselves are unlikely to provide much revenue for AB Dynamics as they are yet to have high levels of scale. However, what this environment does is put pressure on the ‘big boys’ of the automotive industry, like Volkswagen, BMW and General Motors, who are having to increase investment in these technologies, and therefore, increase testing and simulation in tandem, providing revenue for the likes of AB Dynamics.


Secondly, and similarly linked to the point above, new technologies that are stemming from this automotive revolution require so much more testing than old technologies. Think about the amount of driving hours that are required to prove that autonomous driving (a car without a driver) is safe. Every possible scenario has to be tested, over thousands of hours, varying conditions and under different schedules. This marks a significant increase in the demand for testing products and specifically for services such as AB’s fPRO simulator, which can make progress on testing even prior to production.


Acquisitions


The final major pillar for growth to consider with AB Dynamics is acquisitions, which in recent years have significantly boosted AB’s reach and product line. Recent purchases include Vadotech, a German automobile testing outfit with a strong presence in Asia and Dynamic Research Inc, a California based automotive testing company. Both of these acquired companies add reach and expertise for AB Dynamics, but also shift AB’s strategy slightly. The addition of Vadotech and Dynamic Research Inc brings physical test track space in both Beijing and in California. These two companies, therefore, represent a typical ‘testing services’ customer for AB Dynamics’ products to be sold to, and therefore, is definitely a step towards vertical integration.


This strategy is likely going to benefit AB, as they lock these test facilities into purchasing products from the group, but more importantly, it will help AB better understand their customer base and improve product innovation, which will hopefully lead to increased revenues with other customers.


AB Dynamics intends to deploy future cash flows into acquisitions like the above, which will create value for shareholders by adding scale and reach. A large factor supporting the quality and rationale of acquisitions (which as we all know can and do occasionally destroy value for shareholders) would be the large shareholding from founder Tony Best, which is likely to ensure the board approves transactions that are value-enhancing and not risky or destructive.



Risks


There are, however, some challenges that AB Dynamics faces to its growth in the coming years. It is a small company operating within a typically cyclical sector. Automotive companies in general have a tendency to go through periods of intense financial strain, which could result in loss of receivables for a company selling products to the industry such as AB. This specific risk is somewhat mitigated by the fact AB’s revenue is typically derived from automotive R&D budgets, which are seen as required spending to keep an auto brand churning out popular cars in the coming years. The EV and autonomous vehicle revolution also underpins the need for R&D spend from the large automakers to ensure that they keep up.


A second pressure for AB Dynamics is from competitors. Whilst AB Dynamics certainly is a leader in its niche and has a significant number of patents protecting its products, competitors do exist. 4activesystems, a German testing products supplier, has a strong presence in ADAS, and, as you may expect, has strong relationships with the German auto companies BMW, VW and Daimler. Humanetics, also a global operator, has a presence in the driving robot and ADAS testing space. Whilst AB Dynamics is a clear leader in the field of ADAS testing products, some of the other product lines AB sells, such as inflatable dummies and launchpad (pedestrian simulator platform) solutions, are probably easier to copy and so reduce margins for AB.


Lastly, and I would suggest my largest concern as an investor, would be the level of capacity for new equipment. AB Dynamics' products are very high quality; there is no doubt about that. However, there is a limit to the number of customers available in the market and the repeatability of transactions. Not every test facility will need to install new equipment each year, and test facilities can likely undergo testing without buying new equipment. This does mean that in a tough year for the industry, budget tightening can see an auto manufacturer or testing facility maintaining output, but not needing to replace AB’s products. I am sure AB is well aware of this phenomenon and has taken steps to improve in this space. Recurring revenues have grown from 10% in 2019 to 28% in 2020 and 31% in the first half of 2021. Acquisitions of software providers fPRO and track facilities also go some way to improving this recurring revenue stream, which will avoid or reduce the impact of a fallow year for new equipment sales.


Recent Results


As alluded to earlier in the article, the recent interim results for AB Dynamics to the end of February 2021 show order volumes have not recovered yet post the Covid-19 pandemic. Whilst results are broadly flat versus the prior half, H2 2020, revenue H1 2020 was £27.3m down 21% from the year before. Whilst progress seems disappointing, the company did note trajectory and momentum was improving into H2 and the order intake has recently strengthened. The balance sheet throughout the period seems to have remained intact and AB ended the period with net cash of £33.1 million.


Financials


The above table helps us understand the underlying financial performance of AB Dynamics over the years 2015 to 2020. As you can see in the years 2018 and 2019, growth significantly increased to the 50% level, boosted by both organic and acquisitive growth. Even in the formative years 2015-17, the company managed punchy growth levels of roughly 20% — a key reason behind the success for investors over the period. In a typical year, AB Dynamics has very solid operating profit margins of 20% on average, a testament to the pricing premium AB is able to charge for sophisticated products like driving robots. As you can see by the extremely low debt to equity ratio, AB has a very strong balance sheet, with no long term debt as of 2020. To me, this financial table exemplifies a quality company, which, in a typical non-covid or post-covid year, is capable of stellar results.


Summary


I think AB dynamics is a quality business, with attractive growth tailwinds set to endure in the years to come. As AB grows scale and improves its product offering across new verticals, it will likely derive more revenue from a recurring source and unlock cross-selling opportunities. The investment case is not without challenges, and its end customer base is cyclical, but this cyclicality is offset by the consistent nature of R&D budgets and a seemingly unstoppable revolution in the automotive sector with EV and self-driving vehicles.


Analyst consensus has AB Dynamics earning 51p of estimated earnings in 2022, which is the equivalent to 44 times forward earnings. Whilst much could change from now until then, notably on the acquisition front, these estimates probably price AB Dynamics fairly compared to similar businesses with both great growth and profitability metrics. It is quite a rich valuation, and the market is clearly optimistic about the growth prospects for the group. Thus, any further stumbles or signs that order volume is not improving in H2 2021 would result in a pretty hefty de-rating.


On a balance, I am prepared to hold onto the company even considering the quite large gain already achieved, and I remain cautious towards the improvement in order volumes over the coming quarters.


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At the time of writing, The Twenties Trader owned shares in AB Dynamics.


For the full list of Twenties Trader Portfolio holdings, view here.


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