[Note: I wrote this article on March 26, 2010. Since then, this stock has had a bit of a run of about 5%. Even at the new price, I think the thesis of having a large margin of safety is still sound, and the new ongoing concern premium of around $6 million is still much too low.]
It takes a special type of person to look at a stock that reports sales for the quarter have fallen 42.4% compared to the prior year and think, "Hm, I'd like to own a piece of that company." Of course, that just happens to be my kind of crazy.
The main challenge of being a fundamentals focused investor is maintaining a healthy amount of skepticism and discipline when you see an unreasonable differential developing between the stock market and the underlying economy. The stock market continues to hit new highs, and even as I wrote this, the Dow was nearing 11,000. For many people, this would create a sense of urgency, real or imagined, that the train is leaving the station, and they might be left to wait for the dreaded "next train" at this metaphorical waystation in Nowheresville, Holding Cash.
Certainly, this type of thinking is typified by a sort of post-hoc rationalization that while the 10-year cyclically adjusted P/E ratio stands at roughly 20x, which is 25% over the long-term 90-year P/E ratio of around 16x, the market CAN be cheap when compared to a favorable forward P/E ratio of [insert your estimates here]. This way, we've magically turned a headwind into a tailwind. Prest-o! Change-o! Now, we can be off on our way, content in our analytical prowess and free from the restrictive shackles of demanding a margin of safety for our investments.
As most readers know, I choose to be content in my skepticism of the recent high market levels, but that doesn't necessarily mean that we should sit around doing absolutely nothing. The pickings may be slim, but they are not wholly absent, and this week, I'd like to present Deswell Industries, Inc. (Ticker:DSWL).
The stock price has lost a little more than 75% over the last five years. Obviously, this stock is not for the faint of heart. Still interested? If so, keep reading.
(Very) Brief History and Description
Deswell Industries, Inc. was founded in Hong Kong in 1987 as an independent manufacturer of injection-molded plastic parts and components. Since then, Deswell has expanded its business to become an independent contract manufacturer of electronic products, components and subassemblies, a supplier of metallic molds for the company's plastics and electronics operations, and a manufacturer of metal parts for original equipment manufacturers and contract manufacturers. Essentially, you bring them your molding/prototype, and they build your product. The contract manufacturer business model has historically been a pretty good one, and Deswell has a great reputation in the industry. The company's biggest customers are N&J Company Limited (Nintendo (OTCPK:NTDOY)), Digidesign, Inc. (pro audio), VTech Telecommunications Limited (wireless telephones), Inter-Tel Incorporated (communications solutions), Peavey Electronic Corp. (pro audio) and Line 6 Manufacturing (pro audio).
The last two years have not been kind to Deswell. Although the company's average 10-year net income hovers at a little more than $10 million per year, that amount fell to $1.2 million in FY2009 (on an 8% decrease in net sales) and the FY2010 numbers are likely to be around the same as the FY2009 numbers (on a 37% decrease in net sales to-date). Notably, the only reason FY2010 net income will approximate FY2009 net income is because, in the 2Q of FY2010, Deswell sold its old plastic injection manufacturing plant in Shenzhen, China for a gain of $4.2 million. Without this one-time sale, Deswell's FY2010 numbers would surely have swung to an overall loss. (I would guess somewhere in the $2 million loss range.)
These recent problems are the result of a combination of factors. High crude oil prices (a crucial input for the plastic resin that Deswell uses) and higher costs of labor increased the costs of goods sold (COGS) to 84.7% of revenues, which is up from the mid-70% levels of the last few years. The COGS are likely lagging because of an inability to pass the cost increase along until Deswell enters into newer manufacturing contracts. The FY2009 selling, general and administrative expenses (SG&A) also increased to 14.6% of revenues, up from the low- to mid-13% levels of previous years. While, Deswell has had some success in reigning in the SG&A costs this year (in absolute numbers) to $11.66M, that's still a disproportionate 18% of FY2010 revenues. This likely indicates that Deswell is starting to bump up against some fixed costs and provides some insight into the level of operating leverage in the company.
