ProPhotonix consists of two business units: an LED systems manufacturing business based in Cork, Ireland and a laser modules production and laser diode distribution business located in Essex, England. Corporate headquarters and the North American sales activities are run from Salem, New Hampshire. ProPhotonix sells its products principally into three markets: industrial (primarily machine vision illumination), medical, and homeland security and defence.
The company is loss-making, but there was a notable improvement in the second half performance last year when the underlying operating loss narrowed from over $500,000 (£300,000) to only $82,000. ProPhotonix's short-term strategy is to reach sustained positive cash profits, cash flow, and net income as soon as possible. To this end, the company’s senior management team has initiated actions to lower annual costs by approximately $900,000 and will incur one off charges of $150,000 in the first half this year.
Importantly, ProPhotonix has been winning new business, having secured one significant two-year customer contract that is part of its record order backlog of $8.4m (£4.9m). In addition, several significant prototype products have recently been shipped to customers and the company is awaiting final design modifications for the transition to production units during the second half. This offers potential for high volume OEM (custom) applications including illuminators for the semiconductor, optical sorting, endoscopy, and vascular imaging markets. Guidance is for first half revenue to be in the range of $7.8m to $8.2m, up from $7.4m in the same period of 2013.
In other words, 600 Group is acquiring a strategic 26 per cent stake from ProPhotonix's existing shareholders giving it a holding in a small cap company that is moving to break-even by realigning its cost base while also offering prospects for decent revenue growth. Analyst Gurpreet Gujral at N+1 Singer expects ProPhotonix to post cash profits of $500,000 and break-even at the pre-tax level this year, based on revenues rising from $15.6m to $17.1m, before moving into profit in 2015 assuming turnover rises to $18.8m. On this basis, Mr Gujral forecasts cash profits of $1.2m and pre-tax profits of $1m in 2015. Clearly, if these targets are achieved then it will justify 600 Group’s investment in the £3m market cap stock market minnow.
The investment will also help 600 Group to build a working relationship with ProPhotonix. The £1.1m consideration is being satisfied by the issue of 4.9m shares in 600 Group, or 5.5 per cent of its issued share capital, in exchange for 22m new shares in ProPhotonix. This means the acquisition price is 5p per ProPhotonix share, a premium to the current share price.
True, there will be modest dilution to 600 Group’s earnings forecasts as a result of its share issue, but this could be offset by a boost to profits as a result of the tie-up. Indeed, there is a natural link between 600 Group’s fast growing laser marking business, Electrox, and ProPhotonix’s laser module business. That’s well worth considering.
Electrox to drive 600 Group’s profits
Operating under the Electrox brand, 600 Group’s laser marking business designs, develops and manufactures equipment for the permanent marking of a wide variety of materials from its base at Letchworth Garden City.
In the second half of last year, the laser unit increased revenues by almost 20 per cent to account for 18 per cent of 600 Group's revenues, primarily driven by a step up in marketing activity, well received product launches, greater presence at key trade shows, and recruitment of additional sales staff. Importantly, a higher proportion of these revenues dropped down to the bottom line. In fact, operating profit almost doubled to £421,000 reflecting a near doubling of margins to 5.6 per cent. The laser unit's second-half margin of 7.2 per cent adds substance to finnCap's prediction that the margin can soar to 8.8 per cent in the current financial year to March 2015. If achieved, and assuming a 10 per cent increase in revenues to £8m, the division could produce operating profits of £700,000, or two thirds higher than in the prior year.
Importantly, there are "further operational gearing opportunities in the business" as available production capacity is filled. In other words, the ProPhotonix investment could help fill this capacity in time, not to mention lead to opportunities for market share gains. But even without any contribution from the investment, analyst David Buxton at broking house finnCap believes 600 Group’s laser marking unit could generate revenues of £9m and operating profits of £900,000 in fiscal 2016, implying a margin of 10 per cent.
In my view, it looks an interesting deal for both parties and one where the profit enhancement to Electrox could easily justify 600 Group’s modest investment in ProPhotonix, albeit there is no guarantee of that at this stage.
Attractive rating
Irrespective of the potential of the tie-up, I still believe that 600 Group’s equity is being undervalued. So too does Mr Buxton, who expects the company to report pre-tax profits of £2.1m and EPS of 2.1p in the 12 months to March 2015. That’s after factoring in revenue growth of around 7 per cent to £44.5m. Assuming these forecasts are hit, adjusted EPS is set to rise from 1.9p last fiscal year to 2.1p which means the shares are trading on 10 times forward earnings, a chunky discount to the UK industrial peer group average of 16.8 times. Even if you look a further year out, when finnCap is pencilling in EPS of 2.3p, 600 Group’s shares are still trading on a 30 per cent discount to its peer group average of 13 times earnings estimates.
That’s a harsh valuation in my opinion and one that leaves ample upside potential for a re-rating. So, if you followed my recommendation to buy 600 Group’s shares earlier this year when they were priced at 19p (‘Tooled up for a strong recovery’, 19 April 2014), or when I updated the investment case post the bumper full-year results when the price had risen to 21.75p (‘Engineering growth’, 1 July 2014), I have no hesitation reiterating my buy advice with the shares being offered in the market at 21p. My year-end target price is 30p, slightly above finnCap’s own price target of 27p.
■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'
