Bargain Shares 2024: Back this vastly underappreciated defensive play

Nexteq (NXQ) is primarily a hardware product business, operating as a technology design and supply chain partner to customers in gaming, medical, broadcast and industrial markets.

The key value attributes of the patented hardware it supplies to customers are the firmware and software embedded within the product, and an unparalleled service when it comes to integration support, supply chain management, logistics and after-sales support. Typically, B2B customers integrate Nexteq’s solutions into their own intellectual property, thereby freeing up resources so that they can focus their product development effort on the most critical drivers of their business. Nexteq generates revenue each time a customer purchases one of its products for integration into their solutions.

Long-term supply relationships with major global industrial electronic equipment manufacturers typically last for an initial term of three to five years, and Nexteq enjoys a high level of repeat business. Moreover, typical delivery times are three to four months, thus providing near-term visibility through the order book.

Quixant offers exposure to gaming sector

The group’s origins are in its highly respected Quixant brand of specialised computer platforms, which are designed to power machines in the global casino gaming and slot machine market. Some of the world’s largest gaming companies (Everi and Ainsworth) are customers and the segment accounts for around 60 per cent of group revenue.

The computer platforms are installed in casinos and other gaming venues around the world, combining optimised hardware and software elements to address the specialist needs of customers in a highly regulated market. By outsourcing their computer platform to Quixant, manufacturers can focus their research and development (R&D) on the game design, which has the greatest impact on their commercial success. They are also able to bring new products to market more quickly.

Admittedly, the exceptional impact of Covid-19 on the gaming sector led many venues to close or limit capacity, which has made investors more cautious. This had a knock-on effect on Quixant, which saw its pre-tax profits tumble from $10.7mn to $1.3mn in 2020. However, US and European end-market gross gaming revenue has recovered strongly since the end of the pandemic lockdowns. Around 60 per cent of Quixant’s revenue is derived from the US, a resilient income stream that has held up well in (non-Covid) economic downturns.

Furthermore, Quixant's business is far more diversified than it was a decade ago when one gaming customer accounted for 90 per cent of group revenue. In the first half of 2023, the top 10 customers accounted for half of revenue. Customer concentration risk is set to fall even further in the coming years as a key objective of the board is to diversify sales across more customers, product offerings and vertical markets. To achieve this, Nexteq acquired Densitron in 2015.

Densitron targets new markets

Founded over 50 years ago in Japan, Densitron has expanded its capability from display and touch-screen technology to cover a wide range of human machine interface (HMI) hardware, computing, and control system software.

Specifically, Densitron has been targeting the broadcast market, supplying HMI hardware and controls systems that blend touch-screens with a range of tactile object and feedback technologies. The BBC, Channel 4 and the Canadian Broadcasting Corporation are all customers. The mission-critical nature of the equipment is leading to a sustained increase in adoption by broadcast customers, with the segment delivering almost 10 per cent growth in annual revenue to $8mn in 2023, and at a record gross margin.

Analysts at house broker Cavendish expect another similarly strong hike in broadcast revenue this year, which should offset softer demand for its industrial display components (around 20 per cent of group revenue) in what are more challenging macroeconomic conditions.

Bumper pre-close trading update

The resilient mix of revenue streams makes Nexteq a far more defensive play than many investors may realise.

It’s also a more profitable business, too, as the focus of targeting higher-margin products, effective supply chain management (pressures are now easing), and strong price discipline boosted the gross margin from 32.2 per cent to 35.7 per cent in 2023, well ahead of the 34 per cent forecast of house broker Cavendish. So, although group revenue of $114.8mn was 4 per cent shy of the 2022 record result, the increased level of profitability is expected to deliver 37 per cent higher adjusted pre-tax profit of $14mn when the group reports annual results on 13 March.

Cash generation has improved no end, too. Cavendish forecasts 2023 free cash flow (FCF) of $16.9mn, or 70 per cent above its previous forecast, and a 50 per cent rise in net cash to $27.9mn in the second half of 2023.

Moreover, even if Nexteq only delivers a flat revenue performance this year and edges up pre-tax profit to $14.3mn as Cavendish anticipates, forecast FCF of $10mn should see the cash pile swell a further 25 per cent to $35mn, or a third of Nexteq’s market capitalisation of £80.5mn. Strip out net cash and a business that is making operating profit of around $14mn is being valued on a five times earnings multiple, a bargain basement rating.

Moreover, the board is expected to maintain its progressive dividend policy by declaring 10 per cent hikes in the payout for both the 2023 and 2024 financial years. This means that the shares offer a 3 per cent dividend yield, with the payout covered more than three times by a forecast FCF yield of 10 per cent. Buy.