Penny stocks are notorious for being volatile, but they can also carry tremendous growth potential. Solid State (LSE:SOLI) is one such example of the latter in my mind. While it no longer carries a penny stock share price, its market capitalisation is still a small £160m, which, when compared to its industry peers, indicates tremendous room for further growth.
The bull case
As a quick reminder, Solid State is an electronics designer and manufacturer. Operating through a variety of brands, its products include power systems, displays, computing chips, and radio systems, among others used throughout multiple industrial industries like manufacturing and automobiles.
However, management has also been positioning itself within the defence sector, forming relationships with multiple NATO agencies as well as leading industry titans like BAE Systems. This decision has been terrific news for shareholders in recent years.
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While the conflict in Ukraine and Gaza is undeniably tragic, it’s triggered a surge in defence spending by multiple countries, including the UK and US. As such, demand has surged. And as a supplier of defensive communication equipment, the firm has seen its top line take off.
The group’s latest interim results revealed a 48% jump in revenue from £59.4m to £88.1m. A large chunk of this growth originated from £23.4m of new NATO contracts, which may be the first of many if Solid State can keep up with customer expectations.
In the meantime, it sent the group’s net operating cash flows through the roof from £0.5m to £8.3m – a 1,560% surge! Needless to say, this provides far more financial flexibility for internal reinvestment as well as shareholder payouts. So, it’s no surprise that management has hiked dividends for its third consecutive year.
Every investment carries risk
While geopolitical conflict is proving good for business, most governments and society in general are pushing for a swift resolution. When peace finally returns to these troubled regions, defence spending isn’t likely to disappear, but growth will probably slow.
This cyclicality will undoubtedly have a noticeable impact on Solid State. And with the shares currently priced at around 20 times earnings, any slowdown at this valuation could introduce some unpleasant volatility. To be fair, Solid State isn’t a one-trick pony with revenue originating from other industries beyond defence. However, since the latter seems to be the primary source of growth, a cyclical downturn could be problematic.
Therefore, I’ll be paying close attention to the growth of its order book. Currently, the influx of new contracts in its pipeline indicates no immediate problems. But should order book expansion begin to slow, it could be an early warning sign of an upcoming cyclical downturn.
The bottom line
While cyclicality can be frustrating, Solid State’s balance sheet looks robust. The group has more than enough cash to cover its upcoming loan obligations. And suppose free cash flow continues to improve? In that case, the company should have sufficient financial resources to weather a downturn in its flagship target markets. At least, that’s what I think.
