What's Up (Down) With Deswell?

| About: Deswell Industries, (DSWL)

Deswell (NASDAQ:DSWL) has taken a bit of a slide recently, and I think it’s time for an update. Back in April, I wrote that:

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.

Deswell currently trades at $3.70 a share. Ardent followers of value investing know that it’s not uncommon for a stock to trade under its liquidation value. Value investors also know that trying to divine the reasoning behind short-term price movements is usually a exercise in futility.

I’ll give it a shot anyway.

I think this an issue of earnings power. Most companies are generally valued-based on the future earning power of the company discounted back to present value. Deswell’s current situation looks pretty bleak if you extrapolated from their trough earnings/cash flow, so it’s not surprising that Deswell was trading in the $4 range. The newest movement, though, probably has to do with the news coming out of China that labor costs are increasing.

This poses a potential problem for contract manufacturing companies like Deswell. The business model for these companies is usually to throw a bunch of cheap labor at the manufacturing process. Labor costs are reportedly increasing at a time when there’s an inability to pass that cost on to the end consumers of the products due to the stubborn lack of inflation in developed countries. (It’s my contention that inflation hasn’t reared its ugly head in the wake of our zero interest rate policies because of the large amount of unemployment and underemployment.) Notably, increased labor costs aren’t anything new to the Deswell story. In fact, Deswell previously stated that their labor costs were increasing over the last year.

From an assets perspective, it also looks like some of the real estate that Deswell owns might be worth a little less than before given the recent tightening on the runaway Chinese real estate market. However, this doesn’t have that much of an effect on my liquidation value (if any) given that I had calculated the liquidation value of the real estate based on the financial statements, which have recorded the property at cost. It’s highly unlikely that the recent fall in real estate prices has brought the value of Deswell’s property below the booked value.

One thing to keep in mind. As the fragile economic recovery continues, it’s certainly still a possibility that Deswell’s earnings may fail to recover in a manner that’s satisfactory to both management and shareholders. At that point, the asset value of the company becomes the main consideration, and it’ll be a question of whether management is willing to do “The Right Thing” and release value through a liquidation. (Note: I don’t think we’re anywhere near that point yet though.)

Disclosure: Author long DSWL