Taitron Components - Inventory Net-Net With Minimal Downside, But Unclear Upside

| About: Taitron Components (TAIT)

Summary

This discrete semiconductor company is trading at a severe discount of 40% to NCAV, while being cash flow positive and profitable.

While this seems attractive at first I believe that there are several risks that offset some of the strength in TAIT’s fundamentals.

Mainly that the inventory is slow-moving and should be discounted by the investors as reserve valuation is increasing. Also the stock has been trading below NCAV since the financial crisis.

On the other hand, the business has been able to produce cash flow even despite operational losses and could create shareholder value with the recent build-up of cash position.

TAIT could be a pick for the ‘statistical’ approach to NCAV investing (bigger number of smaller positions) as the fundamentals are strong for now, but might not warrant a share price increase.

Company Introduction

Taitron Components Inc. (NASDAQ:TAIT) is a company focused on distributing discrete semiconductor offerings, which includes rectifiers, diodes, transistors and other similar commodity-like semiconductor products. Discrete semiconductors are semiconductors which are able to provide only a single function as opposed to integrated circuit boards (PCBs etc.) which can have several functions. The company was founded in 1989 and largely operates in the US from a factory in California. The company also has production in Taiwan and China.

Their main focus is on 'superstore strategy' whereby TAIT holds a significant amount of inventory, which they then distribute to smaller original equipment manufacturers (OEMs) in the discrete semiconductor space. They also provide original design manufacturer (ODM) services and other 'turnkey' solutions to these companies. These ODM projects are also utilizing the inventory levels of the 'superstore' as TAIT usually receives a request for a specific custom discrete semiconductor, which TAIT might source from their own outstanding inventory and amend it according to the customer's request.

The current revenue run rate of the company is roughly $6 million a year with an operating margin around 1.6% (trailing twelve months). Approximately 60% of the revenue is coming from the ODM services and 40% from the sale of the discrete semiconductors components as noted in the latest 10-K. Geographically-wise 87% of the revenue is coming from the US, with other foreign countries (China, Taiwan, Mexico etc.) covering the rest with no country accounting for more than 5% of the total revenue.

Finally, the company has relatively concentrated customer base with two unspecified customers accounting for 47% (37% and 10%) of the revenue for FY2015, which is consistent with the historical customer concentration.

Investment thesis

I believe that investors could contemplate a position in TAIT because of the following points:

  • The stock is trading at a 40% discount to NCAV. The NCAV value consists roughly of 30% of cash, 60% of inventory and 10% of other assets. For some this discount might seem excessive as it discounts the current inventory levels by roughly 50% (holding everything else constant).
  • While the business is not extremely well positioned for the long run due to the maturity of the discrete semiconductor market, the management has been able to breakeven in the last two quarters, improve margins and grow revenue. In the past, the company was also mostly profitable if one takes away the cost of increasing provisions for the obsolete inventory. They were also able to generate cash through their operations. I believe that there is no reason for all this to suddenly stop, which means that the company could continue to generate free cash flow.
  • The company has now a build-up of cash at similar levels to 2010/2011, when the management decided to invest the money in several joint ventures. This could mean that they could soon utilize the cash position again. They already announced a minor quarterly dividend.

On the other hand, I believe there are several risks that one needs to understand:

  • The inventory is slow moving and it is possible that large parts of it are indeed overvalued. While the company was able to shed the book value of the inventory by almost $5 million from $12 million to $7 million in 5 years, this was mostly done by continuously increasing the valuation reserve. The days inventory outstanding (DIO) is also worryingly high as it now stands at around 600 days. This might mean that the NCAV discount is called for.
  • The management owns a substantial part of the company and controls the voting, which could mean that they might not have the interest of the minor shareholders at heart.
  • The company has been trading below NCAV for most of the time it was listed, which could again suggest that the discount is called for.

In other words, the stock is a good illustration of a net-net without any clear catalyst yet possible margin of safety, but with a history of trading below NCAV. Therefore, I believe that if the management does not decide to utilize the cash position for something that could create shareholder value, the share price could continue to languish below the NCAV value of the business. I would therefore label this stock as 'statistical' NCAV pick.

It makes sense to have a small position in the stock as it could appreciate should the operations continue to break-even and create free cash flow and/or should the management utilize the cash position to provide shareholder value. On the other hand, if there are no visible improvements, I do not see a reason for the stock to be trading at its NCAV value for now.

Business Overview

As mentioned, the company is situated in the discrete semiconductor market and acts as a distributor to OEMs that need access to a broad product offering as the OEMs do not want to hold large inventories due to working capital constraints. The large suppliers of these discrete semiconductors are allowing TAIT to distribute their products as they themselves would not be able to focus on this smaller market of the semiconductor world. This then allows TAIT to earn a profit on providing this service as they take on the 'burden' of the inventory levels.

