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Perceptron, Inc (NASDAQ: PRCP) develops and sells tools used for measuring and inspecting objects in industrial and commercial settings. The company trades at a market cap of around $45 million, yet it has cash and securities worth $23 million (adjusted for a legal settlement), zero debt and is profitable. Furthermore, the company has generated an average of $3.7 million of free cash flow annually for the last decade, which represents a 17% ex-cash yield.

The recession was rough on the company, as the following chart demonstrates.

Perceptron, Inc - Revenues and Margins, 2001 - 2011

Perceptron, Inc - Revenues and Margins, 2001 - 2011

The company’s revenues declined 28% peak to trough. Moreover, this occurred while the company was dramatically discounting, as evidenced by the contracting gross margin. Unfortunately, the company began discounting well before the recession, with gross margins contracting a whopping 1317 bp in just three years from 2006 to 2009.

On the bright side is the fact that the company’s revenues rebounded nearly 14% in the most recent year while the company’s gross margin is back to levels from 2007. The company has returned to profitability and, as the following chart shows, has begun earning significant free cash flows again. Moreover, the company’s backlog rose 15% this year and its book-to-bill ratio is now the second highest in its history.

Perceptron, Inc - Cash Flows, 2001 - 2011

Perceptron, Inc - Cash Flows, 2001 - 2011

Here we see the unfortunate variability in the company’s cash flows. Unlike many of the other companies I have profiled, PRCP’s cash flows tend to be hit or miss. When times are good, the company earns free cash flows that are extremely high relative to the company’s enterprise value.

So what determines whether times are good? As mentioned above, the company’s sales declined remarkably during the recession which suggests a degree of cyclicality. This is to be expected once you realize that the company derives nearly 60% of its sales from the auto industry. Scarier yet is the fact that 12% of the company’s total sales are due to General Motors (a further 20% are related to Volkswagen, which is somewhat less worrisome). Furthermore, a third of the company’s revenues are from the European market, which introduces another set of risks as the macroeconomic situation there is far from being resolved.

So where does this leave us? If you believe the last two years to be an anomaly (i.e. that the worst is behind us), and that the company will return closer to its margins from mid-decade, then the company is cheap. On the other hand, if you foresee continued macroeconomic struggles (i.e. that this year’s results are the anomaly in a longer-term muddle through), then this level of exposure to the auto industry would be something you would want to avoid.

My problem with PRCP is that even at its peak, the company wasn’t doing a very good job with shareholder capital, as the following chart indicates.

Perceptron, Inc - Historical Returns, 2001 - 2011

Perceptron, Inc - Historical Returns, 2001 - 2011

As you can see, the company has rarely earned double digits on invested capital. This is hardly anything to get excited over. For a cyclical company, I would hope to see outsized returns in good times to compensate for the rough patches. We do not see this here, even adjusting for the company’s sizable cash balance (Invested Capital = BV Equity + BV Debt – Cash).

There was one other thing that initially attracted me to PRCP. The company recently began buying back shares, announcing a $5 million repurchase plan last year. Over the year, it repurchased $3.2 million worth of shares. The company had a repurchase program once before, beginning in 2005 and ending in 2007, in which it repurchased $10.34 million worth of shares. I had high hopes that something like this would occur again, until I looked at the company’s share count over time.

Perceptron, Inc - Shares Outstanding, 2001 - 2011

Perceptron, Inc - Shares Outstanding, 2001 - 2011

Notice how the company’s shares outstanding declines dramatically, only to rebound again in 2008? This relates to the company’s use of stock options. Since that $10.34 million worth of repurchases essentially offset insider options, this is effectively a transfer of wealth from shareholders to insiders. I prefer share repurchases that achieve the desired effect of concentrating shareholder economic interest, otherwise a dividend is preferable.

There are many things to like about PRCP. It has a low enterprise value relative to the free cash flows we have seen it is capable of earning. Moreover, its strong book-to-bill ratio this year and growing backlog give reason to have confidence in its future. However, given its exposure to the auto industry, concentrated revenues, unstable cash flows and relatively weak returns even in the best of times, I do not believe it is cheap enough to justify a purchase.

What do you think of Perceptron?

Disclosure: No position.

Source: Perceptron, Inc: Cash With Undesirable Exposure