Interactive Investor

Stockwatch: Snap up this AIM recovery story

22nd September 2017 09:17

Edmond Jackson from interactive investor

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Does Filtronic finally have its act together for a worthwhile recovery? Nowadays AIM-listed, this telecoms hardware developer was a darling of the 1998-2000 technology bull market, only to slump and spend the last 15 years or so re-positioning.

Amid present euphoria for growth stocks, however early stage the business, it's a lesson from the last boom not to chase expectations to silly levels liable to reverse.

It also shows how reality proved very different from what brokers promoting it, on a stratospheric price/earnings ratio (PE), reckoned at the time. Ironically, now Filtronic does look to be shaping up and trades on a relatively modest rating those brokers have all lost interest ("forecasts awaited", according to Company REFS).

True, the table shows quite sizeable losses for the company's 2014 to 2016 years, and an August 2015 placing of 90 million shares at 5p (when Filtronic de-listed from the main market to AIM) resulted in 207 million shares issued.

That's not too many going forward and, if you can stomach tax credits and a currency revaluation boost (see later) enhancing 2017 net profit, then earnings per share (EPS) of about 1.5p implies a modest PE multiple of 8.3 times at the current share price of 12.4p, which capitalises Filtronic at £25.6 million.

No dividend tells you the board remains alert to working capital and investment needs, telecoms being a relatively fast-moving sector, and earnings could remain lumpy until diversification of the customer/technology base is better established.

Yet key elements of a turnaround have been achieved and liquidity isn't bad for smaller investors: a normal market size of 20,000 means at least £2,500 should be sell-able at the published price; thus potential as a tuck-away.

Filtronic - financial summary     
year ended 31 May 2013 2014 2015 2016 2017
Turnover (£ million) 40.0 32.9 17.5 13.6 35.4
IFRS3 pre-tax profit (£m) 0.2 -3.7 -11.0 -7.0 2.2
Normalised pre-tax profit (£m) 0.6 -2.8 -10.8 -6.5 2.1
Operating margin (%) 1.5 -8.6 -61.7 -47.7 6.5
IFRS3 earnings/share (p) 0.3 -2.9 -10.2 -3.2 1.5
Normalised earnings/share (p) 0.7 2.0 -9.9 -2.9 1.5
Price/earnings multiple (x)         8.5
Cash flow/share (p) -0.3 1.7 -3.6 -3.2 1.7
Capex/share (p) 1.5 1.1 0.4 0.3 0.4
Net tangible assets per share (p) 12.5 11.6 5.0 2.2 3.5
Source: Company REFS

4G rollout has been the key driver

The year to end-May 2017 achieved a £2.2 million pre-tax profit on £35.4 million revenue - ahead of budget and a turnaround from £13.6 million revenue in 2016. Mind this was all due to the wireless side soaring from £9 million revenue to £30.5 million, its £4.5 million operating loss becoming £3.5 million profit.

Adoption of 4G networks boosted sales of ultra-wide band integrated antennas to a major telecoms operator, also demand for a broader range of filter products across telecoms and public safety markets.

Mind a caveat in the chief executive's review:

"Disappointingly, the follow-on demand for ultra-wide band antennas has been lower than initially forecast by our customer; however this business has enabled us to gain good momentum into the antenna market and has established us as a credible player in the sector as confirmed by the growing number of trials underway with other customers."

Thus, near-term caution looks prudent, although the rebound is no one-shot wonder. 4G is the go-to technology for operators and consumers alike - BT has a £6 billion investment programme aimed to make it achievable together with superfast broadband for over 95% of the UK by 2020.

Filtronic derived barely 1% of revenue from the UK in its last year, though: 53% was from Europe, hence terms of trade post-Brexit poses a risk; 41% from the Americas; and 5% rest-of-world.

Ericsson and Nokia are not overtly declared customers, though are cited in the annual results as having downgraded projections for their financial year; thus Filtronic's management is "a little more cautious regarding the short term as a consequence".

That's either odd or a very short-term view in the sense that they anticipate renewed demand growth during the 2018 calendar year. As if they want to prudently include a caveat, in case of having to warn.

Yet the adoption of 4G and Long-Term Evolution - "LTE", a standard for high-speed wireless communication for mobile devices and data terminals - implies a growth context for the next few years.

Otherwise, broadband-related revenue edged up 6.5% to £4.9 million with a £900,000 operating loss reduced from £1.6 million. While unsatisfactory, "substantial progress has been made to diversify our customer base and the markets that we serve".

Overall modestly rated as turnaround evolves

Management recognises the need to continue broadening its products to mitigate lumpy revenues; which could be said as "priced in" given most turnarounds trade on a high PE in the expectation of earnings recovery.

Thus, if management is correct in its assumptions for 2018 onwards, the present rating of an historic PE some 8 times - and if that's debatable then a price/sales ratio just 0.7 times - is long-term attractive.

By way of comparison with the chart, there was a sustained fall from an 80p range in 2013 as low as 4.88p in 2015, then a spring 2016 re-rating over 10p and sideways trading for the last 15 months. It appears investors are cautious to recognise better prospects and/or have lost interest.

Yet the operational review reads well in terms of re-affirming existing contractual arrangements; in mid-August the broadband side agreed a £4.8 million new supply deal with a major European defence equipment manufacturer; and investment in sales & marketing teams internationally is said to herald "a growing opportunity pipeline".

Looking further out, the chief executive's review clarifies preparation for 5G - as hardware becomes increasingly integrated - where "Filtronic is well placed to play a part in this major market development".

Admittedly this all requires some faith and profit life-cycles are getting shorter with a constant need to adapt and refine technology; yet management has shown decent progress in the last year and is "making its own luck" for the future. It seems overly negative not to think various initiatives can bear fruit.

Other financial specifics to consider

Mind how 2017 pre-tax profit benefits from an exceptional £740,000 revaluation of a US dollar-denominated, inter-company balance; also how EPS of 1.5p enjoys a £962,000 R&D tax credit, pushing up net profit by 45% to £3.1 million.

Some might prefer to normalise this more strictly for net profit sub-£500,000, hence EPS of just 0.2p. At least it shows how Filtronic's numbers can quite swing about.

Yet, while the income statement is a bit disappointing in such regard, the cash flow statement is more affirmative - turning net cash absorbed in operations from £5.1 million to £3.9 million generated, in the last year. £1.3 million of this was applied to repay borrowings such that the balance sheet is debt free while cash has risen from £1 million to £2.6 million at end-May, despite a net £725,000 spent on plant and equipment during the year.

There were no capitalised development costs after £286,000 in 2016, and goodwill represented a modest third of net assets.

For a technology company, this is decent financial health to advance what is already "an exciting pipeline of new products and customer opportunities in a broader spread of market sectors" - even if there is no dividend.

Long-term attractive risk/reward

Admittedly telecoms hardware is not everyone's cup of tea: fast-moving, hence risky if you prioritise very stable free cash flow for payouts.

It may take a few more accounts to convince sceptics as to Filtronic's true underlying earning power. Yet the market is barely noticing management's industry positioning, thus the stock rates a steady accumulate.

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