At this point, we should think about the nature of the two problems above and ask ourselves if the problems are transient or permanent. On the cost front, the question is whether they can pass on the costs that they have little control over (higher crude oil prices, increased costs of labor, etc.) and reduce the costs that they have more control over (SG&A). I have little insight into their ability to do either of these things, so I'll have to rely on a history of competent management as an indicator that they have a decent shot at getting over these problems. On the revenues front, the question is whether this is a secular readjustment or a cyclical downturn of demand for Deswell's services. Here, I have just a little bit more insight than on the costs question, and I think that the contract manufacturing business as a whole, including Deswell, is merely being depressed by the economic recession.
This picture looks pretty bleak, but here are the silver linings.
Tangible Book Value
At $4.00 a share (closing price on March 26, 2010), the company has a market cap of $63.74 million. The tangible book value of the stock, however, is $7.73 per share based on 3Q FY2010 reports. That means the stock is trading at a little more than 0.5x tangible book value. Historically, the stock has traded at 1.5x book value.
Furthermore, a look at the liquidation value of the stock proves to be enlightening. If we use Graham-type liquidation value parameters and value cash @ 100%, receivables @ 80%, inventories @ 66 2/3%, property plant & equipment @ 15% and liabilities @ 100%, we arrive at a liquidation value of $3.75 per share. That means that a little over 93% of the current market price of Deswell is represented by the likely liquidation value. Of course, this is a theoretical construct. We haven't taken into account the run-rate for the wind-down period during a liquidation process nor have we broached the subject of liquidating a business in China, a process of which I've have absolutely no knowledge.
However, let's assume for the sake of discussion that we could liquidate the company for $3.75 a share. What does this mean for the residual amount? Let's call it the ongoing concern premium. In other words, that's the premium over "kindling" that the market is willing to pay for this company. That premium works out to roughly $4 million @ $0.25 a share. Now, I know things look bleak right now, but for a company that has historically (averaged over a 10-year period) put up net income of $10 million per year and free cash flow of around $4 million a year, the ongoing concern premium starts to look way too low.
Now, in my mind, the decision to use liquidation value or future cash flows to value a company is somewhat asymptotic. As Mohnish Pabrai mentions in an interview,
[i]f future cash flows are easy to figure out and are high-probability events, then liquidation value can be set aside. On the other hand, sometimes the only thing that is a high probability of value is liquidation value. Both work. It depends on the situation.
If you're clearly an ongoing concern, then liquidation value is likely to underprice your intrinsic value. If you're clearly a likely liquidation, I'm going to say that future cash flows will likely misstate (probably underprice) your intrinsic value.
The market capitalization for Deswell is essentially saying that you're paying a fair price for a mythical version of Deswell that posts one year where their free cash flows match their historical norm (likely an understated amount because you wouldn't need capital expenditures in this situation) and you immediately liquidate the company thereafter. At that point, you would roughly break even. (I'll call the discounted value differential of the cash flows a year from now and the capital expenditure differential a wash - even though the latter is likely much greater than the former.) Now, I have no idea what a "fair" ongoing concern premium should be for a terrible company, a mediocre company or even a fantastic company. However, like Graham says, "you don't have to know a man's precise weight to know he's overweight nor a woman's precise age to know she's old enough to vote." An ongoing concern premium of $4 million is too low.
(Additionally, Dr. Mike Burry, has a similar calculation that he did on this very company in 2000 that we can use as a reference point for cheapness -- take a look under "Show me the business".)
Future Cash Flows
(feel free to skip this part, if you want -- if you read through it, you'll see why)
I debated whether or not to figure out the future cash flows for Deswell. On the one hand, for an ongoing concern, which I believe Deswell will continue to be, that's the right way to go. On the other hand, I don't have a lot of clarity on how to calculate the free cash flows going forward.
