Regression to the Mean and a Potential for a Less-Than 10% Buyback
Zytronic PLC (ZYT) designs and produces high quality electronic components and is the leader in its industry. Customers for their niche product, the”vandalism-persistent” large PCT-technology touch- and multi-screens, are used by various big public institutions and private organizations. ZYT supplies to, for example: Coca-Cola, JC Decaux, Microsoft, a majority of the world’s ATMs, museums, etc. ZYT operates in English (9% of revenue), American (26%), EMEAn (46%) and APAC markets (19%). They have a steady revenue growth for the past 10 years.
How come a small growth company made it through that screen!? It seems like it gave a red flag early this year and lost some one-time orders with Coke and ATM customers. This seriously scared our dear friend Mr. Market and resulted in a deep dip.
Return on Invested Capital = EBIT/(NWC+Net Fixed Assets) = 3.055/15.891 = 19.2%
Looking at the above mentioned number this seems like a good business that ZYT is on to. At least this was the case in the past. It seems to have been expanding firmly over the years. Operating income’s current three year average growth is around 20%. Also, EBIT is growing faster than revenues. Other than the troubles with orders early this year, the business has been consistent. It had been enjoying some over the trend revenue in the past year, that is before they flagged and which killed the expectations for this growth stock. And is there anything more the market hates?
Q: How is the management’s bread buttered then?
A: The executives and their families are invested in the business. Salaries are not over the head and they have some significant option and bonus programs available for their directors. These are good indicators for shareholders. It would still be necessary find out if these are people with integrity.
Q: Is there possibly any sustainable competitive advantages that support the argument in favor of existence of profitable growth potential?
A: This could be the case. The company is protected by a patent on the PCT(TM) technology. The next question is how long and how strong is this protection? One would have to look closer to it to determine some form of an answer. It seems like it does have relatively high fixed costs (net PP&E 40%) to possibly form some protection for its niche market. An important consideration is its reliability as a supplier of high-quality touch screens for big customers with big investments that require consistency. When you invest in a whole city full of bike rental stations with touch screens, ATMs in murky places, Coca-Cola Freestyle(TM) stations that are hacked by children in amusement parks and drunks in restaurants, you want your screen supplier to deliver good stuff, and on time. One would have to find out through a person familiar with the industry how solid their reputation is as a quality supplier. This company is not inside my circle of competence.
This was a quick qualitative assessment of the business.
Enterprise value= Market cap + Debt = $23.4 million + $2 million = $25.4 million GBX = small cap.
How much do you pay? Pre-tax earnings yield = EBIT/EV = 3.055/25.4 = 12%
When you first look at the price you would be paying for this business, it seems reasonable.
Q: At $156.5, would I invest in this or a 10-year U.S. government bond?
A: They pay around 25% in taxes, so if I choose a conservative 6% for the risk-free rate and compare these two yields, I get: 12% x (1-25%) = +3%. It makes an interesting case. I would also have to consider the 5.53% dividend yield. It could be that ZYT is more preferable.
EV/EBIT multiple = 8.3x
Q: Balance sheet?
A: There is not much debt and 20% of B/S in cash. Piotroski score: 8. Well that’s looking pretty good.
Q: What is the company doing with the excess cash?
A: It is paying off debt and increasing the dividend. Also a noteworthy footnote from the annual report from last year reveals that it has provided the directors with an option to buy back shares up to 10% of total shares outstanding. This is valid for a year.
Q: Are there any risks?
A: Of course, there always are. In this case the short-term risks would probably be that the growth in share prices had been counting in future growth too much. Also, the margins possibly were abnormal (as the interim report on absence of one-time orders suggests that was the case), and those conditions were priced in before the bad news came out. But those are only concerns for the short-term picture, which I think shouldn’t raise any emotions in an intelligent security analyst. What creates risk for the long term is that competitors can come up with a cheaper product with equal quality if there are no sustainable competitive advantages. You would have to look closer to these things to asses the possibilities and the downside for the next three to five years.
Q: What would be the possible catalyst for a value case?
A: Overreaction to short-term, one-off order problems and a likely temporary deterioration that will be corrected. Regression to the mean. Possibility for cannibalism (buybacks).