It’s 7am on Wednesday morning last week. You’re at your computer bright and early, reading the latest company news as soon as it’s released. Here’s one of your holdings announcing results: “2013 has been another good year… expect Synectics to deliver an equally good performance in 2014”.
Well, that sounds reassuring. But hang on – a little further on in the statement you read “the Board expects results for the current financial year to be at a similar level to 2013”. Oh dear.
Market expectations had been for strong growth to continue, with a 15% rise in earnings expected for the upcoming year. Time to brace yourself! The shares fall by 100p as soon as the market opens, which is slightly more than the size of the profit downgrade.
That’s unpleasant, especially in a stock that had done so well. Synectics had risen from around 100p in 2009 to a high of just over 600p late last year. The current share price of 440p is still above the levels of last summer. But something has changed.
Long-term holders might retain good feelings about the stock despite the warning. Those who bought Synectics at higher levels during the winter will be annoyed, and feeling pretty bad. While those on the sidelines, like me, will be wondering if this is a cheap buying opportunity.
So is it time to dump Synectics stock? Or pick it up on the cheap? In this issue, I want to look at Synectics, and what it can teach us about how the market reacts to bad news.
Synectics is in a growing sector
Synectics supplies high-end surveillance systems to industries where surveillance is mission-critical, and often driven by regulation. Banking, gaming, transport, energy and nuclear use their systems.
System is the key word here. Synectics doesn’t just install a few cameras and some recording equipment. It takes data from a range of inputs – access control, alarms, cameras, number plate recognition, even gaming machines – and pulls it together into a single system.
The big software element along with more high-end big contracts, have helped double margins to 8.8% over the last three years. Sales have grown by 35% to £83m over the same period. It’s a good record.
The business is also becoming more international with 40% of sales from overseas. Synectics completed its biggest ever contract last year – a £7m deal with a Singapore gaming operator. It’s doubling efforts to develop this international sales network.
Along with forging strong links with global majors like General Dynamics and Thales – partners capable of introducing lots of contract opportunities.
Did Synectics overstretch itself?
So, why the pause in profit growth this year?
The truth is that Synectics had sweated its assets hard to generate the growth of recent years. It needs to invest in the business so it’s capable of moving smoothly into the next phase of growth. This involves building a new facility in Lincolnshire.
Research and development (R&D) and capital expenditure are also moving ahead and will be a short-term drag on margins. As will investing in the overseas sales hubs. The company is getting bigger and needs a firm foundation to stop it falling over at some point.
If this investment means a flat 2014 for profits, but the prospect of accelerated growth beyond, then the share price drop will indeed be a good buying opportunity. The overall surveillance market is worth $10bn per annum and is growing around 10% – so there is plenty of scope for Synectics in the future.
And Synectics still expects to get 7-8% growth in revenues this year. But here lies the risk in my view. Management says that the timing of big projects has been pushed out and sales will be “significantly skewed” towards the second half of this year as a result.
Now, the real business world doesn’t always tie in nicely with the stock market’s calendar. Complex projects might take Synectics as long as a couple of years to move through the pitching process. So we shouldn’t be overly critical of an uneven order profile.
However, there’s a clear risk that volumes might take even longer to come through than currently hoped, at a time when overheads are rising.
A warning or an opportunity?
Some investors follow a hard-and-fast rule, and sell immediately when a profit warning is issued. I discussed this ‘zero tolerance’ approach in my last Penny Sleuth. It will definitely be the right action to take if we get another warning in a few months.
On the other hand, the stock market might be presenting us with a buying opportunity in a good quality share that’s merely seeing a pause in its growth trajectory.
We need to look out for news on any contract wins. The interims are due in July, which could provide an important window on the future. Basically, I want some reassurance about that strong second half before I buy the shares.
If 2014 is just a pause, then the prospective price/earnings (p/e) of 13.5 is very good value for a nice company. Market forecasts have the shares resuming their upward progress in 2015. But I think it’s too early to take this on trust.
As a non-holder, I’m happy to keep close tabs on Synectics from the sidelines – even if it means paying up a bit in return for more certainty.
If you own them, it’s a bit more complicated! The shares aren’t quite cheap enough to withstand a second warning if there is one. So I’d be inclined to reduce a big holding. One thing we can agree on though, decision making after a profit warning is never easy.