Deswell has been a pretty well run company (even with the recent lack of profitability). Management runs a tight ship and is pretty conservative in their decision-making. As a result, I personally think that their yearly capital expenditures are much higher than the required maintenance capital expenditures. As a reminder, the historical 10-year average net income hovers at around $10 million, and the historical 10-year average free cash flow hovers at $4 million. I think the historical free cash flows are likely a good deal higher than $4 million, if you're only making maintenance capital expenditures, but I've no ability to pinpoint how much higher they should be. (Sidenote: If we pay attention to capital expenditure amounts for FY2010 when they're released later this year, I think we'll get a pretty good reference point on what maintenance capital expenditures should be for this company.)
As a result, I've decided not to attempt a run at future cash flows. I'll just simply state that on historical net income of $10 million dollars, the company is trading at a P/E of 6x historical earnings.
Where's my catalyst?
One of the exogenous factors weighing down on the stock is that the economic recession has reduced demand, which has resulted in a 37% decline in Deswell's net sales as compared to the nine-month period in the prior year. According to a writeup on SumZero, this decline has been felt industry wide, as Nam Tai Electronics (Ticker: NTE) has also reported a 35% decline in sales for the same period. The same writeup indicates that increased volume in Wiis from Nintendo and cyclical technological innovation from DigiDesign are poised to help lead a recovery in Deswell's net sales, but I'm not putting a lot of weight on those two as catalysts. Instead, I'm just generally looking towards an eventual cyclical rebound in the consumer spending sector to work its way through to the contract manufacturing sector.
Wait a second, you never named a price!
That's right, I didn't. There are a number of different metrics to use to determine a fair price for Deswell. If we're going by the tangible book value calculations, we could say that the target price for Deswell is somewhere between 1x book value and 1.5x book value, which would place the price somewhere between $7.73 and $11.60 share. If we're going by future cash flows, I would think that a fair price would be somewhere between 10x to 12x historical earnings, which would put the price between $6.70 and $8.00 a share. The low-end estimate would place the discount to intrinsic value at roughly 40% and the high-end estimates would put the discount somewhere in the 50-65% range.
As stated before, liquidation values and ongoing concern premiums are more an indicator of margin of safety and undervaluation than they are about intrinsic value, so they're not that helpful here.
Where am I likely to get blindsided?
Barring any material changes in the inputs to the liquidation value calculation, I would think that the downside is pretty limited by the $3.75 per share of liquidation value. (This would doubly be the case if they re-institute the dividend down the road.) Of course, this doesn't mean the price can't go below $3.75; I merely mean that the liquidation value of the company isn't much less than $3.75. However, there are a few things to watch out for as we wait for a possible rebound. We'll want to see substantial improvement in the COGS and SG&A amounts as a percentage of revenues as older contracts roll off and newer contracts are formed. If Deswell can't pass on overall cost increases in new manufacturing contracts to repair their margins, then it might find itself in a jam. Additionally, appreciation of the Chinese RMB could have a big effect on Deswell's future cash flows because of its status as an export-oriented manufacturing company. I would keep an eye on the April 15th deadline for the U.S. Treasury Department to label China as a currency manipulator. If China is labeled a currency manipulator, it would allow the U.S. to slap trade tariffs on goods coming in from China and possibly spark a trade war, which would not bode well for Deswell. Finally, I'd like to briefly touch on the fact that this is a microcap stock. The average daily volume in this stock is about 21,000 shares a day. I would enter this stock on a gradual basis, because on a stock with volumes this small, you may not only move the market, you might actually BE the market.
I'd like to note that I purchased shares in Deswell Industries, Inc. on March 26, 2007 @ 4.000 a share. Deswell Industries, Inc. comprises roughly 8% of my portfolio.
Disclosure: Long DSWL