Stockwatch: A share highly geared to upturn

Have small cap cyclicals been overly punished? This area of the market has seen sharp falls as deflationary fears prompted de-risking. As a general rule, investors don’t want over-exposure to less-liquid stocks if economies are softening. Yet there can come a point where risks are priced in, such that any reassuring update then boosts the stock.

One such example is Anite which provides wireless testing for mobile technologies. From a three-year low of about 80p the FTSE SmallCap shares have perked up to 90p after an update cited commercial momentum continuing into the third and normally quiet quarter of the financial year to end-April 2015.

Management remains confident that annual pre-tax profit will more than double to £22 million, a consensus forecast that has looked demanding after the interim results posted only £5.1 million (although that's still doubled from £2.5 million in 2013) on revenue up just 3% to £49 million. The group is known to be second half-year weighted, but in uncertain times investors tend to want proof than trust any gap can be bridged. Furthermore, higher interim profit has followed largely from cutting sales and distribution costs, and at 90p a share the price/earnings multiple is already 16 times the consensus EPS estimate for 2014/15. So a further significant re-rating does need the commercial momentum to kick forward.

Operational gearing means revenue changes can quickly impact profit

Cost-cutting should enhance what is already a group with high operational gearing, i.e. better revenues will largely translate into operating profit. Handset testing provides just over two-thirds of revenue/ profit, relative to network testing, and orders in handsets work rose by 20% in the first half-year i.e. will bolster the second half as revenues become recognised. Obviously this is a short-term view, but it marks Anite as worth watching for this to continue.

As regards to medium-term potential it will also be interesting to follow progress at last October's acquisition of Xceed Technologies Inc for $30 million (£19.7 million), said to be integrating well. This significantly enhances Anite's data analytics' capabilities, a segment of networks testing that appears to offer good scope. For example Ascom, a rival firm, is targeting 20% annual growth in data analytics and prioritising this to expand its network testing. Both firms’ actions suggest a growth area that isn’t yet overly competitive, hence revenues and margins could prove attractive.

Asia Pacific demand is likely the crux

Anite's customers are largely manufacturers of mobile devices, chipsets, network equipment and such like - explaining a strong geographic revenue weighting to the Far East. This doesn't make the group dependent on economics of the region, as the technology shift to mobile is generated by global customers; but mind how Anite has cited strong demand lately from key manufacturers supplying the Chinese market, also supporting the export aspirations of domestic Chinese manufacturers. So the risk/reward profile of the Chinese economy applies here: are we looking at a country with sustainably high economic growth or heading for a debt bust? It's a significant factor considering how Anite's business is trending.

Asia Pacific demand is also offsetting current weakness in other regions: overall market conditions are described as "challenging, with pockets of exciting growth and some areas of reduced demand" - these typically being Europe and the US. The complexities (and surprise weakness in the US, versus its generally strong economic profile) explain why investors have tended to take their cue from Anite's trading updates. This can add to the stock's volatility as traders get in and out accordingly. Not to lose sight that altogether, Anite is well-positioned in long-term growth markets as wireless adoption evolves. It could be that now marks a point of acceleration from a temporary lull.

Currencies can also affect reported results

With only 3% of revenues deriving from the UK in the 2013/14 financial year, sterling's position is liable to influence outcomes - and in the first-half year, weakness in the euro and US dollar meant exchange rates versus sterling were respectively 6% and 7% lower. The impact on operating profit was limited to £0.3 million however. The network testing business is the most exposed to currency moves, with euro-denominated results converted back into sterling. It’s not a substantial matter, but marginal enough to influence whether or not the company meets expectations. Sometimes the market respects "constant currencies" reporting, other times that it is window-dressing.

Prospective yield of 2.6% emphasises earnings valuation

Given the scope for cyclicality, Anite doesn't pay out a substantial element of earnings, although the table shows a strong cash flow profile with relatively less capital spending needs. In the first half-year alone, cash generated from operations was £11.7 million. Such a profile supports a dividend payout that ticks the box for institutions to hold stock, but is no real attraction for income investors i.e. a market prop. The end-October balance sheet had £137.9 million net assets with £111.5 million goodwill or intangibles, so valuation is all about what these assets can earn -the stock twitching according to expectations.

No debt and nearly £30m cash enables further acquisitions

The balance sheet does, however, put Anite in a strong position for earnings-enhancing deals. This follows last May's sale of Anite Travel for £45 million which had represented about a quarter of group revenue and operating profit. While management has not recently entertained the prospect of deals, page 16 of a 10 February presentation helps show their progression and context in the group. This latest presentation is also well worth studying for a more detailed understanding of Anite.

Breaking out from a recent trading range

The six-month chart has twice seen resistance at about 88p since November, but the stock is challenging this now. In a five-year chart context the price remains historically low, so probably investors are reacting to the positive trading update in this context. With the electronics industry set to continue its shift to wireless devices, Anite looks well-placed to capitalise, hence worth watching to accumulate.

For more information see anite.com.