Gooch & Housego – returning to growth

STRONG BUY

05/07/2010 James Crux

Having suffered a sharp decline in demand in late 2008, to which the AIM-listed concern responded with a timely restructuring and other cost-saving initiatives, optical components and systems maker Gooch & Housego (G&H) is now experiencing exceptionally buoyant demand for its products across a variety of sectors that are leading the recovery.

Set up back in 1948 by Archie Gooch and Leslie Housego, G&H is a specialist manufacturer of precision optical, crystal and optoelectronic components, which it supplies to the world’s leading optical and laser system manufacturers. The company boasts very strong positions in niche markets, which means that it can achieve operating margins in the high teens to low 20s.

G&H is best known in City circles for dominating the market for the Q-Switch, an acousto-optic device that transforms solid-state lasers into industrial and medical tools, by changing their output from a continuous low-power beam into a stream of pulses that are 1,000 times more powerful. At the same time, G&H is a world leader for large crystal optics used in fusion research and a key player in the market for high-end precision optics and acousto-optics.

Firmly back on a growth path after a highly challenging 2009, G&H recently beamed in eye-catching half-year results, with sales coming in ahead of analysts’ expectations. CEO Gareth Jones attributed the strength of the numbers to ‘progressive recovery in our historical business, which has come back with a vengeance. And in parallel, we built up our customer base in the aerospace and defence field, and those efforts began to come together’.

Encouragingly, G&H kick-started the second half with a strong, high-quality order book, and demand for certain of its products is said to be at historic peaks and ‘still rising’. Despite growth going gangbusters and a number of recent earnings upgrades, the shares still only sell on a single-figure p/e, based on estimates for next year.

Strategy

In recent years, under the guidance of the unassuming Jones, G&H has evolved from a portfolio of stand-alone businesses into a structured group with a unified sales and marketing operation. At the same time, it has undertaken a number of initiatives to diversify its business and drive longer-term growth, reducing its reliance on its core industrial laser market while beefing up its presence in attractive growth sectors such as aerospace and defence and life sciences.

Much strategic emphasis has been placed on market and product diversification, both through internal investment (in R&D and new world-leading facilities at Ilminster in Somerset) as well as via recent acquisitions such as ChromoDynamics, bought for $1.2 million in 2006, SIFAM, acquired in 2007 for £5 million, and more recently, that of California-based General Optics.

Acquired in 2008 for $21 million in cash, General Optics, a profitable, global leader in ‘super-polished optics’, dramatically increased the group’s exposure to the US aerospace and defence market. According to Jones, ‘aerospace and defence is a truly vast market and we are hardly scratching the surface’. What’s more, ‘the trend in aerospace and defence is to move towards our product offering, so we are in the right place at the right time’.

Ongoing investment, both in its new world-leading optics facility and on research and development, is also allowing G&H to move ‘up the value chain’, by supplying customers with ever-more complex modules and systems, rather than just components.

Moving into the second half of the year, G&H is still seeing rising demand, so Jones and his management team have been investing in beefing up management/staff capacity, in order to deal with what Jones describes as the ‘relentless’ growth that G&H is experiencing. In order to avoid any capacity constraints, strategic partnerships and the establishment of supply chain relationships are being sought.

And while acquisitions remain an important pillar of the strategy and deals remain, no doubt, on the radar, Gooch has no need to pursue takeovers to deliver value. As astute finance director Andy Boteler opines, ‘We have all the tools in the toolbox to do the job.’

Management

Physicist Gareth Jones has been in the hot seat at G&H since the beginning of 2003. Prior to assuming the CEO mantle, Jones had spent a two-year stint as a partner in a leading UK venture capital firm, where he garnered much sector knowledge in the provision of both risk capital and management resources to early-stage technology businesses. Jones had, in fact, first joined Gooch back in 1978 and was a part of the team that actually developed the group’s acousto-optic technology, which led to the transformation of Gooch from a UK-centric, craft-based optics venture into an international group of high-technology firms.

