After a strong January for stocks it has become more difficult to find a good value. I am always on the lookout for strong dividend-paying companies that I think can grow a dividend. However, it seems many of those steady dividend-paying stocks have had their prices bid up significantly.
One company that is still trading at attractive valuations is Espey manufacturing (ESP). The company has been trading at 25-26 per share, which is pretty far off the 52-week high of 31.00 per share. This is likely caused by both the dependence on the defense industry (75% of their business) and recent statements by the company indicating a very competitive pricing environment, which could cause some pressure on margins.
Espey pays a good dividend (almost yielding 4%) and while they haven't increased the regular dividend at a fast pace in the past few years, they have increased it some and continually paid a large special dividend. Additionally, the company currently has a strong backlog position, a large amount of cash, no debt, and a large pipeline of potential new orders.
As noted in the 10-K Espey Mfg. & Electronics Corp. is a power electronics design and original equipment manufacturing (OEM) company with a long history of developing and delivering highly reliable products for use in military and severe environment applications. Espey began operations after incorporation in New York in 1928 and the primary products are power supplies, power converters, filters, power transformers, magnetic components, power distribution equipment, ups systems, antennas and high power radar systems. The applications of these products include AC and DC locomotives, shipboard power, shipboard radar, airborne power, ground-based radar, and ground mobile power.
Espey services include design and development to specification, build to print, design services, design studies, environmental testing services, metal fabrication, painting services, and development of automatic testing equipment. Espey manufacturing is vertically integrated, meaning that the company produces individual components (including inductors), populates printed circuit boards, fabricates metalwork, paints, wires, qualifies, and fully tests items, mechanically, electrically and environmentally, in house.
There is competition in all classes of products manufactured by the company from divisions of the largest electronic companies, as well as many small companies. The company's sales do not represent a significant share of the industry's market for any class of its products. The principal methods of competition for electronic products of both a military and industrial nature include, among other factors, price, product performance, the experience of the particular company and history of its dealings in such products.
What's holding it back
One factor that could be holding the company back is something other large defense companies are dealing with right now and that is that there isn't a lot of visibility into what the ultimate path of government spending on defense will take. It is very likely to be reduced, but by how much and in which programs remains to be seen. There are other large defense companies, such as Lockheed Martin (LMT) and General Dynamics (GD), that are trading in similar price positions relative to their 52-week high.
While the risk of large defense-spending cuts is real, the company believes it can mitigate that risk by the following points summarized and paraphrased from the 10-K:
- The cuts that would potentially take place aren't necessarily going to impact some of the legacy programs and upgrades to legacy programs that Espey is involved in.
- Upgrades of the legacy systems could actually be the more efficient decision to make, which could result in increased spending for Espey products.
- The US should still be in a military leadership role which could mean the cuts won't be significant.
- Espey has and continues to maintain around 20-25% of its sales that are non-defense related.
Whether or not these factors play out remains to be seen, however the company did end the last fiscal year with $50.8M of backlog and after the most recent quarter (Q1) the company ended with $50.1M USD of backlog, most of which is funded. This gives the company significant visibility and makes it very likely that revenues will grow for 2013 vs. 2012, perhaps significantly.
The second factor holding the company back is likely a result of recent statements in the 10-K about the pricing pressures the company is seeing and the potential impact to margins if the company is forced to get more aggressive. Specifically, the main issue seems to be around the market place pricing of upfront engineering costs that Espey is used to being able to price into the bids. It seems the market is moving where the competitors are taking the hit on some of those costs in order to win business ad Espey may need to follow suit. Despite these concerns the company's Q1 2013 gross margins were as high as any quarter in the recent years at 31%.
For a few reasons I believe Espey is riskier than an "average" stock…that is to say, riskier than the market as a whole, even if the trading/beta may not indicate it (although Beta is a very poor measure for risk in general). For one, Espey is an extremely thinly traded stock and has an absolutely tiny market cap. The company has a market cap of around 55M USD and will usually see trading volume of just 3-5K shares a day. Thus, liquidity is a very big concern and something investors should be knowledgeable of.
Espey also has a very high concentration of sales in just a few customers. As an example, in Q1 2013 the net sales by three customers accounted for 66% of the overall sales. Looking over other historical time periods it is clear there is a consistent trend of a few customers making up a high percentage of the sales. It should be noted that while a few customers will typically make up a high percent of sales, it isn't always the same customers.
I believe based on the backlog and the order pipeline that Espey can grow pretty strongly in the next couple of years. However, given the potential impact of government cuts I have assumed that over the next 5 years they won't grow revenue by more than about 6% yearly (on average). I have also assumed the pricing pressures the company notes will drive margins down to around 24% by year 4 and that level would be a sizable reduction as compared to margin levels of the last 5 years (except 2009). I think the company can continue to maintain a strong focus on the OPEX as they have always done, not allowing it to grow more than the revenue (I modeled a bit less than the revenue growth rate). With strong profitability I believe the company can produce free cash flow in the range of high $6M to high $7M USD per year.
For the term value assumptions in year 5 I have used a few different approaches, but generally I use the ranges of P/B (price -to-book), P/S (price-to-sales), and P/E (price-to-earnings) that the company has traded at over time and steer towards the lower end of those multiples, unless I am counting on multiple expansion. Additionally, the company has a significant amount of cash on the books, ending the last quarter with about $14.2M USD of cash and investments as compared to a $56M USD market cap (about 25%).
I have modeled a few different scenarios based on increasing/decreasing the growth rate, margin assumptions, OPEX, share count growth, multiples, etc and generally I come up with conservative valuations that are 15-20% higher than today's share price. There are some possible paths that could drive the path higher, but those aren't necessarily built into the valuation. For example, if the negotiations in DC result in something favorable to the defense industry as a whole, then Espey probably benefits. Alternatively, if Espey were to make an acquisition that diversifies the customer base away from the heavy reliance on the government, it could lead the market to assign a higher multiple.
Absent those events Espey still offers a good value and represents a company that continually returns cash to the shareholders (they have historical paid special dividends on a regular basis) and is run in a very efficient manner. I would be comfortable adding between $25-26 per share under the current circumstances as a started position and likely adding if it dropped significantly under $25 per share.
Disclosure: I am long ESP.
Additional disclosure: This article should not be taken as investment advice, and is for informational purposes only.