Electro Sensors, Inc. (NASDAQ:ELSE) manufactures sensors for use in industrial applications, which monitor and control various stages of industrial processes. The company's sensors are used for a variety of measurements, including those based upon vibration, temperature, speed, production quantities, tilt and gate switch position. In the past few years, the company's product lines have been updated to include more wireless capabilities. The improvements have come through the acquisition of a new technology and also through internal research and development.
The sensor business provides the main basis of operations for the company going forward. However, in the past the company also had a stake in two other companies. These stakes caused net income to vary wildly from one quarter to another as shares were sold at the discretion of management. As of the latest quarterly report, the company no longer has any securities available for sale. The proceeds of these past investment operations have all been converted to cash and cash equivalents.
The divestiture of the company from other businesses has given the company a large pile of cash with essentially no long-term debt. A bullish case could be made for the company based on three traditional routes companies take with excess cash. First, the company could use the cash to improve existing products and fund new products. Second, the company could use the cash to acquire new technologies, something the company has already done. Lastly, the cash could be returned to investors through dividends or share buybacks, something else the company has done in the past.
All data for this article sourced from SEC filings through the Nasdaq website.
The Balance Sheet And Cash Position
Electro Sensors has a healthy balance sheet on both sides of the equation. For the most recent quarter, there were no signs of anything to worry about, other than perhaps the under utilization of cash. In the past, available securities for sale made the true value of the company harder to determine as market prices would cause this total to fluctuate and the company would sell shares from time to time. Now all of this is behind the company and the balance sheet is clean and simple.
A big concern for many investors is debt. Long-term liabilities total $0.455 million in earn outs related to an acquisition. If the company has to pay these earn outs, the payments will be as a result of product sales. For a long-term liability, earn outs due to product sales are one of the better liabilities to have. Short-term liabilities are $1.23 million. This number will decline in the future, as $0.390 million is due on a note payable, which will retire this note. Also on the right side of the balance sheet equation is $12.1 million in equity, comprised mostly of retained earnings. Thus, long-term debt to equity is a negligible 4% and there is nothing of alarm on this part of the balance sheet.
What really makes the balance sheet stand out is the cash. A whole pile of cash for a company this size. Cash plus Treasuries adds up to $8.58 million. This number trumps the trailing twelve month sales total by $0.85 million, at a time when the company is reporting record sales numbers. Inventories and trade receivables also have grown in recent quarters as a result of increased sales. The current ratio is now 6.9, which will improve considerably after the note payable falls out of current liabilities. Simply put, the company has plenty of cash to fund operations, with room to deploy the available cash.
The table above displays some key ratios of the balance sheet and how these relate to the recent trading area for the stock. The company is trading around 1.5 times cash and 1.2 times tangible equity. For a growing, profitable company, none of the ratios presented seem out of line, with the exception of the return on equity. For the purpose of this article, I'm considering only the operations part of the business. Operations returned a mere 3% on equity. However, much of the company's capital was tied up in investments in the past. As the company focuses more on operations and deployment of cash, return on equity should grow as well. Overall, the balance sheet is incredibly healthy and should improve more as operations become a larger part of the business.
Option 1 and 2 For Cash Deployment: Organic Growth And Acquisitions
From fiscal and calendar years 2011 through the third quarter of 2014, the operating business of Electro Sensors had stagnant sales. Earnings, though increasing in 2011 and 2012, were hit hard in 2013. Margins were hit as well, with after tax margins bottoming at 2.1% in 2013, from a peak of 8.3% in 2012. For the purposes of this article, after tax margins and EPS have been calculated based on operating profit minus taxes. The focus of this article is on the operating company going forward as the company does not intend to be in the investment business in the future. From the 2015 third quarter 10-Q:
"Through its subsidiary ESI Investment Company, the Company has periodically made strategic investments in other businesses, primarily when the Company believes that these investments would facilitate development of technology complementary to the Company's products. Although the Company, through ESI Investment Company, has invested in other businesses, the Company does not intend to become an investment company and intends to remain primarily an operating company. During 2015, the Company sold substantially all of its equity securities."
In 2013 the company took the first of two steps to improve operations - Electro Sensors went wireless. The company launched a wireless console to help run its products, eliminating the need for costly and space consuming wires. This is a good example of trying to grow the company organically. In 2014 the company increased R&D expense by $0.25 million and for the first nine months of 2015 R&D expense was reported in line with 2014. With a large cash position, the company can fund future internal product developments without sacrificing cash needed for operations.
In February 2014, the company completed the second step to improve operational results - Electro Sensors acquired the Insta-Link wireless product family and re-branded the product line as HazardPRO. The total cost of the product was $1.2 million, with up to $0.55 million in potential earn outs over four years. The large cash position allows the company to pursue additional acquisitions in the future to complement or improve operational performance.
