Share in touchscreen manufacturer Zytronic slipped by almost a quarter today as a trading update revealed that a slowdown in the conversion of interest to ordered had slowed, mainly due to its Gaming sector. The share price reacted heftily:
There are perhaps several reasons for this. The profit warning was in quite couched terms – figures were mentioned without referencing expectations, neither were any of the usual words used. Only on comparing to the previous broker notes do we realise that this might be a substantial miss.
Secondly, the company is expected to be growing at a decent rate considering the types of product it sells. The realisation that this growth may not occur, or that the company may be too reliant on certain sectors was met with disappointment.
Partially because of this, Zytronic are an interesting company for many small-cap investors as it occupies a niche that it may be possible to defend depending on how it innovates. (I actually thought there was a profit warning earlier this year, but that was for Filtronic). In fact the last profit warning was a couple of years ago and the share price has recovered fairly well from that.
The warning comes in a morning RNS entitled ‘Trading Update’. Here we go:
The Company provides the following trading update ahead of its interim results for the first half, which are due to be announced on 14 May 2019 and are expected to show revenues of £9.5m (2018 H1: £10.6m) and profit before tax of £1.4m (2018 H1: £2.2m).
Obviously, it can be seen that revenues and profits have declined year on year. Brokers have also penned in reduced profits so it seems clear this may not be short-term in nature.
Here is the explanation:
The reduction in revenues and profits are due to the decline of the sales of products into the Gaming sector, which has only been partially offset by a stronger performance in other sectors. Despite there still being an encouraging pipeline of opportunities in Gaming, the pace of conversion to orders in the year to date has been much slower than the Board had anticipated.
This is perhaps understandable in some ways. The FOBT regulations seem certain to reduce demands from bookmakers for machines as there is now much less profit in them.
Although trading in the second half of the financial year is usually stronger than the first half, Zytronic is cautious on the level and timing of recovery of sales in the Gaming sector and therefore on the expected performance for the second half.
This sounds as if a profit warning is being penned in again for the second half.
Some consolation for shareholders:
The Company continues to be cash generative and is in a strong financial position, with net cash of £12.1m as at 31 March 2019. The Board anticipates maintaining the interim dividend at a similar level to that paid in the previous year. Zytronic remains in a position of having several opportunities with the potential to materially improve future performance.
Zytronic is a good business on the face of it. Investors are excited about the addressable market which is colossal. However, the company is run quite conservatively. Others might have sought to be highly acquisitive, and aggressively expand into other regions, buying up similar companies with debt and equity. Instead, Zytronic have been quite conservative. Growth in revenues has been slow, and instead the focus seems to be on making things work more efficiently. As we can see from the results, profits have grown, but not down to sales:
This has other upsides for the business: operating margins are good, the companies cash generation is excellent, and there is no debt. For investors, the company is not diluting shareholders with new issues to raise cash, and there has been a progressive dividend paid (although this is becoming less covered by cashflow in recent years).
With no debt, the balance sheet looks in healthy shape. Only a modest amount of R&D expenditure is capitalised, which leads to a relatively low balance in terms of intangibles. Approximately £2.5m of freehold property sits within assets, which is also a nice bonus and not immaterial to the market cap. The cash pile of £12m means there is very little danger in the short-term of the company becoming distressed.
So it is easy to see just why people like it. The downsides of the company seem to lie in its operations. We can see from its segment reporting that it is extremely widespread:
Less than 10% of revenues come from the UK, despite the machines being manufactured here. It could be the case that other countries may develop a local producer, especially if they are surpassed in terms of technology. We can also see the relevance of the gaming products, as this generated £8.3m of the £22m. It is also understandable how other segments have not taken up this slack, with industrial, retail or signage perhaps less customer facing and therefore a lower requirement for absolute technology.
In terms of moat, Zytronic have many patents over the use of touchscreen technology, but with almost every phone featuring this nowadays it is clear that these patents only really apply to very specific uses. Looking at their projects they have undertaken and their turnover, it becomes clear that customer concentration is a real issue: a loss of a key customer or segment could really affect profits. Which seems to be the case here.
Another problem for investors was valuation. Zytronic has always been expensive, because of the anticipation behind it. Even late last year this share was trading in the 500p range which puts it at over 20 times profits – punchy considering the lack of growth. The profit warning has almost halved this price from that point, but looking at the Google Finance quote we are still at a P/E of 11.62 and visibility of profits have been removed.
There is a lot to like about Zytronic, as discussed above. We can simply attribute the profit warning to a volatile period of orders. However, the nature of the warning means that we might have to give this some extra though. Gaming is a large percentage of its business, and the lack of any other details in the trading update makes it difficult to infer whether this downturn is genuinely down to macro uncertainties, or alternatively greater competition in the sector. It does seem reasonable that other firms may simply offer to replicate what Zytronic are doing, at a cheaper price.
However, it does seem that the future will bring forward opportunities as the world moves from non-touch to touch. And demonstrably so far the margins earned have proved there are some advantages to be had, and undoubtedly they are experts in the field.
Management appear competent and the conservative approach is bound to see them in good stead as far as operations go. In terms of investment I think it is priced fairly close to good value but £2 might be a better entry point which may be seen if H2 does not go better. 4/5.