Sypris Solutions Looks To Be Significantly Undervalued

May. 5.13 | About: Sypris Solutions, (SYPR)

Sypris Solutions (NASDAQ:SYPR) is a micro-cap company operating in the industrial manufacturing and aerospace & defense electronics industries. The company has a market cap of about $60m and has existed since 1954. Recently the stock has dropped to 52-week lows, and currently trades at about $3.20/share. The stock dropped almost 50% overnight back in November, when the company reported a loss of $5.7m and gave warnings of difficult times ahead in its Electronics business, due mostly to cuts in US government defense spending and sequestration. On top of this the company had to pay a one-time fee of more than $7m to settle an arbitration dispute over the sale of a subsidiary in 2009 which was settled in October 2012. Since then, the company reported Q4 and full year results in March, which showed continued losses (albeit smaller than Q3), and a nearly 25% drop in revenues due to weakness in the commercial vehicle market in the second half of the year. This was in addition to the already known troubles in the electronics business. The company has minimal analyst coverage, (only two according to the company website), but one of these downgraded the stock after the March report, which has likely contributed to the further fall in stock price.

Despite all of these various events that have caused the stock to drop significantly, Sypris now seems poised for a rebound. With many micro-cap companies, there is a greater potential for significant short-term mispricings, and that is exactly what I see happening now with Sypris. Despite the recent drops in revenue, the company has actually increased EPS by 16% YOY from 2012 to 2011, and gross margins by 230 bps. Furthermore, the market price is also assuming negative earnings growth going forward, which seems illogical, especially when you consider a likely rebound in sales to the commercial vehicle market, as has already been indicated by two major customers of Sypris. Putting it together, and the company seems attractively undervalued today by perhaps 50% or more.

Business Overview

First to summarize a bit about the business of Sypris and some key observations relating to recent results. The company is made up of two primary business units - the Industrial Group and the Aerospace & Defense Electronics Group. These two groups are largely independent businesses, operating in quite different industries. A summary from the 2012 annual report:

Through our Industrial Group, we are a significant supplier of forged and machined components, serving the commercial vehicle, off highway vehicle, light truck and energy markets in North America. We produce drive train components including axle shafts, gear sets, differential cases, steer axle forgings, and other components under multi-year, sole-source contracts with Meritor, Inc. (Meritor) and Dana Holding Corporation (Dana), the two primary providers of drive train assemblies for use by the leading truck manufacturers.

Our Electronics Group is organized around two primary business lines: Information Security Solutions (ISS) and Electronic Manufacturing Services (EMS). Our ISS business provides solutions in cyber security, secure communications, global electronic key management, Sypris Data Systems branded products, and product design and development to the U.S. Government, both defense and civilian agencies, international government agencies, as well as worldwide defense and aerospace prime organizations. Our EMS business is focused on circuit card and full box build manufacturing, dedicated space and high reliability manufacturing, integrated design and engineering services, systems assembly and integration, design for manufacturability, and design to specification work.

The breakdown in terms of revenues and gross margins for the full year 2012 is as follows:

Business Unit

FY2012 Revenues

FY12 Gross Margin

FY2011

Revenues

FY11 Gross Margin

Industrial Group

$286m

10.8%

$273.3m

10.0%

Aerospace & Defense

Electronics Group

$55.6m

23.0%

$62.3m

12.7%

Click to enlarge

I think it's important to note from this a few key observations. First is that the Industrial Group is more than 4x larger than the Electronics Group. Although revenues increased in this unit 5% YOY, they were down sharply in the 2H of 2012 due to weak demand in the commercial vehicle market. Important to note here is that most of the company's business in this segment is to only two customers, Meritor (NYSE:MTOR) and Dana (NYSE:DAN), which are the two main suppliers of drive train assemblies to big truck manufacturers. In fact Dana made up more than 50% of Sypris company revenue in both 2012 and 2011.

A second key observation to note here is that gross margin nearly doubled in the electronics group in the past year, despite revenue declines. In this business, the company has seen a lot of weakness due to sequestration and cuts in defense spending. This has included declines in the EMS business, where they are primarily serving big defense contractors such as Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), and Raytheon (NYSE:RTN). However, offsetting this has been significant growth in the international business, where the company has had success in gaining contracts with the arms services of Australia, New Zealand, Japan and India, and has recently been granted approval to sell certain products to NATO countries as well, which should lead to further growth in the international business in 2013. Not only has the company been successful at replacing some of its lost US government revenues with overseas contracts, these are proving to be at significantly higher margins. This shows the strength in the company's products and services and the ability of the company to adapt well in the short term.

