A few weeks ago I wrote an update on SMTC Corporation (SMTX) that highlighted the progress made by the previous interim management and what I expected the hiring of new CEO Sushil Dhiman would mean for the company. SMTC Corporation is an established provider of advanced electronics manufacturing services (EMS) worldwide with global sales of close to $300 million and a market cap of only $32 million. The company's services include product design and engineering services, printed circuit board assembly, production, enclosure fabrication, systems integration, testing, and configuration services. It also provides enclosure and precision metal fabrication, cable assembly, interconnect, and engineering design services for several industries and verticals. The company has several manufacturing / technology centers in the United States, Canada, Mexico, and China. The company has more than 40 manufacturing and assembly lines and employs approximately 2,300 employees worldwide.
Before Mr. Dhiman took over as President and Chief Executive Officer effective January 6, 2014, the interim management led by Interim President and Chief Executive Officer Larry Silber reported a profitable 3Q 2013 and implied that 4Q 2013 would also be profitable. Regarding 3Q 2013 financial results, Mr. Silber commented: "We are pleased with the improvement in revenue over the prior quarter and our order book remains strong. Significant gains have been made across our business resulting in improved customer satisfaction. We will now put additional emphasis on our operational effectiveness leading to margin improvement through increasing productivity, third party supplier actions and lean initiatives,"
Mr. Silber continued, "Our short-term goals includes substantially reducing inventories, improving the efficiency and profitability of our sites, continuing to expand our business with existing customers and the pipeline for new customers, and continue with our strong order book to make sure that our work is efficient and timely delivery of the order book in hand."
Commenting on Mr. Dhiman's appointment, Executive Chairman Clarke Bailey stated: "we are pleased that our search resulted in Sushil joining SMTC as President and CEO. He brings a wealth of experience in operations, customer service and business development. I believe he is a great fit for our company and expect him to have a significant impact on the success of SMTC."
Mr. Dhiman is a respected and accomplished executive with over 25 years of experience in the EMS industry. Prior to joining SMTX, Mr. Dhiman was a competitor's Sanmina-SCI (SANM) Senior Vice President of Operations. During his career, he has been responsible for managing multiple facilities generating over $500 million in revenue. Mr. Dhiman has successfully grown and lead complex operations by developing new business and effectively managing costs and working capital. Prior to joining SANM in 2010, Mr. Dhiman was Vice President - West Coast Operations for PNY technologies where he managed all aspects of the West Coast operations including Mfg. operations, Engineering, Business Development and Human Resources with complete P&L responsibilities.
It is interesting to note that SANM's stock price went from $2 in 2010 when Mr. Dhiman joined the company to $16 recently. Therefore he has witnessed and participated in a successful turnaround of one the sector's leaders. This type of experience is key to take poorly-ran SMTX into sector prominence. Years of instability at the top have relegated SMTX as a sector laggard falling behind better-managed competitors like similar-sized Key Tronic Corp. (KTCC).
Despite the remarkable job done my SMTX's interim management, there were still some "skeletons in the closet." It did not take long for new CEO Dhiman to discover an inventory problem at the company's Chihuahua, Mexico facilities.
On January 27, 2014, the company's reported that the new management team lead by Mr. Dhiman determined that the Company should conduct a full physical count of its inventory. The Company's previous practice was to perform cycle counts of inventory on a periodic basis as permitted by generally accepted accounting principles. As a result of this full physical count, the Company identified an overstatement of inventory at its Chihuahua, Mexico of approximately $3.2 million
SMTX estimates that adjustments to the Company's inventory balance resulting from these errors as of the end of the fourth quarter of 2012, which includes the impact of adjustments for immaterial errors in prior periods in 2012, will total $725,000, and as of the end of the first three quarters of 2013 will total $390,000, $410,000 and $350,000, respectively. The remaining impact of the overstatement, approximately $1.33 million, is expected to be recorded in the fourth quarter of 2013. There goes the profits for the quarter, or at least a significant hit on profitability.
But it appears that the company will benefit from a one-time credit resulting from changes in tax laws in Mexico implemented during 4Q 213. I expect that the magnitude of that credit to be similar to in magnitude to the $1.33 million hit resulting from inventory problems discussed above. I base this comment on the fact that competitor KTCC claimed a $1,5 million credit in the quarter ended December 31, 2013 that resulted from Mexico's tax-law changes. In its latest financial report KTCC stated:
"Results for the second quarter of fiscal year 2014 (ended December 31, 213) include a one-time tax benefit of approximately $1.5 million or $0.13 per diluted share due to changes in Mexico's tax laws enacted in December of 2013. Mexican tax reform was signed into law in December 2013 creating a discrete benefit of approximately $1.5 million that was recognized during the second quarter as a result of a change in applicable tax regimes. In recent years, the Company had been subject to a Mexican business flat tax called Impuesto Empresarial a Tasa Unica (IETU). However, effective January 1, 2014, IETU was repealed as part of a larger reform of the Mexican tax system."
