Yesterday, hardware encryption company Senetas Corporation Limited (ASX: SEN) released a strong set of results for 2016. However, the market reacted poorly to the news with shares finishing the day at 11.5 cents, down 11.5%. Here are some of the key highlights of the result:

  • Revenue up 19.3% to $19.3 million
  • Net profit after tax (NPAT) up 29.9% to $5.2 million
  • Closing cash $20.9 million and no debt
  • Operating cash flows $5.2 million

Why the sell-off?

The following paragraph contained in the commentary section of the report may explain yesterday’s sell-off:

“… some of the delayed US Federal Government sales will now not proceed as some agencies move from a SONET to Ethernet network over the next 3-4 years. Growth in Senetas’ maintenance revenue from FY2017 may moderate as the higher cost SONET maintenance contracts roll off throughout that period. However, the Company expects that its lower cost Ethernet encryptors will replace the existing SONET encryptors in those updated networks.”

The US Federal government would represent a major customer for Senetas and the company seems confident of winning the business back following the transition to Ethernet. However, the above comments suggest that even if Senetas does retain the business, the replacement products would be lower value than those currently installed.

In 2014 Gemalto, a European company, acquired Safenet, a US firm and previous distributor of Senetas’ products. Since then Senetas has seen a marked improvement in sales, particularly to corporations, thanks to Gemalto’s broader distribution network. However, sales to government customers have dropped off and Senetas is looking to work closely with Gemalto to reverse this trend. To this end it was reassuring to hear that Gemalto has now completed the,

“Split of US Federal Government business into (a) separate entity.”

Commitment to R&D

Unlike some technology companies, Senetas expenses rather than capitalises all of its R&D cost. Despite spending an extra $1.4 million on R&D this year, the company achieved a strong improvement in NPAT on a relatively modest rise in revenue. This was possible because of the company’s impressive gross profit margins which were 83% in 2016.

The profit result was assisted by $2.1 million in R&D rebates from the government and once revenue exceeds $20 million the company will no longer be eligible to receive these. Senetas recorded $19.3 million in revenue in 2016 and so it is quite possible that the company will surpass $20 million in 2017. Once revenues exceed $20 million then the tax rebate, which is equal to 45% of R&D spend, becomes a tax offset worth 40% of R&D spend lowering the company’s effective tax rate to just over 20%.

Outlook

Senetas is “extremely positive” regarding the outlook for the data security sector in general, but said that its revenue growth is hard to predict. This is due to long sales lead times and customers’ reluctance to disclose purchase details. Given industry tailwinds and with new world class products planned for release in 2017, Senetas looks to have a bright future.

After a double-digit rally for the ASX since 2016 lows share prices look a little frothy to me right now. Make sure you're only holding high quality businesses in case the market turns south and check that none of these three rotten shares are lurking in your portfolio.

Plus here's one top pick worth buying, even if the market sours and the RBA keeps rates at an "emergency low." Simply click here to uncover these stocks

HOT OFF THE PRESSES: Motley Fool’s #1 Dividend Pick for 2017!

With its shares up 155% in just the last five years, this ‘under the radar’ consumer favourite is both a hot growth stock AND our expert’s #1 dividend pick for 2017. Now we’re pulling back the curtain for you... And all you have to do to discover the name, code and a full analysis is enter your email below!

Simply enter your email now to receive your copy of our brand-new FREE report, “The Motley Fool’s Top Dividend Stock for 2017.”

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our https://www.fool.com.au/financial-services-guide">Financial Services Guide (FSG) for more information.

Motley Fool contributor Matt Brazier owns shares of Senetas. Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.