Company overview
Sevcon (SEV) manufactures microprocessor-based controls for zero emission and hybrid electric vehicles (94% of LTM revenue) used to vary the speed and movement of vehicles, integrate specialized functions and optimize the energy consumption of the vehicle's power source. Customers include manufacturers of on- and off-road vehicles such as cars, buses, motorcycles, forklifts, aerial lifts, mining vehicles, airport ground support vehicles, utility vehicles and sweepers.
SEV also manufactures special metalized film capacitors (6% of LTM revenue) used as components in the power electronics, signaling and audio equipment markets.
Market quickly prices in a recovery - and prices it out just as quickly
From December 2013 - February 2014 the stock almost tripled as conditions stabilized and visibility improved following weak industrial demand at the beginning of 2013. However, the stock gave back a majority of the gains despite the continuing improvement in the growth outlook. For example, 3Q14 was the sixth consecutive quarter of sequential revenue growth (see chart below) as strong double-digit growth in Asia and the U.S. more than offset flat sales in Europe and lower demand from manufacturers of mining equipment.
Gross margins have improved from 36.6% in 2013 to 39% in the LTM due to an improved product mix. The outsourcing of manufacturing provides consistently high operating leverage. A workforce reduction in 2Q13 brought the cost structure in line with the lower revenue at the time and reduced the OpEx run rate by $2 million, which helped improve the operating margin from (1.1)% in 2013 to 4.2% in the LTM. A majority of this operating income drops down to net income given the low effective tax rate as a result of lower foreign tax rates (including a reduction in the U.K. rate scheduled to take effect this year) and ~$6.7 million of foreign NOLs that do not expire.
Going forward, company-specific drivers include the growing global OEM customer base (especially in the critical Asian market), continued new product introduction and competitive advantages such as unique hardware/software capabilities. SEV is a prime (and unconventional) beneficiary of the increasing demand for electric and hybrids vehicles as evident by two recent contracts, which have the potential to generate additional revenue over the next several years.
In April 2014, Phoenix Motorcars launched a new electric vehicle platform and shuttle bus. This platform (aimed at both domestic and international markets) could be used to support retrofits of existing fleets in addition to new vehicles. Demand received a further boost after G-20 leaders recently agreed to take action against climate change (especially through improving energy efficiency and phasing out fossil fuel subsidies) while the new Green Climate Fund is near the goal of securing $10 billion in pledges. This fund will support clean energy technologies, which could benefit SEV as it helps auto manufacturers comply with increasing fuel efficiency and emission standards by providing start-stop and regenerative braking functionality.
On the 3Q14 conference call, management said that the broad-based growth in the four wheel on-road sector was driven primarily by shipments to Excel Hybrids (a manufacturer of hybrid power and condition systems for commercial vans and trucks), which is only one of the projects that could become a significant opportunity.
The total addressable market extends beyond motor vehicles given the broader shift away from internal combustion towards electrical systems. Management said that the pipeline includes products for the off-road industrial and electro hydraulic market and noted the first shipments of gyro stabilizers for leisure yachts and commercial marine applications.
Although the balance sheet was already relatively healthy with net debt of <$500,000 at the end of 3Q14*, SEV is in a better position to take advantage of these growth opportunities by ramping up hiring, increasing R&D (although grants help limit the growth in expenses) and potentially acquiring other companies following the oversubscribed $10 million rights offering in September 2014, which insiders and the largest institutional holder Gabelli participated in.
*This should improve if a ~$550,000 receivable is collected as expected. This receivable is from a French customer that was placed into legal administration protection in January 2014. This company was acquired in June 2014 by Central Motor Corporation (an SEV customer), which announced that it would inject $20 million of working capital into the former operation.
Chinese joint venture already paying off
In February 2014, SEV entered into a 50/50 joint venture with automotive supplier Risenbo Technology that will sell Sevcon products for on-road electric and hybrid vehicle applications to Tier 1 automotive suppliers in China. Earlier this month, SEV reported its first contract with a large Chinese manufacturer to design and supply controls used in motors with production scheduled for 4Q14.
BMW projects China will be the largest market in the world for electric vehicles within five years. The government is serious about reducing pollution as evident by the waiving of the 10% sales tax on electric cars, removal of six million older polluting vehicles from the road (to be replaced with lower polluting gas or pure electric cars), commitment to having electric cars account for at least 30% of government vehicle purchases by 2016, setting a target for capping carbon emissions for the first time and building out the network of charging stations with $16 billion in funding. To provide a glimpse of the growth potential, China-based Kandi Technologies Group reported a 238% increase in the number of electric vehicles sold in 2Q14 (the more recent 3Q14 number was negatively skewed by the previously mentioned purchase tax exemption that went into effect 9/1/14).
Risks
The end-user demand is highly cyclical and dependent on economic growth although this risk has been reduced by the expansion beyond the traditional off-road industrial sector into the on-road electric vehicle market.
The lumpiness of two wheel on-road sales is expected to continue. For example, sales decreased 39% in 3Q14 and increased 32% in the prior quarter.
SEV relies primarily on two main assemblers for its finished products (one in Poland and the other in the U.S.) although the ongoing efforts to duplicate certain test facilities at both locations should reduce this risk.
There is foreign exchange risk as ~50% of revenue was in USD, 25% in GBP and 25% in EUR while ~80% of the cost of sales was incurred in GBP and EUR in the YTD period.
Lower demand or changes in technology may result in a higher inventory reserve (10% of gross inventory in 2013 compared to 9% in 2012).
The defined benefit pension plans are underfunded by $8.3 million. This risk was reduced after the plans were frozen and the underfunded status improved from $10.3 million in 2012.
Valuation and price target
A more extensive peer comp is difficult as many of the direct competitors are either divisions of larger companies or private. As shown in the chart below, SEV trades at a significant discount to its closest pure play peer UQM on an EV/Revenue basis. The valuation discount is even more striking considering UQM does not generate EBITDA while SEV generated $2.1 million of EBITDA in the LTM.
The expected rebound in the stock driven by the growth ramp up should receive a boost from the low float as a result of the 26% insider ownership and 50% position held by Gabelli. The conservative price target of ~$10.75 is based on a 1.5x revenue multiple. The stop loss should be placed below $7.00.
