Edmond Jackson's Stockwatch: A contrarian "buy"

A plunge in the shares of diversified electronics group TT Electronics is interesting to follow because it is a long-term attractive business. Either a new chief executive (since July) will sort the situation out, and/or there will be predatory interest.

An ongoing weak share price is likely because a latest update has indicated "materially lower" performance in 2015 as a result of delays with an operational improvement plan whose first benefits will only be seen in 2016. With the extent of the dividend possibly in question, the shares are exposed to stop-loss selling as holders seek better prospects elsewhere. The adage how "profit warnings come in threes" may also affect sentiment given deflationary signals from the eurozone where TT derived 49% of revenue in 2013.

The stock is a potential contrarian "buy"

While the situation doesn't look good and a 30% plunge in the price to 112p has extended to 105p, it has features of a reliable stock-picking approach: to buy into businesses with relatively short-term problems, that otherwise are well-established in growth markets and have a proven financial record. TT has a long history on the London Stock Exchange, it is not a spiv company making rapid acquisitions with aggressive accounting, and its debt is manageable. It can bounce back assuming we are not on the edge of a global cyclical downturn with its epicentre in Europe. 

It is also interesting to follow for evidence about continental Europe amid conflicting macro data. The dilemma is deflation: in response to weak global demand (see the relatively flat five-year trend in TT's revenue) the company is cutting costs, relocating some manufacturing operations from Germany to Romania and production lines from California to Mexico. This includes for example, electric-vehicle components and electronic sensors to customers such as BMW and Volkswagen.

Whatever mix of issues involved, from negotiations with German trade unions to management’s own execution of the plan, it has become delayed hence postponed cost benefits into 2016. This has been known since the summer, but the latest update added financial negatives such as a review of historical R&D spend and amounts carried on the balance sheet, and cited a weakening in order intake at some European facing businesses.

Tidying up capitalised R&D is nothing problematic; the trouble is TT’s fixed cost base lagging a deflationary environment. 2014 profit is predicted at the low end of expectations (implying about £28 million pre-tax profit and 13.5p earnings per share) however "the performance of the business will be materially lower in 2015" and it will take until first-half 2017 to fully implement the improvement plan. With 2015 earnings per share targeted around 9p, the rating depends on whether the market considers it can recover.

A recent corporate culture of sloth?

There has been misjudged or misinformed share buying by the directors. Non-executives can partly be excused as they have less exposure to operations; three of them bought £69,378 worth of shares in August at prices around 170p after TT came out of its close period for the interim results.

The chief executive then bought nearly £25,000 worth at 168p on 30 September. The polite explanation is his only just discovering the extent of challenges, but this would imply a slothful corporate culture with management less alert to business needs and communication to board level being unsatisfactory. If so, it is worrying because culture needs time to change.

The new boss was head of aerospace and security, the principal division of Cobham which is listed in the FTSE 250 index, prior to which he spent 13 years at Goodrich Aerospace in various management roles.

Where is there a support level for the shares?

Tangible net assets at end-June were £108.6 million (subtracting £62.5 million goodwill and £19.8 million other intangibles) or 68.6p a share. Fair value in a technology business involves some intangibles, just mind the likely write-down of capitalised R&D.

The dividend is significant as a prop, and brokers appear to be targeting about 5.5p a share implying a prospective yield just over 5%. This would involve earnings cover of about 1.7 times if the 2015 profit forecast of £19 million is realistic. TT's historic cash flow profile looks strong (see table), however the interim cash flow profile was less encouraging: operating cash flow was significantly negative, £16.2 million compared with £3.1 million negative in the first half of 2013.

In fairness, 2013 as a whole saw £30.3 million cash generated from operations, so the figure may improve in the second half of 2014 with seasonal factors. The dividend paid in the first half of 2014 required £6 million while overall cash reduced from £54.9 million to £27.9 million and there were £16 million proceeds from borrowings (similarly as 2013). Net debt has risen from £14.9 million at end-June to £30.7 million at end-October; seasonal influences again being possible.

Altogether the cash flow profile has deteriorated, this now followed by a caution about order intake in Europe. If a downturn results then prudently a dividend cut may become necessary.

So while the shares appear to have found support around 105p, mind this may be a short-term view.

Longer-term the business has bright prospects

The Interim Management Statement concluded: the board "is confident that the actions in place will provide a strong foundation to deliver growth and shareholder value." The company has a good product portfolio and the improvement plan should in time deliver better margins. Contrarian investors will therefore recognise a cost-averaging exercise where timing is the main challenge.

Opinions differ, what extent Europe's problems relate to dysfunctional monetary union or other structural reforms needed. The bearish scenario is this company in the bind of deflation, especially if problems in China and/or Japan get exported and the US recovery eases post QE. So it is possible, pre-tax profit has de-rated for a while below the £20-30 million range shown in the five-year table. More positively, while the margin is only about 5% the group’s return on capital employed is over 20%, another factor for bid potential.

From the website, you can see that TT’s sensing and control technologies (54% of 2013 turnover and 57% of profit) are essential items in a variety of industries. The second main division (28% revenue, 29% profit) is integrated manufacturing services (IMS), a solutions business combining design and engineering skills; and the third is components (19% revenue, 14% profit) such as resistors and semiconductors. It's a cyclical product profile yet a quality one; so if the stockmarket proceeds to value it at a discount to fair value then an industrial or venture capital buyer will step in.