Is it time to avoid this FTSE 250 company despite its strong progress?

A dividend yield, rising earnings and a positive outlook, but I’m wary of this one.

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Today’s trading statement from electrical and electronic components distributor Electrocomponents (LSE: ECM) reveals that the company’s ongoing performance improvement plan appears to be bearing fruit.

Compared to the equivalent period the year before, The FTSE 250 firm achieved a 6% increase in like-for-like revenue in the four months to 31 January. Chief executive Lindsley Ruth is optimistic and confident the company can gain a further share of the market “irrespective of market backdrop.”

Operational improvements

We could view Electrocomponents as a turnaround and growth proposition because it is working on developing a “leaner and more scalable” operating model with the aim of achieving higher profit margins. But I’m wary of the shares right now because distributors of all kinds follow the fortunes of the industries they serve. As such, quite a lot of the trading outcome depends on how well their customers are trading, which is outside the distributors’ control.

Yet Electrocomponents is a big player in the market with operations across the world and trading brands that you might have heard of such as RS Components, Allied Electronics and Automation and IESA. The company reckons it supplies more than 500,000 industrial and electronic products, but one of the main challenges, as I see it, is the cyclicality of the business. If we get a world economic slump, I’m sure that demand will likely fall off a cliff, taking Electrocomponents revenues and profits with it.

You can see the volatility in the share-price chart. Profits dived during 2015 but then staged a recovery that propelled the shares more than 300% higher over the next three years, peaking at close to 747p in September 2018. The share price has fallen back since and now trades around 567p, but I think the firm could be overvalued. The forward-looking price-to-earnings multiple sits just above 14 for the trading year to March 2020 and the projected dividend yield is about 2.8%.

Opportunity and threat

It has to be said that City analysts are predicting further increases in earnings this year and next, but I think the valuation assumes that such increases will continue. But they probably won’t. Looked what happened in 2015 when earnings plunged. I think weaker periods like that are part of normal business for cyclical outfits such as Electrocomponents, which brings both opportunity and threat for potential investors. If you caught the rise in the shares from 2015 you’d have done well, but I reckon there’s a lot of risk to the downside now, despite the ongoing improvements in earnings.

One way of attempting to gauge the strength of the business and its outlook is to look at the dividend record. Back in November, the directors pushed up the interim dividend by just under 1%, which looks like a cautious move to me. Meanwhile, over the past five years, the dividend has increased by about 25%, which is welcome, but unspectacular.

I’m not tempted to make a long-term investment in Electrocomponents and I think the time for catching the cyclical up-leg has passed, so I’m looking elsewhere for enduring investments.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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