Trio-Tech: Stale Status Quo, Most Likely A Value Trap

| About: Trio-Tech International (TRT)

Summary

TRT is a niche manufacturer of semiconductor equipment and tester of semiconductor products. It is mainly operating and selling its products in Southeast Asia.

While TRT seems to be severely undervalued (on the basis of P/TBV, EV/EBITDA, etc.), the business prospects, operations and dubious Chinese real estate assets show that the valuation is justified.

The company’s risks are further increased by TRT’s reliance on one customer for over 60% of the revenue and its inability to turn its biggest revenue stream to profit.

Thus the stock is best avoided as of now.

Company Introduction

Trio-Tech International (NYSEMKT:TRT) is a manufacturer, tester, developer and distributor of various semiconductor-related products. It was incorporated in 1958 in the US and is headquartered in Van Nuys, California. The company operates six different facilities, one in the US and five in Southeast Asia, specifically China, Malaysia, Thailand and Singapore.

Below we can see the revenue segmentation of each of the revenue streams.

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The company also has several real estate assets in China from which it derives an insignificant amount of rental income. Geographically the company sells mainly in Southeast Asia and does not break down the sales further than that.

Industry Overview

The company is tied closely to the semiconductor industry, specifically to the semiconductor equipment used in the production process' last stage, testing. In essence, TRT is used as a company for outsourcing of manufacturing of some of these products. The company also provides testing itself, again on an outsource basis.

Manufacturing

TRT manufactures several products both on the front-end and back-end of the testing process. An example of a front-end product can be 'Wet Process Stations,' which are used for handling chemical processes with the wafer chips, which increase reliability for controlling for impurities.

A back-end example can be equipment used for the actual process of testing such as 'Autoclaves and HAST (Highly Accelerated Stress Test) Equipment,' which simulate an extreme scenario in a short-time span in order to validate the chips preparedness.

All of these products that TRT and many other manufacturers produce have a limited variability of the product offering. Thus one can think about them almost as commodities, which are unlikely to be significantly profitable. TRT's own operational results support that as this revenue stream is struggling to turn a profit. The key advantage that one can have in this space is likely an economic scale, whereby the production cost can be minimized.

Turning to the big picture, the developments of the semiconductor equipment revenue are not overtly positive as the revenue has been volatile after the crisis. Smaller producers such as TRT are also more exposed to the macro developments than others as during the crisis many major semiconductor players pushed for in-house solutions as outsourcing is a source of increased costs.

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That being said the start of 2016 shows that the billings are increasing (book-to-bill over 1).

And the positive trends are likely to continue due to the slow advent of Internet of Things (IOT), which PwC dubbed 'the next growth driver of the semiconductors industry.'

Although all these opportunities and trends will be almost impossible for TRT to capture as it has a limited customer base and insufficient financing to explore these possibilities.

Testing Services

For TRT, this segment is the most important one as it renders the company profitable. Testing is a ubiquitous process for semiconductors and outsourcing of the process is desirable as the outsourcer can retain its core focus and save time.

The testing process is going through a slow shift as it is becoming one of the key cost factors for the bigger semiconductor players. The reason for that is that as the chip size is shirking (Moore's law continues to be valid) and with it its cost, there is a decreasing amount of cost-saving opportunities and thus testing is now scrutinized more than ever. This can also potentially create a vicious circle for the smaller testers as they will not be able to keep with the revenue declines.

Testing is also going through increasing technological advances, which make use of new software approaches that potentially could be used as a differentiator, when choosing among tester companies.

That being said, the testing segment revenue is actually expanding and is forecasted to expand (at CAGR of 4.7%) alongside the broader semiconductor industry.

Although again, for TRT it will be challenging to expand in this space as the company is limited by its size. The company's marketing efforts are also likely to be minimal as the revenue did not see any significant developments in the last four years.

Investment Thesis

While the stock seems to be undervalued at the first glance as it is trading at 0.62 P/TBV, the business is not resilient enough to make this a buy. The company is relying on one customer for 60% of its revenue with a history of significant operational volatility. Furthermore, the management is not supporting the operations as it focuses on dubious revenue streams, such as Chinese real estate. The board is also preventing any breakthrough of the status-quo due to the fact that the same board has been with the company for over 20 years.

Margin Of Safety

When I decide upon the thesis, I always adhere to the following three points in the examination of its prospects, business moat, financial stability and valuation.

  • Business moat, which creates significant free cash flow.

As we have seen in the industry overview, TRT is not unique in its product offering, customer focus or geographies and is competing with many similar companies. Thus the moat of the company is limited to customer relationships and TRT's ability to sustain its contracts.

I have also pointed out that the markets where TRT is operating are growing, but the providers of outsourcing services, such as testing or manufacturing of non-core products, are going to be pressured with regards to the cost.

While TRT's overall margins do not seem to be in a negative trend, what matters is that the company is not able to turn a profit on its biggest revenue stream, manufacturing.

As you can see the only segment that renders the company profitable is testing, which as shown could be under increased cost pressure. The variability of the profitability is also further burdening the company's operation.

This then negatively translates into free cash flow production.

Furthermore, when the company created a significant amount of free cash flow (years around 2008), it decided to spend the money on buying up Chinese real estate, which proved to be an unreasonable decision as I show later on in the risk section.

Despite the volatile and weak fundamentals, the outlook is not necessarily negative for the upcoming year as the state of backlog seems to be stable, although the decline in testing could be harmful for the FY2016 results.

