Interactive Investor

Stockwatch: a quality small-cap share to buy after chart breakout?

22nd November 2022 11:47

Edmond Jackson from interactive investor

Up over a third since early November and now at a three-month high, this stock plus two bullish operational updates have caught the eye of analyst Edmond Jackson.

TT Electronics (LSE:TTG) – a circa £300 million “global provider of engineered electronics for performance critical applications” (trying to distinguish itself as a components supplier) has delivered three punchy updates in the second half of 2022.  

Despite a 17% jump to 170p yesterday, this positive news flow comes in context of a two-year de-rating from 290p in September 2021. The rise tests what chartists might say is a critical 200-day moving average at around 185p.

In a long-term context, however, this stock is a roller coaster, its 14-month fall taking it back to a median around 150p that has persisted since 2010. Over the great recession, TT plunged from 250p in early 2007 hitting 20p in March 2009. 

Long-term investors grumble about an extensive history of acquisitions meaning serial exceptional charges – hence there’s a regular differential between normalised and reported profit/earnings. Top directors are paid very well for mediocre growth at the reported level, and debts have been persistently high. 

This differential is affirmed by the six-year financial summary which also shows modest single-digit operating margins at the reported level, hence similarly for return on capital employed. 

Management does therefore need to be pulling some rabbits out the hat, otherwise the business is not sustaining its intrinsic value during inflation.  

As a technology-driven business, TT has also had to commit roughly half its operational cash flow to capital expenditure (capex actually breached cash flow in 2021) and, while dividends look propped by a healthy cash balance, it also supports material debt. 

TT Electronics - financial summary
Year-end 31 Dec

 201620172018201920202021
Turnover (£ million)333360430478432476
Operating margin (%)5.75.63.83.51.54.1
Operating profit (£m)18.820.016.516.96.619.3
Net profit (£m)16.747.713.415.81.312.8
EPS - reported (p)7.38.47.87.50.87.2
EPS - normalised (p)7.513.818.320.713.617.6
Operating cashflow/share (p)16.417.715.121.616.88.0
Capital expenditure/share (p)8.39.111.511.28.09.6
Free cashflow/share (p)8.18.63.610.48.8-1.6
Dividends per share (p)5.65.86.52.14.75.6
Covered by earnings (x)1.31.51.23.60.21.3
Return on total capital (%)5.37.34.44.21.43.7
Cash (£m)49.846.544.769.870.268.3
Net debt (£m)55.4-45.941.769.183.9103
Net assets (£m)231267278266296328
Net assets per share (p)143164170162170186

Source: historic company REFS and company accounts

£6 million annual cash flow boost triggered yesterday’s rally 

TT’s pension fund trustees have agreed a bulk annuity scheme with Legal & General, turning it more into asset than liability.  

This helps ahead of a possible global recession, yet with pensions accounted for as a £3.4 million long-term liability on TT’s last balance sheet (not even 1% of total liabilities) it is hardly de-leveraging. 

An immediate and annual cash flow benefit of £6 million does however mitigate financial risk, as TT will not need to make further contributions and the scheme’s circa £400 million liabilities are covered.   

It supports dividend prospects alongside a £76 million cash cushion (albeit which has deflated 24% year-on-year) and where the interim 2022 net finance charge took 37% of operating profit after £9.4 million restructuring and acquisition costs. 

The balance sheet context is £360 million of net assets supporting £182 million long-term debt and £13 million short-term debt. But due to historic acquisitions, 63% of mid-year net assets constituted goodwill/intangibles. If you add £23 million leases and base on £132 million net tangible assets, net gearing was 108%. 

It is a typical acquirer’s profile where management should indeed retract a few horns if the economy is turning down. 

Superficially attractive valuation criteria versus outstanding narrative 

At 168p currently, and if forecasts for £26 million net profit this year approaching £33 million next, are fair, the 12-month forward price/earnings (PE) ratio is around 9x and dividends of 16p to 19p imply a prospective yield near 4%.  

