I believe that the company is presenting a compelling opportunity for investors, due to the following points:
- While pressured on cost, the company was able to grow its revenue base rapidly and thus maintain a slim but stable profitability. With the advent of Internet of Things and the continuous need for PCBs this is unlikely to change.
- The stock is undervalued from both a relative and absolute point of view with a price to tangible book being only 0.45, EV/EBITDA under 5 and P/E around 15. The NCAV of the company is also only 25% lower than the share price.
- While the company lacks a precise catalyst, in the past the shares have surged twice without an underlying change in fundamentals. The most recent surge happened in 2014 and since then the company continued increasing its revenue, yet the share price declined.
I believe that despite the slightly negative quarterly result on the 12th of September the thesis still holds.
Share Price Reaction
As you can see the investors were quick to sell out after the results. This erased the gains that the stock was able to make since my first publication in late July.
I believe that the share price move makes partial sense as the company saw a 2.9% revenue decline since Q4 and a decline of 8.25% when compared to Q1 of the previous fiscal year. While the gross margin was not impacted, as the company is operating mainly within a fixed cost environment the net income was impacted and fell by 77% compared to the previous fiscal year.
On the other hand, I would say that while the quarter was not the best, the company managed to turn a profit and did not state that this revenue trend should continue as it was mostly due to slower demand that the management is now seeing slightly reversing. Moreover the undervaluation is still present and thus it is better to continue holding the position and not sell-out after one challenging quarter.
Impact of the results on the investment thesis
- Management remarks about revenue
As mentioned the revenue was the main culprit behind the negative quarter, but the management has stated that they believe second quarter should show improvement as some orders were delayed into Q2. They mentioned that these were already starting to get filled and thus the trend of declining revenue is likely not continue into the next quarter, at least not on the same relative scale.
In the 10Q report the management also mentioned that they are going to continue with their CapEx plan. In this quarter they spent $1.5 million in order to increase their capacity due to the forecasted new demand. They mentioned that they are going to spend another $1.5 million for the remainder of the year. Lastly, they also mentioned that they still believe that the increased demand forecast received last year will materialize and the company might need additional access to capital in order to expand the working capital.
Due to these points it seems that the management does not believe that the revenue declines should continue. For now, I am cautiously accepting the view and will scrutinize the next results.
- Inventory build-up
One thing that could potentially become a burden if the revenue fails to pick up is the inventory as it increased yet again.
This is understandable as the company is expecting extra demand (seen in increasing backlog and aforementioned statements of the company), but the management also stated that the increase in this quarter was also due to the slow demand.
This means that if the demand continues to be slow over the next year parts of the inventory base might become obsolete and one would have to discount the tangible book and NCAV valuation as 36.1% is in finished products as seen below.
That being said if the management statements are truthful, we should see a decline of inventory in the upcoming quarter which could bring in substantial positive cash flow.
In my initiating article I mentioned that I would accumulate my position in SGMA in three phases, first one after 10-K (50% of desired position), second after Q1 (30%) and last after Q2 (20%). I would hold on with the second phase for now and wait until the next quarter in order to see that the revenue decline is not continuous and there has not been any major change in the underlying fundamentals.
Disclosure: I am/we are long SGMA.
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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