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Is Gooch & Housego a falling knife worth catching, down 20% today?

The market’s reaction to today’s AGM trading statement from Gooch & Housego (LSE: GHH) has been volatile. Indeed, the photonic components and systems manufacturer’s share price was down more than 20% in early trading today.

But to put that move in perspective, the stock has been a big success, and even today’s price around 1,200p is more than 160% higher than it was six years ago. That long move was driven by annual rises in revenue and earnings.

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Today’s statement starts with the headline: “Continued growth despite microelectronic headwinds.” In the first four months of the firm’s trading year, it saw a downturn in demand for critical components used in industrial lasers for microelectronic manufacturing, “particularly from China.” The news chimes with other recent reports about slowing economic activity in China, so perhaps we shouldn’t be surprised.

In the last full trading year to September 2018, around 23% of revenue came from the Asia Pacific region and countries other than the UK, US and those in Europe. So revenue from China falls in that classification, which puts the slowdown in context a bit. But, of course, the decline could gather pace to affect trading in other regions more over time.

To balance the negative news, the company said in the report that demand for fibre optic products and high-reliability fibre couplers used in undersea cable networks has strengthened “still further.”  The company reckons that high-reliability fibre couplers “are about to experience a multi-year growth phase.” That’s why the company is investing in further capacity to take advantage of its “market leading” position in the industry. The directors think the benefits of the first phase of such growth will arrive in the second half of the firm’s trading year to September 2019. So we are getting negatives and positives in the same statement.

Cyclicality biting

To add a bit of colour, GHH owned up to having “long been aware” of the risks regarding the inherent cyclicality of the microelectronics sector. It also pointed a finger at the impact of US/ China tariffs. Although demand in the area of microelectronics was up against strong comparatives from trading last year, uncertainty in the Chinese market means stocks will take longer to shift than the directors thought.

The bottom line is the firm expects percentage growth in low single digits overall for the full year to September 2019. So that’s not a disaster and growth is still growth. Indeed, the order book is almost 2% higher than a year ago at £91.4m. However, I think the news today reveals the company’s Achilles heel, which is its vulnerability to economic cycles in the sectors in which it operates.

Meanwhile, the forward-looking price-to-earnings ratio stands close to 19 for the trading year to September, and the anticipated dividend yield is about 1%. City analysts following the firm expect earnings to cover the payment more than five times, though, and I reckon high cover like that suggests the directors see plenty of opportunities ahead to invest in growth rather than pay out all the company’s spare cash with the dividend. If I had been holding the shares for a long time, I’d continue to hold, but to enter a position now, I’d demand more of a discount in the valuation. But Gooch & Housego is firmly on my watch list.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has recommended Gooch & Housego. 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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