- Customers still clearing stock
- Divergent company fortunes
The UK’s manufacturing sector contains a subset of companies that most people have never heard of. These businesses make highly specialised electrical devices and – further down the food chain – individual electronic components. Think micro-circuits, switches, cables, sensors and resistors.
Demand for these types of products surged in the immediate aftermath of the pandemic, when supply chains snarled up and customers increased their stock levels to guard against more disruption. Orders waned last year, however, as the same customers worked through excess inventories against a gloomy economic backdrop.
The question for investors is whether the worst is over for these niche manufacturers, or whether there are more nasty surprises to come.
Shortly before Christmas, electronics components group discoverIE (DSCV) said client destocking was “largely complete” and that its order book was “almost back to historic norms”. In February, however, it reported that organic sales had fallen by 7 per cent in the four months to 31 January and that orders had only edged up by 3 per cent in the same period. Its shares are down a further 12 per cent in the weeks since.
TT Electronics (TTG) is under similar pressure. A high order backlog boosted organic sales by 12 per cent in the first half of 2023, but things kicked into reverse in the second half and underlying sales across the entire year were flat on the year before. While management is focused on internal measures to improve profitability, sales are expected to fall again in 2024.
Other companies are having an even rougher time. Gooch & Housego (GHH), which makes photonic optics components, has downgraded its forecasts for 2024 because “inventory adjustment" is proving to be "deeper and more prolonged than previously anticipated”.
Meanwhile, shares in power control systems provider XP Power (XPP) crashed this month when it suspended its dividend on the back of the “semiconductor downcycle” and weak demand from medical and industrial customers.
The picture emerging from recent results and trading updates is clear: the market environment remains sluggish and most companies are still waiting for orders to rebound with any vigour. Amid the corporate malaise, however, there are still opportunities.
A tale of two power companies
XP Power ranks as the worst-performing electronics and electrical equipment stock of the past 12 months, with its shares down by almost 50 per cent year on year. Volex (VLX) sits at the other end of the spectrum, having grown its share price by nearly 40 per cent in the same period.
Crucially, however, the two companies operate in very similar markets. XP Power makes hardware that converts power from the electricity grid into the right form for equipment to function, while Volex makes cables, plugs and power cords.
In some ways, XP Power’s struggles cast a cloud over Volex, which is expected to publish a full-year trading update next month. It is possible that Volex will also experience demand weakness. In fact, it already has: organic electric vehicle sales – previously a key driver of growth – decreased by 16 per cent in the six months to October as a result of “short-term customer destocking”, and its consumer electrical division is also under pressure.
However, analysts at HSBC argue that Volex is better protected than its smaller peer. While both companies supply the medical sector, Volex mainly works as a contract manufacturer, meaning production tends to be backed by firm corresponding orders. Similarly, while XP Power has been pummelled by an “industry-wide cyclical slowdown in semiconductor manufacturing equipment”, Volex sells cables to data centres, where production has been accelerating.
Just as important, however, is Volex’s internal transformation. The group’s adjusted operating margin has been climbing since 2014, it has reduced the concentration of its client base, and diversified its footprint. By contrast, XP Power’s margins have been shrinking and its debt has been rising. According to Peel Hunt, net debt/Ebitda is expected to increase to 2.75 times by mid-2024, “uncomfortably close to covenants”.
The broker added that it was “difficult” to predict when sales would stabilise, and customer relationships may come under strain in the meantime. XP Power’s order book shrank by 38 per cent in 2023 to £192mn.
Volex is not guaranteed to escape the current market unharmed, particularly given the struggles of its peer group. However, the divergence with XP Power is a reminder that, even within this small subset of companies, there is still scope for very different outcomes.
