Free to read: What’s the bottom line for Volex?

The business is performing well and on track to meet its medium term trading profit targets. Whether shareholders see much profit growth is less certain.

Photo by myenergi on Unsplash

Volex shares have been on a storming run as the business has tapped into attractive growth trends in consumer electronics and electric vehicles.

A combination of strong underlying growth and some decent acquisitions has served shareholders very well. This was further confirmed in Thursday’s very strong interim results release.

The sell off in the shares on the back of them is symptomatic of the amount of money chasing short-term momentum in the current market. Many holders were expecting another increase in profit guidance and when they didn’t get one they sold out.

This doesn’t mean upgrades can’t happen over the next few weeks and months. A look at the implied second half performance based on current consensus forecasts could raise a few eyebrows and make you think that the company could end up doing better than its current guidance.

Those investors with a longer term view will look at the performance of the business and find a lot to like.

Electric vehicle and consumer electronics sales are booming

Revenues are the lifeblood of every business and revenue growth is a key indicator of health. Volex is clearly in good shape as its sales of electric vehicle charging products continue to soar. Consumer Electronics sales have been helped by acquisitions but are still showing very healthy growth.

Medical sales are recovering and are underpinned by decent long-term fundamentals in areas such as health screening.

The only source of weakness came from data cables where a running down of stocks saw subdued sales. Going forward, the launch of a 400 Gbps data cable bodes well for medium term growth.   

Volex: Sales Mix

Source: Volex/Invest-ability

The company has added over $90m of annualised sales during the last six months. A reasonable chunk will have come from the acquisition of the Turkish white goods company DEKA but organic growth is clearly still very decent as evidenced by the more than tripling of electric vehicle sales in the first half.  

Improving returns but weak free cash flow

Whilst revenue growth has been strong, the company has experienced some cost pressures from higher freight costs and rising copper prices. The good news is that these are being passed on to customers with higher prices but with a lag which has dragged down gross margins along with  changes in sales mix towards lower margin consumer electronics products.

The company has done a good job in controlling its operating costs and limited the damage to operating margins very well.

The real hit has come from a materially higher tax charge compared with last year when there was a big tax credit. As a result, diluted EPS barely changed (there is around 6 per cent dilution from share options) and trailing twelve month(TTM) EPS is around the same as that achieved in the year to April 2021.

Investors should take heart from the fact that return on capital employed(ROCE) and return on operating capital(ROOCE) continue to move higher and are at very healthy levels despite lots of investment and acquisitions.

Volex: Key numbers and ratios

Source: Volex/Invest-ability

The company’s free cash flow performance was weak due to heavy investment in working capital (inventories and trade receivables). 

Rising inventories in manufacturing businesses should always be watched as they remain a great way to shift overhead from the income statement to the balance sheet. In this case, it is not really a cause for concern as it means that the company has enough inventory to meet expected demand which is better than not having enough.

This will reverse out in time but probably not for the rest of the year.

Checking out the soundness of full year forecasts

The company has retained its profit guidance for the year to April 2022. However, this implies a second half performance that looks much weaker than the first half which raises lots of questions.

The current consensus of the four analysts contributing to forecasts on SharePad is for pre-tax profit of $51.2m/26.2c EPS compared with $41.6m/30.0c last year.

Backing out the implied second half forecasts from the full year consensus implies a marked slowdown in revenue growth to a mere trickle compared with the first half.

Is this reasonable?

The company has given a cautious outlook on the potential for supply chain disruption and has highlighted a moderating in demand for EV chargers at the end of the second quarter as vehicle manufacturers have slowed production due to a shortage of semiconductors.

Consumer electronics sales have been exceptionally buoyant and are expected to normalise. Given that this is Volex’s biggest source of revenue currently, a sharp pullback in sales could bring down the revenue growth rate by quite a lot.

Volex: Implied H2 forecasts

Source: Volex/SharePad/Invest-ability

Data cable sales are also expected to slow due to high customer stock levels and a moderating in demand in 100 Gbps products.

On the positive side, there is pent up demand in the Medical business as well as a contribution from new acquisitions. The effect of the increase in selling prices is hard to call but is a positive on a unit basis.

The real uncertainty with Volex’s forecasts concerns the amount of tax it will expense. Current consensus forecasts for the next few years seem to be based on tax rates of 12.7 per cent this year, 5 per cent next year and 8 per cent in 2024 if I look at post tax profits as a percentage of pre-tax profit forecasts.

The company still has a decent sized deferred tax asset of $23.7m on its balance sheet which allows it to utilise previous tax losses against future profits. This suggests that there is potential for its tax rate to stay low for the foreseeable future if profits are made in the right places.

On track to meet 2024 operating profit targets but what about the bottom line?

The company looks well placed to hit its medium term targets of $650m in revenues and $65m of operating profit by 2024. It might need another smallish acquisition to get there but the current view of analysts is that it won’t be far off.

This would represent very decent progress as long as the company can maintain its excellent returns on capital.

Volex: Current Consensus forecasts

Source:SharePad

My concern with Volex is that despite the excellent progress it is making at the revenue and trading profit level, uncertainty on issues such as its tax rate and ongoing dilution from share options means that its earnings per share(EPS) in 2024 might not be much higher than it was in 2021 when it was 32 cents on a basic level and 30 cents on a fully diluted basis.

Forecasts are often wrong but this risk should not be dismissed.

There’s no doubt that Volex is a very good business and its management is not complacent. There’s a lot to like about it.

Its acquisitions and investments are broadening its revenue base into new sectors and markets whilst protecting its cost competitiveness. This will be key to its long-term success in the EV market where it expects the competition to increase.

At 405p, the shares trade on a one year forecast rolling PE of 19.2 times. This does not look too excessive for a business in good health. After a strong run, upgrades are arguably needed to drive the shares higher in the short-term.

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