While the discrete semiconductors are a stable part of the semiconductor offering, throughout the history they were frequently replaced by integrated circuits, which allow for more than one function of the semiconductor device and therefore are preferred in most of the semiconductor applications. That being said, the demand for discrete semiconductors is unlikely to suddenly stop and the product offering still has many viable applications that are utilised every day.

The maturity of the demand for these products can be well seen in TAIT's revenue, which has been moving sideways since the financial crisis.

The inventory has also been proven to be slow moving and while the company's balance sheet is showing that they have continuously shed the inventory levels, a closer look on the state of the inventory shows that they partially achieved the lower inventory levels by increasing valuation reserve for obsolete inventory.

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The days inventory outstanding ratio also confirms that the company is slow in reducing the inventory.

Albeit the company does seem to be getting slightly better at that as seen below.

Finally, the management has been continuously reminding investors this following fact:

We continue to be impacted by the severe decline in demand for discrete semiconductors from the U.S. market, which began in late 2000. As a result, we have experienced declining sales in such components since early 2001.

Source: 10-K for FY2015

This then confirms that TAIT is likely facing a long-term secular decline of its business as the demand for discrete semiconductors is not growing, which had an impact on the profitability of the business prior to 2016 as seen below.

Note: Graph ends in 2015.

That being said one has to remember that the company is annually increasing its inventory provisions, which negatively impacts its cost of goods sold. This then dampens the overall picture of the business margins as you can see that the actual economic earnings shown below are showcasing that the business has suffered only minor operational losses in the past 5 years.

Click to enlarge

Despite the slightly more positive picture, the management has mentioned that they understand the long-term risk of the discrete semiconductor market shrinking and thus the company decided to partially alter their business strategy in 2012, which seems to be working for now as seen in the latest margin trends.

The company achieved this margin improvement by offsetting the discrete semiconductor market decline by shifting focus from being predominantly a distributor to utilizing parts of the superstore inventory as a base for the ODM services and projects, which carry higher gross margins and are likely to also optimize the operating costs. Prior to the shift, the ODM services have accounted approximately for 15% of the revenue, but are now roughly 60% of the revenue base.

This shift has been also supported by two investments (Zowie Technology & Grand Shine Management) that the management undertook in 2011. TAIT invested into these two joint ventures in order to help TAIT with its costs regarding the ODM projects. While it seems that they did indeed work towards the benefit of TAIT (as the margins improved) the value of the joint ventures have been either reported at an investment loss or the investment was impaired, which slightly contrasts the outcome for TAIT. This is the latest status of the investments.

Click to enlarge

The company does not explain why they impaired the investment values other than the usual commentary about not being able to recover the original amount. I would say that it is definitely negative to see this happening, but the value of the investments are not likely to significantly impact company's ongoing operations.

To conclude, while it is clear that the company is not in an advantageous position market-wise, I do not believe that it should see the business evaporate completely in the near term as they have been able to offset part of the demand decline by focusing on the ODM projects.

Cash Flow Strength

As I believe that the business is not going to be significantly disrupted in the short term, cash flow of TAIT is then the strongest argument for a long position. The company has been able to continuously create positive cash from operations despite the income statement 'losses' as seen below.

And because the company has little capital expenditure (the inventory purchases are part of operations) and little need for financing, then most of the operational cash flow turns to free cash flow and the company is able to grow its cash position.

As mentioned, you can see that the cash position is at the same levels as around 2011, when they invested in the two joint ventures. This might mean that the management could be looking to do something with its cash position yet again.

NCAV value & Inventory

Because of the strong cash flow, the cash is now accounting for around 30% of the current assets as can be seen below.

Note: The NCAV value does not include approximately $4.1 million in PP&E, which could support even deeper undervaluation. The price to tangible book ratio is roughly 0.4.

While it seems that there should be plenty of margin of safety for the inventory as the NCAV discount is close to 40%, I believe that it is prudent to discount a portion of the inventories. The current inventory discount implied by the NCAV discount is roughly 52% (I held everything else constant and just lowered the inventory levels to match the current market cap - i.e. in this case the inventory levels are $3.82 million). This does not seem to be completely unreasonable as I pointed out that the company continues to increase the reserve valuation and struggles to meaningfully shed the inventory levels.

Moreover, one also has to scrutinize what happened with the inventory in 2015 10-K when the company suddenly reported lower valuation reserve as seen below.

Note: The missing data in 2014 is intentional as they are not relevant for 2015.

What I am trying to stress here is the fact that from the data it seems that the company most likely sold/used almost $1.5 million of obsolete inventories whilst buying up a significant amount of new inventory as the cash flow report showed a $1 million increase in inventories (cash outflow). Despite the significant size of the sold/used inventory the revenues were stagnant and the gross margin did not move either. This could mean three things.

First scenario could be that the management has sold the inventory for almost nothing (as there was no revenue or margin increase) and therefore this could mean that the inventory is indeed highly overvalued. Second scenario might be that the inventory was somehow used in their operations, which would be neutral as that would not impact the thesis in any way, but this is unlikely as this change is unusual and did not happen in the past.

