DDi Corp. (DDIC) came out with a Q2 result Thursday afternoon that continues to build on a 2010 that has so far been a striking change from what investors in North American printed circuit board (PCB) companies have grown accustomed to over at least the past 10 years. Sales of $68.4 million were up 6% from an already strong Q1 and up 30% from pro-forma Q2 2009. EPS jumped to 29 cents from 19 cents in Q1 and only 2 cents in Q2 2009. This equates to an annualized ROE of about 30%. In contrast to that, the stock, even after a 7% move up to $9.06 on Friday, sits at 7.8x annualized EPS and well below sales per share of over $12.
Where the share price is concerned, the key at this point is the question of the degree to which these results should be seen as sustainable. The company, in raising sales guidance for the year, and from the tone of the Q2 conference call, seems to be indicating that the results, by and large, are sustainable. That confidence was expressed in a tangible way in May when DDi initiated a $.06 per quarter dividend.
The market, however, is clearly not yet convinced—as indicated by the share price relative to earnings*, sales, and the rate of sales growth.
Which view is more reasonable? The case for doubting the sustainability of DDi's strong results is simple. This is a cyclical industry. Orders are strong today but they will be weak tomorrow. To respond to this requires looking at things a little more deeply.
The PCB business in North America has suffered terribly over the past decade. The tech market meltdown in 2000-02 was only the beginning. The flight to lower costs in Asia virtually eliminated non-military volume production here, leaving what was left of the industry to try to survive mostly on prototyping and quick-turn work.
Those low-volume segments of the PCB market are a tough space in which to make money. The challenge, to put the matter as plainly as possible, is to produce complex boards without too many of them having to be trashed. Low-volume PCB production can never be entirely automated and so it will always remain something of a craft. Even with good people and proper procedures in place a company may still see 10-25% of boards being rejected, and those boards contain precious physical inputs: plenty of copper and, often, significant amounts of gold. Some of that value can be recovered through recycling, and flawed boards can sometimes be repaired, but it's easy to see how low yields can decimate results. To top it off, low yields inevitably mean a poor record of getting boards to customers on time, which can hold up their operations and make them, needless to say, rather unhappy.
Orders are strong for everyone right now? Firan Technology Group, a perfectly worthy Toronto-based competitor of DDi, from their July 7 press release, saw Q2 sales at their California facility fall 45% year-over-year due primarily "to some operational and yield issues."
The flip side of all this, however, is that because the realities of the PCB business are such that companies are expected to be yield-challenged and operational stumbles are common, if you can get your operations to the point where they produce consistent, superior yields, you can make a great deal of money. And the process can build upon itself, as strong yields that lead to better margins will also lead to customers who are happy because the boards work and are on time—and who then place more orders. But getting into, and staying in, this virtuous cycle requires a passionate, almost religious, focus on details, maintaining equipment, and shepherding the product along until it is in the hands of the customer. When DDi says, in its latest 10-Q, "Our entire organization is focused on rapidly and reliably filling complex customer orders and building long-term customer relationships," it is no cliché. It is the basis of the business.
Some of DDi's good numbers stem from the successful acquisition of Coretec at the end of 2009, but what is key is the gross margin rate of 22.4%, up from 18.5% for all of 2009. This is particularly impressive given that the integration of Coretec's sizeable Toronto operations into DDi will not be completed until the end of Q3. The 10-Q states that "Gross profit in the second quarter benefitted from leveraging labor and fixed overhead costs over higher production levels." True enough, no doubt, but the comment leaves out the role of what must have been solid yields in the quarter. Even if yields were merely unchanged year-over-year, and all of the increase in the gross margin rate came from economies of scale, it would still be an impressive accomplishment and a testament to how DDi has likely kept its customers happy given the dramatic sales growth.
Finally, and this is the key point here, maintaining what I called this "virtuous cycle" will, to some degree, help shelter strong PCB businesses from the inevitable downturns. You can see this in some first-rate smaller board shops. Even in periods of weak overall demand customers come to them because they would rather pay a bit more than risk having their order late or otherwise bungled. To what degree DDi will find its results thus "sustainable" remains to be seen but the company gives every indication of doing a good job of building the kind of goodwill with customers that could have lasting value.
It should be added that DDi may also be benefiting from industry changes over the past few years. Michael Porter famously observed that the best industries in which to invest are those with high barriers to entry and low barriers to exit. The barriers to entry in the PCB business—technology, capital costs, customer relationships—are arguably high enough. The problem has been that the industry has been distinguished by effectively high barriers to exit as high investments in fixed capital have inspired struggling PCB companies to endure year after year of losses rather than see their fixed capital be sold at fire sale prices. This, combined with the never-ending hope that yields will magically rise in the near future, has made the agonies of the PCB business in some ways resemble those of the airline business—another industry sometimes plagued by high barriers to exit. Though it was long overdue, there has finally been something of a wave of closures and consolidation in the North American PCB industry over the past few years.
The fact of industry consolidation, however, should only be seen as a secondary issue in the DDi story. What matters most is that, in an industry where operational and on-time excellence are unusually difficult to achieve, and hence returns can be dramatic and perhaps also less volatile when they are achieved, DDi is making it happen. If and when the market starts to see the company as fundamentally improved, rather than merely the beneficiary of a temporary upsurge in orders, the stock will likely move significantly higher.
* - Q2 earnings were aided by a reported tax rate of only 5%, which might suggest that the stock is not quite so cheap, though the company points out that accumulated tax losses from both DDi and their 2009 Coretec acquisition will keep taxes low for years, and that when the rate ultimately does rise it will only be to about 25%. So the effect of eventual higher taxes on present value should be seen as moderate.
Disclosure: Long DDIC