Earnings cover would be over 2.5x but such estimates are based on adjusted earnings, meanwhile exceptional items are a genuine cost. 

In such context, TT has delivered two bullish operational updates. 

The 2022 interims achieved £269 million revenue - up 10% at constant currency and 8% organically - “reflecting TT’s position in structural growth markets and new project wins”.  

Record order intake saw 23 significant new contract wins achieve over £60 million revenue (spread out over future years). Order intake was materially ahead of revenue as shown by a book-to-bill ratio of 144%, with orders more than doubled since pre-pandemic years and up 55% year-on-year. 

It appears to reflect manufacturers in aerospace and defence, medical, transportation and other industries, recovering their mojo after pandemic disruptions. 

Even so, while TT’s interims adjusted operating profit rose 5%, it fell 4% at the reported level due (yet again) to restructuring and acquisition/disposal-related costs.   

10 November update reinforces distinguished story

The four months to end-October had shown 18% revenue growth at constant currency - helped by product price rises to pass on higher costs, and exchange rates mitigating them. 

With most (38%) of TT’s revenue deriving from the US, a strong dollar lately would have helped. The US may also face lower risks with recession given its energy independence versus Europe/Asia.  

Elsewhere, Asia constitutes 23% of revenue, the UK 22% and continental Europe 16% with central/south America a residual element.   

This stock is therefore a hedge on specific risks of the UK economy, so long as the global economy does not slump after most central banks raise interest rates – in a context of humongous public/private debt.   

Unlike other companies starting to caution, TT’s order book “remains well above historic levels across the business and provides excellent visibility for 2023”.  

A fortnight ago the book-to-bill ratio had eased to 127% for 10 months of 2022, hence implicitly so had the growth rate of orders, but it remains outstanding among companies reporting. 

Margin improvement is anticipated in the second half of 2022 despite higher costs of wages, materials and energy. 

There was however no upgrade to 2022 net profit expectations where profit is already expected to near-double. 

Can TT’s client industries genuinely buck a global recession? 

The impression is that companies will do well if they have exposure to secular growth trends – for example defence spending as NATO modernises, healthcare as the global population ages, and green energy substituting fossil fuels. 

TT’s origins were as Tyzack Turner, a long-standing industrial group that in the 1990s expanded into electronics via acquisitions. Electronic components tend to be cyclical, quite like packaging, hence listed firms in both such industries profess “specialist” areas – hopefully to convince investors they are low-risk. 

The 2009 recession still impacted the group by way of a 15% decline in revenue to £500 million; yet operating profit before exceptional items plunged 76% to £6.5 million. The normalised operating margin fell from 4.6% to 1.3%. 

There was a £14.2 million restructuring charge (after £3.8 million in 2008) and £3.8 million goodwill impairment. A £5.7 million net finance charge (on debt assumed for acquisitions) plus taxation took the 2009 annual loss near £20 million. 

Operations were not dissimilar to now: highly engineered electronic components for defence/aerospace, medical, automotive and general industry. 

And despite ongoing acquisitive development by a new CEO since 2014 (the ex-head of Cobham’s aerospace and security side) recent revenue/profit is not radically changed from 14 years ago.  

In due respect, 2010 saw a revenue rebound to £572 million and operating profit over £25 million – before TT’s trademark, £4.5 million exceptional items, likewise £4.5 million net finance costs. The net profit on continuing operations was £18.5 million. 

You therefore need to consider what global outlook you believe in. History suggests TT’s narrative and numbers will deteriorate if a widespread recession follows. 

Stock uptick may also reflect wider sentiment twitching 

It might, however, equally be fair to say, a recession of sorts was priced into TT’s 125p low earlier this month.  

Even Morgan Stanley’s bearish equity strategist now asserts: “Prepare for bargains in the first quarter of 2023” and Wharton professor Jeremy Siegel argues “90% of our inflation is gone, US equities offer 20% upside in 2023”. That amounts to saying, buy quality cyclicals. 

If recessionary indicators fail to deepen as feared, in months ahead, then yes: Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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