Stock to Watch: Volex

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A resilient update and modest share buying by the chairman and chief executive of FTSE SmallCap, electrical and optical connecting solutions group Volex (VLX) has currently put a floor under a deteriorating chart that saw a volatile 250p to 350p range last year, then a slide to 220p in January. The price has improved to test 250p.

I drew attention at 315p last July, given broadly strong financials and Volex deriving over half its sales from Asia, where it provides connectivity devices such as power cords, to technology manufacturers - across consumer, telecom/datacom, healthcare and industrial sectors.

The shares then got caught in negative sentiment during the second half of last year, that also affected Pace (PIC) and IQE (IQE) - fear that lower demand for technology would leave suppliers over-stocked along the assembly chain, hence a cyclical downturn.

But technology suppliers are now generally indicating firmer prospects. Weakness in Volex shares has been a bit curious given the half-year results to 2 October 2011 showed revenue and profit growth in the percentage mid-teens - albeit flat, basic earnings per share, after a significantly higher share-based payments charge.

There was still an interim dividend and no real caution on trading: management indicated full-year results in line with expectations.

This has been reiterated in a 13 January interim management statement (IMS) which cited "solid" trading in the third quarter of the company's year to end-March 2012. It sounds a respectable label for a flat quarter to end-2011: reporting in US dollars, like-for-like revenue was a constant $125.1 million (£80.9 million) and profit was "restrained" i.e. hit, "by exceptional start-up costs on new products for the company's largest customer". It is possible to regard this as necessary spend to sustain competitiveness.

For example, $2.8 million has been spent on the migration from PVC to halogen-free power cords, as part of an overall technology upgrade. It is said to deliver sustainable competitive advantage with scope to attract a wider range of customers. It still has to be made, showing how fast-moving technology tends to involve an ongoing tax on value, to ensure upgrades. The shares' modest rating more than discounts this however,

Volex continues to look a relatively high-quality technology play, supplying essentials, so long as you mind cyclical risks. Shares hit 16.5p with the 2008/09 bear market, yet this was largely the fear factor - also with Volex having to dispose of its wiring business, then a chronic problem. A new management team has since made good progress.

Company REFS shows brokers' analysts with unanimous 'buy' ratings from October to December, forecasting about £17.5 million equivalent pre-tax profit for the current financial year - rising to about £22 million in 2012/13. If this is at all realistic, annual earnings growth is going to continue well in excess of 20% to about 30p equivalent, since the 2008 dip to minus 0.7p (or 4p normalised).

This therefore implies a forward price to earnings multiple of just 9.5 times, falling below eight - so the market is taking a very cautious approach. Possibly it relates to quite a tight market in the shares: for example when the chairman and chief executive just recently bought, it was just 1,000 shares and two lots of 1,000 shares at prices around 218p - to own 106,000 and 53,000 shares respectively. It was light buying, yet a marker for value. The directors' modest share ownership - just 0.6% of a sub-£150 million company - is perhaps more of a concern.

Dividend forecasts vary from 1p to 3p a share for the current financial year, rising to 2p to 5p, hence a minimalist yield in prospect - but at least a commitment to payouts. This may mitigate future share price volatility, since there was no dividend policy during the 2008 catastrophic drop to 16.5p. At 125p for example, a 5p a share payout implies a 4% gross yield - but it would need a serious global recession to prompt such falls again, and the group has also restructured.

Like some other cyclicals, Volex shares are marking time until there is firmer evidence the eurozone woes won't tip the world back to chaos like 2008. Larger cyclicals have rallied on relief the US and Chinese economies are not slumping - as was the fear last summer/autumn - and European sovereign bond auctions have gone better than expected, with yields turning lower.

Small cap cyclicals are waiting because investors still fear being trapped in them if trouble flares up again over Europe, and possibly the US economy flatlines again while consumer disposable income remains low. With tight liquidity, such shares are liable to lead market downturns and lag upturns. But as the Volex directors are showing, the down-drift can extend too far.

Last October, Volex's (long-term) borrowings were about 100% of net assets, however $25.8 million cash brought gearing down to about 31%. The debt still meant nearly $2.5 million finance costs against $12.8 million interim operating profit (after $2.1 million share-based payments charge) and a reduced tax charge was the only way interim net profit edged ahead.

So the market has been mindful of what needs to be gained in the second half to end-March - for Volex to meet double-digit growth forecasts. The IMS affirmed them although it assumes taking a normalised view: reported operating profit was down 33% like-for-like, in Volex's third quarter, up 12% normalised.

The modest directors' share buying, compared with increased appetite among investors for risk assets, implies Volex shares have further recovery potential. Less than 20% of group revenue was derived from Europe/UK in the 2010/11 year and it is going to need another debt shock from Europe - spreading internationally - to derail improving confidence.

For more information see www.volex.com, and for previous stocks to watch, visit Edmond's archive.