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The account receivables also increased by 14% in the latest quarter, which is again showing that not much is likely to change in the few upcoming quarters.

Finally, when we compare TRT's operations with its two main competitors, the company is not falling behind and showcases similar trends.

Aehr Test Systems (NASDAQ:AEHR) is a manufacturer and provider of burn-in and testing services for the semiconductor industry. inTest Corporation (NASDAQ:INTT) is a manufacturer and provider of thermal testing services for the semiconductor industry.

To conclude, the company is operating almost without a moat and the margin situation is bleak, especially when the major revenue stream continues to be unprofitable. This then creates significant drag on the margin of safety.

  • Financial stability that ensures the investor that the company won't have any issues with their obligations.

TRT is satisfactory at this point as the company is not under any pressure from its financial obligations. The company is maintaining three credit lines as seen below.

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These are mostly unused and the company has more cash than the amount of the debt outstanding. Historically the situation was similar.

The only other financial obligations that the company has are its operational leases on several facilities, which amount to $3 million (spread out in the future), but are likely to increase as some of the leases with expiry soon are probably going to be renewed. This could then increase the lease commitments by a significant amount, but this should not be an issue if the operational cash flow remains similar.

  • Favourable asset valuation so that whatever negative information will surface the stock, if impacted, is not likely to lose significant amount of value at once.

While on the first glimpse the stock seems severely undervalued, we must remember that the company's earnings are volatile, therefore P/E is not telling the whole story. The tangible book is also slightly distorted as it does not include around $3.8 million of the aforementioned operating leases that the company has in place.

If we include these leases then we are looking at 0.77x, which is not as attractive as before when we take in consideration that one can apply discounts to several of the company's assets, namely the Chinese properties, which are in a continuous loss and thus of doubtful value for other investors. If we take for example a 50% discount on these, the ratio would climb to roughly 0.87x. One could also apply a general discount of stock illiquidity and we could be looking at a tangible book roughly in line with market capitalization of $12 million, which further deteriorates the margin of safety as the company's profitability is in question for the upcoming years.

John Leonard, a micro-cap analyst, suggested a break-up of the company in 2013, when the discount in tangible book was probably unreasonable. I agree that the company could be worth more if bought by someone, but the likelihood of that is small due to the management, which I cover further in the risk section.

Although standalone, the company does not look as attractive as one might think; peer valuation suggests that a discount could be present, but this does not offset the lack of margin of safety in the business moat.

Risks

Investments into Chinese real estate

Unfortunately when TRT was able to increase its cash position during favourable years, the company decided to invest into the Chinese real estate market, which proved to be a waste of money. The company purchased three properties (MaoYe, JiangHuai and FuLi in Chongqing, China) that do generate rental income, but in the end lose money as seen in the business moat section. The company also provided two loans to Chinese developers, one of which the developer defaulted and TRT is unlikely to ever recoup the cash.

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While the dollar amounts are not going to pose a significant issue for the company, the main point is that the management should not venture in such business opportunities when it is in the business of semiconductors.

If the company has ever again several windfall years that provide it with increased cash position, the company's management could again decide to pursue dubious business opportunities and thus further destroying shareholder value.

Stock Ownership & Board Management

Ownership is in the hands of a small group of insiders, although they fall short of controlling the business, as their stakes combine to 43% of the company. There is also limited amount of institutional owners with FMR LLC, which holds 7.2%, being the most significant one. This concentrated ownership could be of an issue, if the insiders suddenly decide to sell, albeit historically the insider action has been limited and mostly positive.

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The board itself is also an issue as it has not seen change for over 20 years. Moreover it is rather a small board with three insiders and only two independent directors, which also do not have any experience in the semiconductor industry. The Chairman A. Charles Wilson, who is now 91 years old has been with the company for over 40 years.

The CFO, Mr. Richard Horowitz, recently had issues with law in the case of mis-selling variable annuities to the terminally ill. He has settled the charges with the SEC in 2014. While this is not implying anything with regards to TRT, it definitely does not help with the perception of the board.

Thus it seems that the management is imposing a stale status-quo onto the company's prospects.

Customer Concentration

The company relies on several major customers for its revenue stream as can be seen below.

'In fiscal year 2015 and 2014, combined sales of equipment and services to our three largest customers accounted for approximately 72.2% and 70.9%, respectively, of our total net revenue. Of those sales, $21,503 (63.4%) and $21,986 (60.6%) were from one major customer for fiscal years 2015 and 2014, respectively.

Although the major customer is a U.S. company, the revenue generated from it was from facilities located outside of the U.S. The majority of our sales and services in fiscal years 2015 and 2014 were to customers outside of the United States.'

Source: 10-K for FY2015

Previously mentioned companies are AMD, Freescale semiconductor (NYSE:FSL) and as you can see the biggest customer is a US company, which confirms that it could be either of those two.

The risk here is obvious. Should the major customer switch to another tester/manufacturer, TRT would be left without meaningful revenue streams going forward. The company could also improve disclosure about this risk as there is not much information one can gather about the extent of this risk.

Conclusion

Most of the time businesses with low or almost non-existent moat continue to win business because of their long-standing customer relationship and built-in convenience. This is hard to quantify and presents a weak margin of safety, which needs to be offset by other positive fundamentals. TRT is not presenting any such fundamentals as the company's margins and revenue streams are volatile year over year and thus one can't be sure about the stability of the cash flow coming into the business.

The valuation is not supporting this as the company is not trading at a significant enough discount.

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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