Questor share tip: Imagination Tech shares jump on better outlook

Imagination Technologies
221p+31p
Questor says HOLD

Imagination Technologies [LON:IMG] provided an upbeat profit outlook for the “first time ever”, sending shares 16pc higher yesterday, even as a slump in sales of digital radios and rising costs led to a loss during the first half of the year.

“Now that our product lines are complete and the heavy investment phase is over, we expect to see lower rates of operating cost growth going forward and increased focus on financial returns,” said Hossein Yassaie, chief executive.

Broker Investec said the guidance on future operating profit margins of between 30pc to 40pc, more than double the current forecast for about 15pc, provides a return story “for what feels like the first time ever”.

The Hertfordshire-based technology group’s main business is designing microchips so graphics and video can be used on smartphones and tablets. The company’s fortunes are inextricably linked to its biggest customer, Apple. Imagination relies on the iPhone and iPad for more than a third of its revenue.

Imagination generates revenue in two ways: one is through granting a licence for the customer to use the technology; the second is through royalty payments for every unit produced.

The company reported royalty revenues of £56.3m, largely flat on £56.2m in the same period last year. Licensing revenues, however, increased by 11pc to £16m, an encouraging sign given that they are seen as a leading indicator for future royalty revenues.

The overall performance in the first half was relatively poor, with a £10.7m loss before tax, down from a £2.2m profit in the same period last year. Total group revenue in the first half was down 4pc to £82.2m for the six months to the end of October. The damage was partly done by its legacy digital radio business Pure, where it made a loss as revenue tumbled 35pc to £9.4m.

The FTSE 250 company previously enjoyed record growth as Apple blossomed, and reached a valuation of about £1.9bn in March 2012. But that has now more than halved to £573m. This summer, the shares took a hit as the group issued a profit warning, with licensing revenue hit by delayed orders and customers such as Texas Instruments moving out of the highly competitive mobile phones market. Now, that licensing revenue is showing signs of turning a corner.

Yet there are still other concerns around the company. It made a risky move into microchip design, buying the US group MIPS last November for $100m (£63m). Although over the long term this deal may pay off, it will take time and investment.

Meanwhile, net debt levels increased during the first half to £26.8m at the end of October, up from £5.1m at the same stage last year. But Imagination is expecting a much stronger cash performance in the second half of the year as royalty receipts are paid in cash.

So should investors try to catch the falling knife at Imagination Technologies? The shares are still not cheap, trading on 31 times forecast earnings, falling to 24 times next year. The company has to deliver a profit recovery against the backdrop of a very difficult market.

There is undoubtedly strong demand for smartphone and tablet technology which uses Imagination Technologies microchip designs but competition is getting fierce. Given the recent market selloff the prudent approach is to wait for the next set of results for strong cash generation and rising licensing revenue before upgrading shares from a hold.