7:59 cut – VLX

Volex – H1 Results

Volex last updated us on 30th July saying that Q1 was 12% ahead YoY (and 14% in constant currency), with successful integration of its recent acquisitions. Prior to that the annual results showed strong organic and overall growth and I was particularly pleased with indications that Silotec had grown strongly during Volex’s period of ownership.

Today’s results are therefore somewhat behind my personal expectations, being only 7.3% ahead in revenue at the half-way stage, despite contributions from various recent acquisitions. Underlying this is a significantly greater fall in low-margin power cords revenue than I had modelled and somewhat lower than expected growth in the higher quality cable-assemblies (now renamed “complex assemblies”) side.

However, I believe that investor perceptions have lagged considerably behind the unfolding story and it is the transformation in profitability and critically the increase in claimed underlying operating margin from 5.4% to 8.1% that will rightly be the focus of the market this morning. For some investors the resumption of dividend payments will also be key.

Despite the recent share price strength my modelling shows that the valuation does not reflect the dramatic structural improvements that have been made to the business over the last two years, leaving them significantly undervalued. With underlying H1 earnings of US 8.5c in H1 alone, a period during which the last two acquisitions did not make a full contribution, it is easy to see the consensus (which had already been upgraded several times) of 17c being beaten, leading to earnings in excess of 14p. Applying a very modest PE of 10 gives a natural short-term price target of 140p.

Beyond that I think there are various judgements to be made in order to gain a steady-state valuation:

• What is a reasonable normalised level of adjustments / exceptional items in this business? The lack of any separately recognised restructuring costs this year should probably be considered exceptional itself, whereas share-based payments are likely to prove ahead of the long-term average.
• What is the underlying organic growth rate of the business, after stripping out legacy declining business?
• What is a reasonable risk premium (or discount rate) for this kind of business?

Where an accounting earnings multiple valuation methodology is used then the above can be used to arrive at a target P/E ratio. Here I note that XP Power (whose business could be compared to the complex assemblies side in terms of customer stickiness and defensiveness [edit: if not yet margins]), currently trades on a forward P/E of 17 despite forecasts of poor earnings growth.

In addition to there remains significant potential for further earnings-enhancing acquisitions. The recent strength of the share price further widens the discount between Volex’s earnings multiple and that of their targets, making it easier to issue their shares as a currency with the potential for a virtuous circle of increasing valuation and increasingly earning-enhancing acquisitions.

This is my second largest position and I intend to hold for the moment.

[Edit: Whitman Howard now estimate fair value at 160p. If you are not yet a subscriber to Research Tree then you can get a discount by signing up via this link]