The efforts of the company have paid off in increased sales. Trailing twelve month sales have increased for each of the past six reported quarters and quarter over quarter sales have increased for the past eight consecutive quarters. Sales are now at quarterly and trailing 12-month records. Finally, the bottom line for operations received a boost, with Electro Sensors reporting the highest operating profit of any time in the last six years (as far back as I went for this article). Below is a picture of the company's trailing twelve months sales and earnings:
Now to put a reasonable valuation on the company as it stands. So far the company's efforts have paid off, with a resultant increase in sales and now operating profit. Operating profit and margins should continue to grow as the new HazardPRO line increases in volume. From the 2015 third quarter 10-Q, the company states:
"For the 2105 and 2014 nine-month periods, the gross profit margins were 56.1% and 58.2%, respectively. Gross profit margins were lower in the 2015 periods due to higher manufacturing costs on the initial HazardPRO products. We expect to decrease HazardPRO manufacturing costs through production efficiencies and increased purchasing volumes."
Assuming a slower growth rate in sales, but an increase in margins, here is a conservative projection of growth in the coming five years:
I assumed a 12.8% growth in fourth quarter 2015 sales, which is the sales growth for the first nine months of the year. Of course the company may not grow at a 10% clip, margins may decline for one reason or the other, and other events may occur. However, the company is focusing on operations, has grown the product line through internal R&D and through an acquisition, and the company has plenty of cash with no meaningful long-term debt. All of these factors lead me to believe the company should sustain moderate growth going forward, with at least moderately increasing margins.
So, without any further investments in the operations, Electro Sensors appears to be fairly valued. Over the next five years a moderate growth rate would give the company around $0.65 in earnings cumulatively, and the company has equity, less intangibles of $2.94 currently. Between the two, shares look accurately priced. However, the company has already shown a propensity to fund new product development and acquire new technologies. Any efforts to do so in the future would leave shares undervalued and due for an advance.
Option 3 For Cash Deployment: Returning Equity To Shareholders
Two common ways a company returns equity to shareholders are dividends and share repurchases. Not everyone considers returning equity to shareholders as a positive quality of a company, but for small caps in certain niche markets I consider these actions as a bullish reason to buy a company. In the past, as the company's investments were unwound, Electro Sensors paid a regular dividend. From the fourth quarter of 2003 through the second quarter of 2013, the company paid a quarterly dividend of $0.04 per share. In the second quarter of 2006 the company paid an extra $1.00 as a one-time special dividend. However, the dividend policy was suspended in 2013. There can be no assurance the company would pay a dividend in the future, but the idea is certainly not a new one.
The company could also repurchase shares. At $3.60 a share the company could repurchase all of the floating shares of the company and still have over $2 million in cash. Although this has not been an option used by the company in the past, one could see a share repurchase in the future, with so much cash on hand. Any repurchase of shares would give remaining shareholders a larger stake in the operations of the company.
A return of equity to shareholders also may be favorable in the future due to the controlling interest owned by one person. The wife of a deceased board member owns a 51.7% stake in the company, effectively making her a controlling interest. Her son also is a board member and has options to buy 22,500 shares. Employees own over 4% in the company's retirement plan and board members have options to acquire 4% of the company. All together insiders and employees own around 60% of the company. Although returning equity to shareholders is not a given, a controlling interest and a good sized stake for employees are often precursors to such uses of cash.
For investors there are many caveats related to Electro Sensors. First and foremost the company is very small. With a current market cap of around $12 million and a float of under 1.8 million shares, the company can be easily manipulated and is subject to wild swings. The bid and ask range at any given time is likely to be 5% or higher and often under 1,000 shares are traded in a day. Shares of Electro Sensors are very thin, making it hard for investors to easily move in or out of shares.
Second, any investment the company may make to grow operations might prove unprofitable. Investing in a new technology through R&D or through another acquisition is always a risk. In order to improve returns on equity and increase operational performance, the company will have to invest profitably in new products.
Third, the company may remain stagnant for several years or operations may decline. Right now the company is fairly valued by my measure. Without additional investments in the business or a return of equity to shareholders, there is little upside to the company. Although there is possible upside to my conservative projections, there also is possible downside.
There are plenty of other risks, but the last major risk of note is the majority shareholder. At any given time this shareholder could decide to sell shares and dilute the market or the company could be sold out with little upside to shares. One majority shareholder means what is best in one person's interest is going to be the course for all shareholders.
After a long history of volatile results, Electro Sensors has sold off investments and is now focusing on operations. Currently, by my estimation the company is fairly valued, based on an under utilization of cash and operating results which don't leave upside for the current share price. However, the company has a pile of cash. In the past few years the company has used cash to fund internal growth and to acquire a new technology. This focus on operations leads room for upside potential in the company's value in terms of equity and share price. Additionally, a return of equity to shareholders, should the company choose to do so, would yield an increase in value as well.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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