There is also strong growth in the oil, gas, and petrochemical markets which saw a 27% growth in sales in 2012, and the CEO stated on the conference call he expects double digit growth again in 2013. The company doesn't break down what percentage of revenues this makes up in the Industrials Group, however, it was stated that it has higher margin and impacts the bottom line more substantially, which is why there was an increase in 80 bps for gross margin in Industrials even though revenues declined. In the annual report, the company states that about 35% of the increase in gross profits from 2011 was due to higher sales in specialty closures used in the pipeline market. With strong growth of these products expected again in 2013, we can expect further margin improvements here as well. It should be noted however that longer term, the pipeline market is not expected to grow that rapidly, as little as 1% CAGR by some estimates, and the demand is clearly cyclical based on fluctuating demand for large projects.

Outlook for the Commercial Vehicle Market

It appears the commercial vehicle market is set to be the inverse in 2013 as it was in 2012. In other words, the first half will be challenging but the second half of the year should be much stronger. Most importantly, this sentiment has recently been confirmed by the two biggest customers of Sypris. In the quarterly conference call from Dana last week, management stated the following:

In the commercial vehicle market, we've seen a slower start to North American end market production, yet we expect improvement during the remainder of the year. Our full year guidance is based on 260,000 to 270,000 Class 8 unit production in North America. We are starting to see signs of a slight uptick in sales and we are watching closely the releases from our customers.

This seems to be an uptick in demand from just a few months ago, compared to figures stated by TruckingInfo in January of this year where estimates were for about 210,000 - 240,000 Class 8 units. The other key customer of Sypris, Meritor, just had its quarterly conference call earlier this week, and management also reported that demand seems to be returning for commercial trucks:

Transitioning to market activity this quarter, we're pleased to see momentum in Brazil as well as higher order intake in North America and Europe, which is supporting a step-up in production for commercial trucks.

Although there is still lack of clarity on whether the full year 2013 demand for commercial vehicle components will indeed be higher than 2012, both Dana and Meritor seem to indicate there are signs of a rebound as we move further into 2013. This should bode very well for Sypris, because it has sole-sourced contracts with Dana and Meritor running through 2014 and 2015, respectively, for specific drive-train and axle shaft components. Since these two customers make up 70% of total revenue, it is highly likely we see a rebound in sales in the Industrials Group in 2013.

Shareholders and Management are Aligned

Insiders of Sypris own 49% of the company, and therefore clearly have a big stake in the fortunes of the company going forward. In the past year, the CEO has purchased 14k shares in the open market for about $60k, and another director has purchased 10k shares for about $50k. All of this when the share price was in the $3.6 - $5.75/share range. There have also been no open market sales, even as the stock has dropped over 50%. This is a good sign that management seems to also see value in the shares today. Beyond this the company does pay a dividend of $0.08/share, which was reinstated about a year ago. After the recession it was stopped for a few years, but previous to that, the company had a steady payout for many years.

Valuation - The Current Price Assuming Negative Growth is far too Conservative

Due to uncertainty and the cyclical nature of some of the markets Sypris operates in, operating results have been choppy in the past few years. The most recent full year EPS from continuing operations was $0.50, an impressive improvement from $0.43 the year before despite a variety of weaknesses (commercial vehicles, a write-off from a deferred contract, and the defense budgetary reductions). Note that this excludes the one-time arbitration settlement of $7m paid in October. As stated above, the double digit increases in the oil & gas market and the growth in the international business (both higher margin) more than offset the weaknesses in operations. We also know from management commentary that both of these units are expected to continue to do well in 2013, which is a good sign for further improvements on the bottom line. Although I would be surprised to see another year of 16% growth in EPS, it is not out of the realm of possibility if the commercial vehicle market does indeed rebound as discussed above, since this makes up a large portion of the overall business.

Due to the big fluctuations in past results for this company and the cyclical nature of the industries it serves, I'd be hesitant to predict an accurate long-term growth rate of earnings or cash flows. However, it seems 5% could be a reasonably conservative estimate, especially considering improving margins due to the growth in new business lines. If you assume 5% growth for 10 years starting from $0.50/share, with a 12% discount rate and a terminal growth rate of 0%, the fair value is just over $5/share - a margin of safety close to 40%. Other conservative valuation metrics related to tangible book value, such as the Graham number, show a value even closer to $6/share. With tangible book value at $2.76/share, a debt/equity ratio of 0.30, and cash per share of nearly $1, I think it's safe to say the stock has a pretty solid floor under it with a lot of potential upside, perhaps as much as 50-100%.

The Bottom Line

Sypris is a hidden away micro cap that seems to be significantly undervalued, as it has drifted down to a low price not seen in well over a year. The last time the stock dipped to about $3 in October 2011, it quickly shot up above $4 again within a few months. With signs of improvements in the commercial vehicle market coming from key customers, and improving margins from a more favorable product mix, Sypris seems poised to rebound in the remainder of 2013. I think the catalysts are there which should boost the stock price in the near term and provide prudent investors who buy in at today's prices with a nice profit.

Disclosure: I am long SYPR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.