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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.

Suppose a very wise and analytical investor makes the following argument:

1) The U.S. national debt is over 17 trillion dollars; which will lead to

2) The U.S. having to monetize the debt; which will lead to

3) Increased inflation; which will lead to

4) A rise in gold prices; which will lead to

5) An increase in the value of gold miners' assets and earnings.

6) Therefore, investors should invest in Barrick Gold Corporation (NYSE:ABX), a leading gold miner.

Now suppose that this brilliant thinker is right about 80% of the time - an excellent rate of being right, almost as high as your mom's. Even with that high rate of prediction, however, the chances that the final action (number 6) leads to profits is only about 33% (0.8^5). The more steps that are required for your investment to come to fruition, the less likely the success (think probability of a perfect March Madness bracket). If the five predictions prove to be true, it certainly will look very impressive, but investors don't make bonus profits by investing in complicated situations. I prefer simple situations, whereby success can be achieved through one step instead of five. In this article, I will show how Deswell Industries (NASDAQ:DSWL), a company with a strong balance sheet, has been throwing cash to shareholders for many years. Warren Buffett said, "I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over." Investing in Deswell is like stepping over a one-foot bar.

Profile

Deswell was founded in 1987 with corporate headquarters in Macau, China and operations in Dongguan, China. It has three main business segments:

1. Plastic Injection Molding

2. Electronics Assembly

3. Metallic Parts Manufacturing

The business environment for the company has been very challenging due to increased competition and higher labor costs. From the company's website, we can see:

Revenues

Gross Margins

2008

144

18.3%

2009

132

15.3%

2010

82

15.5%

2011

84

11.4%

2012

65

14.6%

2013

54

12.6%

Deswell has about 16.3 million shares outstanding, a market cap of $39 million, $44 million of cash, and zero debt. The company has very conservative accounting policies. For example, the company reported in its 2nd quarter 2013 filing that it held $24.6 million of cash and cash equivalents. Upon closer evaluation, an investor will find another $12.0 million in fixed deposits, $5.7 million in marketable securities, and $1.5 million in available for-sale securities. The company's total current assets are about $68 million against total liabilities of $14 million. The company's net current asset value of $54 million ($68M minus $14M) is well above its market cap.

History of Returning Cash

As the revenue numbers above show, Deswell's business is shrinking. What I like about the company is that it has consistently returned cash to shareholders through dividends as the table below shows. The company has treated shareholders fairly by not building an empire. It has made no poor acquisitions nor hoarded cash, two common vices of companies (many of which I admire). Furthermore, the company began a $4 million share buyback program in early 2013 and was $1.9 million into it by September of 2013 at an average cost of $2.61. Given Deswell's undervalued stock price, share buyback is a very wise decision by management. Many companies unwisely buy back shares when their price is high and issue shares when the price is low. For example, JC Penney (NYSE:JCP) bought back shares between 2004 and 2006 at an average price of $46.40. Last summer it raised close to a billion dollars by selling shares under $10.

Deswell EPS & Dividends

EPS

Dividends per share

EPS - Dividends

BV per share

2004

1.04

0.47

0.57

6.54

2005

1.02

0.65

0.37

7.09

2006

0.59

0.63

-0.04

7.16

2007

0.81

0.65

0.16

7.42

2008

0.57

0.61

-0.04

7.68

2009

0.08

0.24

-0.16

7.62

2010

0.09

0.10

-0.01

7.47

2011

-0.50

0.10

-0.60

6.87

2012

-0.09

0.12

-0.21

6.65

2013

-0.12

0.20

-0.32

6.20

Source: Gurufocus

The negative EPS numbers may frighten many investors but upon closer inspection of the cash flow statement, investors can see that the company consistently reports cash flow from operations in excess of net income. This further confirms Deswell's conservative accounting principles. To be sure, a shrinking company like Deswell has tailwinds with regards to its cash flow operations. For example, through reduced inventories, it can increase net cash inflows. This is as opposed to a growing company that has headwinds with regards to cash flow generation. Nevertheless, Deswell is cash flow positive, paying generous dividends, and maintaining a book value well in excess of its market cap despite the generous dividend yield. Since 2004, the company has returned $3.77 in the form of dividends. The stock currently trades for about $2.39. If this type of dividend payout continues, a shareholder can make her initial investment back after a few years practically through dividends alone.

