Imagination Technologies IMS – Great company but the wrong price

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I have always believed that Imagination Technologies (LSE:IMG) is a good company. And you have to pay for quality. But you can overpay for quality and right now that is what investors in this stock are being asked to do. The company issued a detailed trading statement on 12 March which should not have provided ammunition for the bulls but the shares are now trading higher than a few weeks ago at 552p.

Shorting a FTSE 250 stock right now is a risky business. Money is flowing into the second liners (from bonds) and this pushes valuations to ever more “generous” levels. And so I fully admit to calling this wrong (short term) as a sell on February 5th at 523p.

You can read my detailed analysis HERE

I now refer you to the Interim Management Statement of March 12th which states:

The continuing macro-economic volatility creates caution among our customers. Despite this, the licensing pipeline remains very active, although there are uncertainties over the timing of deal closures, particularly as some semiconductor companies in certain regions are undergoing structural and business changes.

 We expect further product launches from our customers, including a number of our significant design wins reaching production, which will continue to drive strong growth in unit volumes and revenue and we are now confident that the unit shipments for the current financial year will exceed 500m units.

MIPS is expected to contribute approximately $11m of revenue in the current financial year which would result in a loss of approximately $1m. For FY14 MIPS is expected to generate revenues of approximately $50-55m and with the reduced cost base would be accretive to Imagination’s earnings.

Despite the short-term difficult market conditions, we expect to see a financial improvement in the Pure division over the medium term, driven by new product opportunities and international markets.”

That says it all. This is a good company that is making progress but the macro headwinds are very unhelpful. As such the risk to earnings forecasts MUST be on the downside.

The consensus is for earnings to come in at 12p this year to April 30th (up from 10.2p) and to increase to 16.3p in 2014 and 19.7p the year after. On that basis the shares now trade on a current year PE of 46, falling to 34 in 2014 and 28 the year after. Supporters would argue that the rapid rate of earnings growth justifies such a rating. Maybe. For those stocks that have consistently delivered superior earnings growth over many years and where the business model clearly supports many more years of such earnings growth that sort of case can be made. I would cite Domino’s Pizza (as explained here) or plausibly ASOS ( as explained here) as cases in point.

You might even have a look, in the same vein, at Britvic – see HERE

However technology is rather different. The fact that Imagination spent £37 million on R&D in the first half of this year alone is a clear demonstration of how rapidly technology can change and that must pose a question mark over valuation models derived on a long term DCF basis – the benchmark for most sell side analysts.

I accept that we are almost into the 2014 financial year but is a current year PE of 34 really good value when the risks to earnings forecasts just have to be on the downside? I think not.

There are other reasons for caution as I explained in my earlier piece here

Given the momentum most FTSE 250 stocks have I would not short Imagination but if I was sitting on a profit I would certainly be taking some of that off the table now.

Tom Winnifrith writes for 10 US and UK websites. You can get links to all of his work at www.TomWinnifrith.com and you can follow him on twitter @tomwinnifrith

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