Slowing Economy Hurts CML Microsystems Profits, Shares Fall 30%

By | 1st February 2019

Essex-based semi-conductor maker CML Microsystems (LON:CML) today issued a profit warning in which it guides full year revenues to be approximately 12% lower that the previous year, resulting in a ‘material’ drop in profits below market expectations. In common with many shares, the action has been weak throughout the past year and todays warning has dropped it to a 52-week low:

Shares tumbled to 300p early on in trading before making a quick recovery to 346p. A first glimpse at the company shows that this does not fit the general template of one in trouble: there are real profits, a real progressive dividend with very good cover, great operating margins, no debt and an increasing cash balance. With so many things in its favour it is no surprise that a heavy drop in turn saw some good support.

However, past performance is no guide of the future and in some cases it could be that a profit warning provides a turning point for the company fortunes.

CML deal in the manufacture of semi-conductors, which are parts used inside other finished products. In some ways this is quite similar to Filtronic (who also issued a profit warning recently) but CML offer a much simplified structure, dealing in storage products such as flash cards and storage drives and communications (data communications products). The split in terms of revenues is almost 50/50 on both.

This type of market can be very lucrative as companies own intellectual protection rights over technology, which is quite similar to IQE , but it is plainly easy to see that there is a lot of competition in this field. However, it is also apparent that the market for CML’s products is not going to go away any time soon and is increasing with the demand for more connected products at higher data rates and a growing shift to flash storage.

The Warning

The warning comes in a trading update issued today. The previous expectation was that although the year would be challenging the hit to profitability would not be as much as other measures would be taken. Today is seems that isn’t the case, and whilst not using the word Brexit, the implications are clear:

Since the half year announcement, we have seen the tangible effects of a softening of the Chinese economy along with on-going geopolitical issues and can report that a number of our customers have exhibited weaker demand and remain in an inventory correction period. As a result, new order bookings have not met with internal management expectations.

Helpfully, the effects are quantified, although the effect on profit is not:

With only two months of the financial year remaining, the Company now expects second half revenues to be below those achieved during the first 6 months and full year revenues to be approximately 12% lower than the prior 12-month period. Given the expected sales performance, the Company therefore expects revenues and profit before tax to be materially below current market expectations. Gross margin has continued to track above last year due to product mix and the cost base has remained stable.

Stocko gives a 2019 estimate as £4.29m, so a material miss would see this being a year-on-year fall of profits, and perhaps quite a pronounced decrease.

The warning ends on a more bullish note:

Whilst this is disappointing to report, the Board believes that medium to long term growth drivers for our products remain particularly strong and we are focussed on driving the business over this period and our strategy remains unchanged. We are maintaining levels of investment in product R&D on the back of many consecutive years of profitability. The growing product portfolio and our expanded global sales coverage is driving the value of our sales opportunity pipeline significantly higher. Despite the challenges associated with current market dynamics, we believe that the Company remains very well placed to benefit as these external situations normalise.

What isn’t said in the short-term that the issues with the Chinese economy and the ‘geo-political’ issues might have to get worse before they can get even better.

The Business

As mentioned before the company has a great record of profitability. From the stock report, we can see historic figures such as these:

There have been consistent profits, although some might say the rate of growth has been very slow, especially considering the storage and communications markets have been heavily evolving over the past decade. We could conclude that management are quite conservative and adverse to risk. This is not necessarily a bad thing.

One thing that immediately comes to mind in a company that owns intellectual property is the intangible assets. In this case development costs are capitalised as intangible assets, which currently are valued at £12.5m. The depreciation charge is high – for the last year it was £4.7m, although new development costs of £5.7m were capitalised. This is not a problem on its own and given the type of products whether the amount of depreciation is enough is personal opinion. There is also £9.2m of goodwill on the balance sheet, created through previous business combinations.

That said, with the business debt-free and holding £13.8m of cash there this is far from being problematic. Further to this they also own almost £4m worth of properties, from which they generate a sideline from renting it out.

With this there is no real solvency issues. The groups claim that they are cash generative is correct, but as the cashflow statement shows, virtually all the cash that is generated goes back out in research and development and dividends. In fact the cash balance has stayed stable for a while.

One key risk in this business may be customer concentration: quoted from the annual report:

Customer dependency for the year reflected some movement against the prior year. Contribution from the top two customers fell slightly
to a combined contribution of approximately 28%, although only one of these customers was above the 10% threshold. All other customers
remained below the 6% level.

That requires some thought: if only one of the top 2 customers is above the 10% level, then it must be the case that this customer must account for at least 19% of contribution, so anything adverse with this customer will have the potential to really skew the results.

Comment

Aside from the concentration issue this appears to be a good small business: prudently run, with good asset backing and no debt. The current market price means that cash and property make up a significant chunk of the valuation, which in effects makes the business better value than a price/earnings ratio would suggest.

What the profit warning then boils down to is whether this is due to temporal factors or is something more fundamental within the company. A softening of the Chinese economy appears to be quite frightening. From the recent results we can see that CML is heavily exposed to these markets:

Roughly half of turnover is coming from the Far East, so it also would be a fair bet that at least one of their big customers is coming from this region as well. Another concern for all firms operating in this region are the more lax IP laws.

It also may be difficult to discern the effects of R&D costs. CML are incurring these now, although the economic benefits of this may be several years away as products are developed. There is no guarantee that any new products released will be successful.

The issue as an investment goes is the value in the price. The market has always recognised the strengths behind CML and this was reflected in the share price. The market cap yesterday was £74m, which is fairly undemanding on an EBITDA basis but considering that development costs will be constantly needed, the valuation seems quite high, although admittedly nowhere near as far out as IQE.

I do like the company, but it is at the mercy of larger factors somewhat, and even at the reduced price the valuation is not what I would regard a bargain just yet. It seems likely that in the short-term there may be further warnings which might provide a better entry point. 4/5.

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