Taylor Devices - Not A Bargain, Yet

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 |  About: Taylor Devices, Inc. (TAYD)
by: Tal Davidson

Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Seeking Alpha contributor John Leonard recently articulated a compelling case for Taylor Devices (NASDAQ:TAYD). His eloquent and insightful writing encouraged me to initiate my own research on the company. Now I want to report my findings, discuss a few aspects of Taylor Devices' business and management, and conclude with my approach to valuing its shares.

The Business

Taylor Devices is doing pretty much the same thing it had done since 1955. Shock absorbers have not changed materially during the last several decades. The few advances that did occur were mostly around finding new applications for the same resilient technology. As an example, the use of shock absorbers for seismic and wind protection of buildings and bridges started only in 1994. In addition, new applications in aerospace and military are being introduced every once in a while. The risk of substitute technologies is low due to the nature of this slowly evolving industry.

Let's next examine the company's competitive positioning. Having built its expertise over decades, and through developing its patents' intellectual property, Taylor Devices seems to maintain a viable competitive position within its industry. The industry for shock absorbers is established, growing moderately at best, and sports conservative returns on capital -- thus, the risk from new entrants is not significant. On the downside, as a small player, Taylor Devices does not have much pricing power over its suppliers. Moreover, its customers retain much of the pricing power. A significant portion of Taylor's revenue comes from governmental and public buyers. Those make buying decisions through a competitive bidding process, which Taylor has but little control over.

Taylor does not report its manufacturing capacity and its utilization rate. My interpretation of the $3 million investment in renovating the newly purchased buildings in the city of North Tonawanda is that it is aimed at expanding its manufacturing capacity. The company plans to perform manufacturing at the new site, as well as utilize the existing factory for assembly and product testing. Acknowledging that growth is capped by manufacturing capacity, this development can serve as an indication that management believes in long-term expansion. So far, growth over the long term has been consistent, yet low. Revenues of $13 million in 2004 have grown to $25 million in 2013, a CAGR of about 6.7%.

The Management

Two notable aspects about the management team is their very long tenure and conservative compensation. CEO Douglas Taylor is the son of the founder, Paul Taylor, and joined the company in 1976. The two other executives are Mark McDonough, who joined in 2003, and Richard Hill, who joined in 1978. CEO Taylor's total compensation in 2013 was $423,000, and the others' was around $300,000.

Management has been very conservative, insisting on growing organically, running with zero debt (except for brief periods), and not issuing new shares. Indications of the honesty and conservatism of management can be found in The Wall Street Transcript's interview with Douglas Taylor. Management focuses on being good operators, and do not engage in resource conversion activities such as M&A, refinancing, etc. As such, Taylor Devices can be regarded and valued as a pure going concern.

The Price

As a small company in a niche market, Taylor Devices' performance changes significantly, depending on its customer mix and state of the economy. Taylor operates in three segments: aerospace/defense, construction, and industrials. The mix changes significantly from one reporting period to another. The company has been profitable for the last 10 years, and probably for the last 30 years as well (though I did not check). Return on capital fluctuates above 10% (it was 17% for 2013).

The range of valuations for Taylor Devices is wide, due to the low predictability of its future revenues. I examined three scenarios, trying to come up with an estimation of a normalized earnings power.

(in K$)

Optimistic Case

Pessimistic Case

Baseline Case

Assumptions

Revenue

26,000

20,000

24,000

Gross Profit

9,100

5,400

7,440

27% - 35%

SG&A

5,200

4,600

5,040

20%-23%

Operating Income

3,900

800

2,400

Interest Income

0

0

0

Taxes

1,014

280

672

26%-35%

Net Income

2,886

520

1,728

Click to enlarge

As of the time of writing, TAYD was trading at $8.3, which equals $27.3 million. This translates to a P/E of 9.5, 52, and 15 for the optimistic case, pessimistic case, and baseline case, respectively. TAYD have been trading with P/E ratios of 10 to 60 during the last 10 years, with an exception of lower valuations only in the midst of 2008-09 economic crisis. Note that the company has a significant stock options base, which reduces the value to equity holders by about $450K, according to company estimates, as disclosed in its 10-K.

Conclusion

Taylor Devices provides the small individual investor an opportunity to invest in a profitable, relatively simple business that has demonstrated resilience and profitability over a very long period of time. It is a conservative, slowly growing profitable business, and is likely to stay this way as long as the existing management is at the reins. Investing in Taylor Devices is an opportunity to partner with an honest and experienced management team.

Nevertheless, this does not come without its share of risks. Revenues and earnings fluctuate quite a bit and cannot be predicted with high confidence. Competitors may be better financed and have a larger scale, and thus seize the good business opportunities. And then there's the dependency in the top three executives. Expending the manufacturing capacity with the buildout of the new factory adds fixed costs, which can be a burden on profitability should the company not grow at a sufficient rate.

Taylor Devices is an adequate investment, but not a superior one. Therefore, while I will add it to my watch list, I would wait for a more compelling price before opening a position. At a market cap of $20 million (representing a P/E of 12 over the baseline view of normalized earnings), the company may start looking like a bargain. Until such a price is available, I will remain on the sidelines, favoring omission risk over commission risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.