Lastly, it could mean that the company is going to value inventory differently going forward. It might well be that they used to attribute the reserve valuation to the old inventory, but not the new (the one that was bought in the current period). Therefore if the 'old inventory' was either depleted or the company believes it is no longer obsolete, the reserve valuation is not going to be assigned to the incoming inventory. This would be definitely positive for the stock and the thesis, but it's unlikely to be the case as I don't see a reason for this change in the inventory valuation right now.

This change in the reserve was not commented on by the management and therefore one can't be sure what happened, but the worst-case scenario is that the company sold this inventory cheaply, which reflects that the provisions are useful and that it is possible that if the company continues to increase the valuation reserve then the NCAV discount is definitely called for.

Especially when this discount has been present in the stock for the last 8 years. Although this could change as the business is breaking even after a long period of losses.

Finally, I would also mention that there are possible long-term regulatory issues with the inventory (linked to lead) that the company owns. This is mainly revolving around the EU legislative 'Restriction of Hazardous Substances', which banned majority of TAIT's product offering in Europe. The US has not adopted similar laws (albeit California has a 'light' version of the legislative), but if this should be the case it could impact TAIT's business significantly.

With regards to the liabilities, they do not seem to pose a threat to TAIT as the debt, the biggest liability, originated from a related third party in 2008, when the company needed financing to get through the financial crisis. The repayment of this debt has been prolonged ever since and is currently due June 2018, but the company has extended this due date several times already. This means that it is unlikely that the liability will become a pressing issue.

Ownership Risk

On top of the uncertainty regarding the NCAV value, there is also the question of the management, which has been around the company for more than 20 years in almost unchanged ensemble and controls the company. The CEO, Mr. Stewart Wang, owns 26.3% of the common shares and 100% of Class B shares, which carry voting power. This gives the CEO 61.5% of all votes. The Chairman, Mr. Johnson Ku, owns 24.2% of the common shares, but has only 9.6% of voting power.

The biggest risk is that they are going to use the cash that they built up in the last three years to either unproductive effort or to mainly enrich themselves. The first part seemed to already happen as I mentioned that both of the joint ventures from around 2010/2011 have investment losses and/or have been impaired. I understand that the joint ventures might have been beneficial for the business, but the lack of transparency as to why they are being impaired is troubling.

The second part is partially happening now as the company did recently announce an annual dividend, but the distributions also go to the holder of the Class B shares, Mr. Wang. This means he will be able to receive most of the dividends. So far the dividend is not substantial ($0.5 million per year), but should the management increase the payouts, it would mainly benefit the CEO.

On the other hand, the management does seem to want to keep the company publicly listed as the insiders had a peculiar buying pattern of the stock when the share price was below $1, which is the required minimum for continuous listing.

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Note: The rest of the pattern can be seen on openinsider.com

This is could definitely be seen as positive as the owners are likely to believe that TAIT's share price is going to increase at some point.

Additional risks of the company

  • Further increase in inventory reserve or inability to drive cash flow

The attractant of the business stands at its ability to create cash regardless of operational performance. If the company fails to continue to sell off inventories, which it has been doing so at a slow pace, then the business is not going to show much fundamental strength.

  • Customer base is going to be acquired, which could lead to a loss of business

On top of the fact that the discrete semiconductors market is mature and likely to shrink over the long run, the semiconductor industry is also undergoing a consolidation, which could put smaller players under strain or completely out of business. This could then threaten the business model of TAIT as a distributor as larger players would likely deal directly with manufacturers and not with TAIT.

Conclusion

I would say that it is very well possible the share price will appreciate, but many of the long arguments can be negated as of now.

While the company has been able to turn around its operations and become profitable, the NCAV value discount is maybe called for as parts of the inventories are likely to be obsolete. Also the likelihood of continuous profitability is uncertain as the long-term outlook is not bright for the discrete semiconductors.

Lastly, while the company has been able to build up a cash position, it is unclear whether the management is going to use it for anything that would create shareholder value as their track record of capital allocation does not seem to be strong. Therefore investors that are focused on the statistical approach to NCAV investing might want to consider TAIT as it is likely that the downside is limited. I believe that investors that hold a more concentrated portfolio are better off staying away as the upside is unclear for now.

Finally, I would say that the stock is similar to ADDvantage Technologies Group, Inc. (NASDAQ:AEY), which I covered recently here. The companies share a business model, which is based on holding extensive inventories which account for most of the NCAV value. AEY also has a history of trading well below NCAV for a prolonged period of time and is also not extremely well positioned in the long run (main revenue stream is declining). Despite the similarities, I conclude that TAIT is a better candidate for a position than AEY.

The main difference is that the business of AEY is not showcasing 'stability' as TAIT is. AEY also needs to focus on building a new revenue stream because of that instability, which might result in burning the NCAV value. TAIT might be in the same position in the next 5 years or so, but it is not in immediate need of change as of now and therefore the management is less likely to burn the generated cash.

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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