The man who oversees the growth metrics at G&H is no-nonsense Andy Boteler, appointed as finance director last August, having had a chance to familiarise himself with the business during earlier spells in the non-board position of acting chief financial officer (from April 2009 to August) and before that (2007 until 2009) as the company’s head of finance for the EMEA region. Boteler, who earned his accountancy spurs with Ernst & Young, joined the group in 2007 by way of Gooch’s acquisition of SIFAM, where he was the finance director.

Operations director Terry Scribbins is briefed with ensuring things run to plan down at Ilminster. Originally joining the business back in the early 1970s, before leaving to start his own company in 1985, he was welcomed back into the Gooch fold in 2004 to lead a new management team and has been highly instrumental in the transformation of the business since.

G&H is able to call upon the expertise of Julian Blogh, a chairman with a strong background in the defence electronics industry who joined the board (as non-executive chairman) in 2006. Seasoned City followers may recall that Blogh led the management buy-out of certain defence and aerospace electronics businesses from the TI Group back in 1993 to form Ultra Electronics.

Prospects

2009 was a very tough year for G&H, which began the current financial year facing many uncertainties. However, what is clear is that the business is now experiencing a dramatic and sustainable recovery across most of its product and market sectors, as demonstrated by the recent strong interim results to March. These showed operating profits increased 62 per cent to £2.6 million, on turnover up 8 per cent to £20.4 million (2009: £18.8 million). Pre-tax profits powered ahead from £39,000 to £1.7 million, as G&H reaped the benefits of earlier cost-saving initiatives.

Recovery, led initially by Far Eastern markets and followed by the US and European markets, is driving a rapid upswing in demand for the Q-Switch and other acousto-optic products, as activity levels in the semiconductor and microelectronics sectors pick up strongly. In fact, Q-Switch demand returned rapidly in the second quarter, by the end of which it had returned to historic peak levels seen in 2007. At the same time, G&H is reporting strong growth in precision optics sales, driven by the strategic ties it has now fostered with aerospace and defence customers.

While interim sales were increased across all market segments, the aerospace and defence and life sciences sectors contributed the most significant growth, with a 21 per cent rise year-on-year, which augurs well for the future. And in a further encouraging trend, non-industrial markets contributed 46 per cent of sales, up from 43 per cent a year earlier and a modest 23 per cent in 2008, reflecting the successful diversification of the business.

Boteler is keen to explain that ‘we have made great strides in reducing our net debt, and the quality of our order book has improved’. Strongly cash generative in the period, G&H managed to pare net debt from a year-end £12.1 million to £9.3 million by the end of March, even after the strengthening of the US dollar versus the pound, a currency movement that increased its net debt in sterling terms.

Meanwhile, the period-end order book had grown to £19.8 million, 27 per cent higher than the September 2009 figure. Since £14 million of these orders are scheduled for shipment in the current year, investors can look to analysts’ forecasts with a good deal of comfort.

Valuation

For the year to September 2010, house broker Investec envisages G&H returning to profitable growth to the tune of

£4.7 million, as turnover mounts from £36.4 million to more than £41 million. By September 2011, the broker thinks sales should reach £44 million, from which Gooch looks eminently well placed to deliver pre-tax profits of £6 million.

G&H, which managed to grow earnings per share 108 per cent to 7.9p in the first half of the year, is forecast to swell EPS from 11.5p to 16.5p this year, ahead of further enticing growth to 20.5p by 2011. Based on those estimates, the 211.5p shares, which value G&H at only one times forecast annual sales and have traded between a 52-week peak and trough of 218p and 81.5p, are trading on a forward p/e of 12.8. This rating drops to a miserly 10.3 times for the following year.

Not only does this represent a discount to the wider electronic and electrical equipment sector, it also looks ungenerous given the strength of the group’s intellectual property and the growth potential arising from its leadership in attractive, niche growth markets. One bear point is that the shares do not currently pay a dividend – cash will be reinvested in order to pursue exciting growth opportunities on offer. With G&H saying it intends to return to the dividend list ‘as soon as it is sensible’ and with racy earnings growth to come, the shares are a strong buy.

Tags: AIM, Growth Stocks, Mergers & acquisitions, Restructuring

Sector: Electronic & Electrical Equipment

Companies: Gooch & Housego

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