Questor

Zytronic is protected against competition and the shares aren’t expensive, but needs a long-term view, says Russ Mould

THIS column is always searching for firms with a competitive edge that gives them pricing power, which in turn leads to high margins, lofty return on capital, strong free cash flow generation and, ultimately, healthy dividend for shareholders.

Nestled on an industrial estate in Blaydon, near Newcastle, Zytronic looks like it may be just such a company.

A leading position in rugged, mainly touch-interactive displays and screens means that Zytronic has come a long way since its Forties origins, when it made eyepieces for gas masks. But the firm’s expertise in handling and processing glass, plastics and laminates represents both a key competitive edge and a huge barrier to entry to would-be rivals.

At its single three-factory site, Zytronic shapes

the materials, drills holes in them and then prints on them before making the screen a touch sensor through the deployment of a combination of clever software and electronics.

Its clients come from the financial services, vending machine, retail, leisure, gaming and medical industries, although it also supplies public digital signs and displays. The screens have to be tough to withstand the battering they can get from their human users, and also the weather and elements to which they are exposed.

More than 90pc of sales go overseas so this is a British export success story if ever there was one. Any continuation of sterling’s recent weakness could help sales and earnings, especially as previous contracts designed to hedge and mitigate currency movements start to unwind. The company is looking to expand its local sales efforts in both America and Asia. For many of its customers, bigger is better. There is a clear trend towards displays 30-inches across or larger as buyers look to better engage with their own customers or boost productivity in their own businesses.

This is good news for Zytronic because it means that more specialised components are used in each unit, and that boosts profit margins. A trend towards more complex, multi-touch, multi-user sensors and displays brings similar benefits.

The firm sold 18,000 display units of 30 inches or bigger in its financial year to Sept 2017, from a total of 138,000. Those figures represented increases

from 14,000 and 130,000 respectively in the 2016 fiscal year.

Unusually, those strong figures did not help the gross margin, which slipped a little from 42.8pc to 41.1pc, although the resulting operating margin of 23.7pc and return on capital employed of 20.3pc are numbers of which many firms can only dream, not least as they led to strong cash generation and further bolstered a balance sheet that boasts net cash.

Such is management’s confidence in the business that it sanctioned a 100pc increase in the interim dividend in May and further rises, to add to a proud streak of dividend increases that dates back to 2005, look likely. The shares yield just under 5pc, while a track record that has seen sales all but double and profits nearly treble since 2007 offers the prospect of capital growth too.

This all suggests that a forward price-to-earnings multiple of a little more than 15 represents some value – but there are still clear risks of which potential investors must be aware.

Zytronic must continuously adapt to shifts in technology and invest in development to meet its customers’ needs but must do so with limited revenue visibility. The order book extends for only a few months and there are no service or maintenance revenues to speak of, since reliability has to be a key initial selling point.

The lumpy nature of contracts and limited visibility mean that profits can move sharply up or down in the near term, even if the long-term trend looks good. A slackening in demand for screens for cash machines is a current challenge, and since flotation in 2000 annual profits have fallen year-on-year on four occasions (2002, 2007, 2010 and 2013). The shares can be volatile as a result so patience will be required.

But this high-quality business looks attractively valued and the yield may also appeal to patient investors.

Questor says: buy Ticker: ZYT

Share price at close: 467.5p