Besides returning the company to profitability, improving working capital and receivables management, and to achieving bank-covenant compliance, the interim management lead by Mr. Larry Silber made significant progress in several key performance areas prior to Mr. Dhiman's arrival:
Gross Margin Improvements
According to the 3Q 2013 earnings transcript, an important company focus has been to ensure a more efficient operation of the Mexico facilities. SMTX brought on board Chris Christiani as Senior Vice President of Operations to optimize the Mexico operations. According to Executive Chairman Clarke Bailey, Mr. Christiani has done a great job establishing and implementing processes aimed at enhancing quality, and improving efficiency and gross margins in the Mexico manufacturing complex. Mr. Bailey commented, "So there's some good things that we're doing in Mexico. We think that as their margins come up you'll see the gross margin come up."
Other initiatives to increase gross margins relate to: 1) supply-chain optimization to improve procurement terms, 2) throughput and productivity optimization and implementation of lean initiatives in the company's manufacturing plants, 3) inventory management improvements, 4) software system upgrades to improve efficiency and the ability to manage materials flow through the factory, 5) better management of bill of materials to make sure that they process through the plants in a more effective way, 6) working with a host of third-party suppliers, like logistics companies, insurance companies to optimize insurance costs, HR consultants to optimize manpower requirements, etc.. Mr. Bailey added, "I think these things will certainly contribute to improved margins as we go forward into 2014."
Improvements in the pipeline and customer quality
During the 3Q 2013 CC, Mr. Silber responded to an analyst's question regarding the pipeline of opportunities, "Well, we have a pipeline today, whereas last quarter I would tell you we didn't really have a pipeline of new viable customers that we can consider would become reality in the future.
So, we believe we have what we call - we've created a three-tiered pipeline, in terms of readiness so we have some in early stages of development, some mid-way along and some - we're actually at the quoting stage, so we have a pipeline and we're optimistic."
Mr. Silber and the interim management team have spent a lot of time in developing the profile of customers to go after that are best fitted for SMTX's capabilities. Mr. Silber added, "As an example, we put out a press release a few weeks ago relative to a new customer called SpiderCloud Wireless and we've actually done a fair amount of business with them already this year and that's been a new ramp-up and a nice development for us. And going into 2014, it's going to be a significant customer for us. Indeed, since Mr. Silber made those comments during the 3Q 2013 CC, SpiderCloud Wireless claimed that 2013 was a breakthrough year for enterprise small cells and 2014 and beyond will see explosive growth in this technological area.
Mr. Silber further added: "We are actively engaged in seeking innovative customers like SpiderCloud Wireless because they are a great fit with our expertise and our capability primarily in doing process engineering and throughput technology and capability in our factories, and the fact that particularly when it comes to ramping up a new product we are fairly flexible, in terms of our manufacturing process and we can manage that type of activity very well in our various plants. And then as they reach full production capability or volumes, we could move them to some of our larger higher volume plants and move their material through"……"we've gone through a great deal of effort over the last six months in identifying what is the appropriate profile of the customer that we can handle, most effectively within our manufacturing facilities and within our capability in our engineering group."
The 25% downward correction that resulted from the January 27, 2013 inventory-problem revelation is exaggerated, and in my opinion a significant correction is warranted. This is particularly true since recent information from KTCC implies that the hit the company was expected to take in 4Q 2013 will be compensated with a credit of similar magnitude thus resulting in the expected profitable quarter. Furthermore, as an SMTX shareholder I applaud the new CEO' strong initiative to right this ship and set it on a profitable and more transparent path going forward.
With the recent correction, SMTX is currently extremely undervalued trading at 0.1 time sales or a fraction of sector leaders Flextronics (FLEX), Sanmina-SCI , Celestica Inc. (CLS), and Jabil Circuit Inc. (JBL), and competitor KTCC. There are several positives at play including the improvements made by the interim management led by Mr. Silber, a new well-qualified CEO with extensive industry experience, new innovative high-growth clients like SpiderCloud Wireless, significant and persistent insider buying, and a relatively small public float of less than 10 million shares. But since no investment is risk free, those considering in investing in SMTX are encouraged to carefully read and understand the risks associated with investing in this (or any other company) as stated in 10-K and 10-Q filings with the SEC.