Why I wouldn't buy this tech stock despite a positive trading update

Imagination Technologies

Mixed-signal and Radio Frequency (RF) semiconductor manufacturer CML Microsystems(LSE: CML) has released an upbeat trading update today. It shows that the company is on track to meet full-year expectations. However, its shares lack appeal. Here's why.

CML's sales for the first half of the year are around £13m. This includes a two-month contribution of product revenues from the acquisition of Sicomm of £0.4m. Pre-tax profit is expected to be around £1.9m in the first half of the year and the company's cash generation continues to be healthy. In fact, as at 30 September, CML has net cash of over £11m. This should provide it with sufficient capital to continue to grow over the medium-to-long term.

CML should also benefit from the relatively high quality and reliability of its technology. This helps to create a competitive advantage in its two highly niche markets of industrial storage and communications. It should allow CML to continue to deliver improved financial performance. And with further investment in R&D, CML has a bright future.

In fact, CML is expected to grow its bottom line by 5% in the current year. While this is a positive outlook for the company, its valuation appears to more than adequately price-in its future potential. For example, CML trades on a price-to-earnings (P/E) ratio of 20.9. In itself, this is expensive but when combined with CML's growth rate it shows that the company lacks a margin of safety.  

For example, its price-to-earnings growth (PEG) ratio is 4.2. This shows that the company is priced as a growth stock but as far as the current year goes, it lacks the double-digit growth outlook such a high valuation demands.

Of course, CML is set to perform well as a business beyond the current year. It's well-placed within its markets to deliver further increases in profitability. However, following its 18% share price rise in the last three months, it now lacks appeal compared to sector peers such as Imagination Technologies(LSE: IMG).

Growth ahead

Imagination Technologies has endured a very difficult period that culminated in a loss last year. However, it's on track to return to profitability in the current year and is expected to grow its bottom line by 34% in the next financial year. Although it trades on an even higher P/E ratio than CML, Imagination Technologies' rating of 44 equates to a PEG ratio of 1.3 when combined with its forecast growth rate.

As such, Imagination Technologies has a wider margin of safety than CML. Although its near-term prospects remain uncertain due to the challenges it has faced in recent months, its valuation appears to price this in. It may not pay a dividend over the medium term as it returns to full health, while CML yields 2% from a dividend covered 2.6 times by profit. However, Imagination Technologies' bright outlook means that dividend growth in the long run could be rapid.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK owns shares of Imagination Technologies. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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