For the uninitiated Micropac is a electronics manufacturing company located in Garland Texas. They develop electronics for the defense, aeronautics and space industries. You'll immediately notice their biggest customers are all government related. The company's products are split with 35% being custom designs and 65% being commodity designs. The company hopes that many custom designs will eventually become useful in creating new commodity designs, but it's far from certain that this will ever happen.
When I first wrote about them the company they were much more attractive. Earnings and margins were much higher than they are now, although NCAV was lower then. So in the past two years the company earned $.64 p/s last year, and $.18 p/s this past year. They've grown NCAV from $5.86 to $6.17. Here is the net-net worksheet:
The company is still selling for a discount to their NCAV, although with the recent earnings drop a solid argument could be made that maybe they're not worth NCAV.
The company is closely held with directors owning 76% of the company. This number is a bit misleading, there is one shareholder, a German industrialist who owns 75% of the shares. It's unclear what his relationship is to the company, but apparently years ago he spotted something he liked in Micropac and purchased most of the company.
The company's earnings fell due to lower sales volume in their high margin space related product. Without the higher margin items the company needs to boost their sales level if they want to bring earnings back to what they'd been in years past. The concerning aspect of this is that 65% of the company's sales are to the DoD and NASA, two organizations that aren't exactly experiencing a growth phase right now.
Most of the company's clients are defense contractors, meaning that Micropac's revenue will ebb and flow with government spending. As of this post it's mostly an ebb and not much of a flow, although that could change.
Even with reduced earnings the company is still profitable, although this past year there was some cash drain. The company ate into almost $1m worth of savings investing in plant, paying dividends, and letting receivables expand.
The good news is that Micropac has a backlog of $9m in orders that they expect to fill in 2013. This means they only need another $8m in new sales throughout the year to equal 2012's performance. If they can kick their sales team into high gear they could maybe notch revenue back up to the $20m plus range where earnings per share would be over $.50 again.
The investment case when Micropac was selling below NCAV with loads of cash and selling for a P/E of 8x was much easier to make than now. This past year the company has burned down some of their cash reserves and earnings fell off a cliff. They now have a P/E of 32x and a EV/EBIT multiple of 6.9x.
I'm re-evaluating what I want to do with my Micropac position. If earnings continue at the pace they were at for 2013 I would consider selling them at NCAV or NCAV plus PP&E. If earnings recover to the pace they were at over the past few years I would hold on for a sale price close to $10. So right now I'm just continuing to be patient, but I do have one finger on the trigger pending the next few quarters results.
Disclosure: Long Micropac
My impression is that the theory behind investing in stocks selling below NCAV is; when you buy really cheap stuff, good stuff tends to happen on average. And that makes sense if you believe that the NCAV is a backstop for what can go wrong at a company. So I would question why after investing on the basis on NCAV, you would make your buy and sell decisions based on the earnings outlook. To me that would seem to defeat the purpose of being invested in a Net-net at all...
ReplyDeleteOn the other hand, I can see how you would want to evaluate each situation independently, and that one stock does not invalidate the strategy overall....
Just food for thought. Good post.
You're correct that's the theory, but I think there's more to it.
DeleteBuying below NCAV gives a floor for what the company should be worth, NCAV. In the case of a profitable company it should be worth at least NCAV if not more. So when buying below NCAV I'm saying that my low end return should be NCAV. But for a profitable company the market isn't evaluating based on NCAV, they're looking at earnings, so I should as well. Earnings plus excess cash in MPAD's case is the high end of the valuation.
MPAD is a good, albeit volatile business, earning 20% average ROIC. It suffers when high margin orders fall off in random years, such as this most recent one (3 years ago was another example, with EPS falling from $0.74 to $0.32 despite flat sales).
ReplyDeleteBut unless you think those high margin orders are going away permanently (annual report doesn't provide much info), then it's appropriate to normalize the earnings power of the business over a longer cycle.
20% average ROIC on ~$10m in invested capital = $2m in normalized NOPAT. Capitalize that at 12% = $16.67m. Add back net cash of $9.4m / 2.57m shares = $10/share intrinsic value.
Now capital allocation is another story, as it's a travesty that so much cash is just sitting on the B/S. I've been frustrated with the stock, but it is definitely worth more than invested capital / NCAV, unless of course you think those high margin orders are going away. And if you have any insight on that, please let me know ASAP :)
-Adam
Long MPAD
Adam,
DeleteGreat comment, that's how I view a terminal valuation as well, somewhere close to $10.
Here's what concerns me, the high margin products were from the space program, they stated volume dropped on them. Additionally the government is moving away from NASA funding and encouraging private sector space exploration. So I don't know if this is a new normal or just a volatile quarter thing, that's why I'm in wait and see mode.
As for capital allocation, it's concerning, especially the line in the annual report where they stated they're looking at acquisitions or large capex spends for the cash. I'm not sure if there's any ROI for dumping a few million into a new machine if prices are essentially limited by their biggest client, the government.
Been able to find anything about Mr. Hempel? Seems like a lot hinges on what whether he is smart and ethical enough to do something with that cash that is good for the shareholders.
ReplyDeleteBTW, ever looked into deswell DSWL?