But Wait There's More…

As we saw above, the company's net current asset value is above its share price. Now let's take a look at the company's other assets. Per Deswell's latest 20-F filing, the company has about $42 million worth of property, plant and equipment. This consists of:

March 31,

2012

2013

At cost:

Leasehold land and buildings

$

33,715

$

33,715

Plant and machinery

54,809

54,100

Furniture, fixtures and equipment

13,369

13,248

Motor vehicles

1,428

1,421

Leasehold improvements

3,543

3,799

Construction in progress

80

535

Impairment

(4,402

)

(4,592

)

102,542

102,226

Less: accumulated depreciation and amortization

(56,365

)

(59,532

)

Net book value

$

46,177

$

42,694

Let's conservatively assign a value of zero to all the plant, machinery and equipment. However, there could be huge potential value in the land and buildings, which is valued in the books at $33.7 million. A payment was made in 2000 for the right to use the land and buildings in China. The term expires in 2050, well into the future. Land and property prices have sky rocketed in China since 2000 and the company could further extract cash from the mere rights of using the land and property until 2050. I do not know how much to value the land use rights but it is a significant value, which makes the case for investing in Deswell even more compelling. Another well managed Chinese company, Nam Tai Electronics (NTE) is slowly exiting its business of electronics manufacturing and becoming more involved in real estate development. Nam Tai has similar land use rights albeit in a more desirable location than Deswell. One common bear argument against Nam Tai is that it has never developed real estate and has no expertise in that business. However, I believe with sound shareholder friendly management, companies that are sitting on valuable assets will have little problem monetizing it. If you had bought an old house and the land appreciated ten-fold, you still would be able to make a tidy profit even if you did not have any real-estate expertise. Companies like Deswell and Nam Tai are holding valuable assets that the investment community is overlooking. There is great uncertainty as to how they will eventually realize the value of these assets but little risk.

Insiders

As a further confirmation of my investment thesis, I always examine whether the key insiders are vested in the business or if they are selling. Selling by multiple insiders is a red flag, a strong deterrent for a conservative investor. For example, in April of 2012, Mark Pincus, the founder and then CEO of Zynga (NASDAQ:ZNGA), along with at least three other executives sold over 18 million shares of the stock at $11.64 after the expiration of the lock up period. The CEO's large sale was a major warning for shareholders. In all fairness, the insiders continued holding many more shares. Such widespread insider sales, the news of which is easily available online, can potentially prevent huge losses for individual investors. Zynga's stock ended the year trading under $2.50. In July of 2013, Mark Pincus gave up his CEO position. If the founder can so easily relinquish his "baby," then another red flag is raised.

Deswell's two main insiders, Richard Pui Hon Lau (Chairman) and Chin Pang Li (Executive director), own close to 22% of the company as of June of 2013. More importantly their stake, as depicted by the table below, has been increasing.

Percentage Ownership at June 30,(1)

2011

2012

2013

Richard Pui Hon Lau

10.4

11.4

11.5

Chin Pang Li

9.2

10.2

10.3

Risks

Deswell is a microcap company and shares should be accumulated slowly at limit prices. Even modest size orders can significantly influence the share price. The average trading volume is about 42,000, so individual investors can easily acquire a significant position over several weeks. The company is also located in China, which exposes investors to currency risk as well as political risks. The company's core business is shrinking which may lead to dividend cuts. This could put further downward pressure on the stock price due to selling by income oriented investors.

Share price as of January 29, 2014: $2.39

Source: Deswell Industries: A 1-Foot Hurdle Investors Can Step Over