Taitron - Downside Still Limited, Upside Still Unclear

| About: Taitron Components (TAIT)

Summary

TAIT reported slightly positive results, which did not seem to change the initial thesis.

The company remained profitable and created meaningful operational cash flow, but failed to shed its inventory levels and increased its valuation reserve.

This supports the argument that a NCAV discount is called for, although as the valuation remains unchanged, the downside risk does not seem to be larger.

The same might apply for TAIT's upside, as the company did not alleviate the uncertainty about the long-term outlook of the operations.

The CFO's past does not add to the positive arguments.

I initially covered Taitron (NASDAQ:TAIT) here. My investment thesis was based on the following points:

  • 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 buildup 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.

I believe that all these points hold and the stock remains on track to showcase limited downside, but unclear upside.

Share Price Reaction

As you can see, since my article in the middle of October, the share price has appreciated. This is most likely because of the earnings report that was filed on Nov. 14. I believe that the share price action is reasonable given the results, which were mostly positive and did not showcase any new negative trends.

The company was able to continue to break even and drive operational cash flow that helped to pay off $0.5 million of company's debt. On the other hand, the company continued to increase the inventory reserve and did not showcase that they should be able to grow their revenue stream significantly. Thus, the upside remains unclear and I would not deviate from owning only a small "statistical" position as the valuation of the stock remains similar to what I said in my earlier article.

Operational Results

In order to get a clearer picture of the results, we need to take away the inventory provision, which distorts the economic earnings.

While it seems as if the profitability is indeed getting better or at least is sustainable (the company tends to change the inventory reserve significantly at the end of the year, which could impact the profit), the long-term outlook was unchanged this quarter. This means that the company still faces an uncertain long-term future, as the market for discrete semiconductors is likely to be mature and might slowly start to decline as integrated circuits are going to continue to replace it.

Cash Flow and Inventory

On the back of these results, the company was able to increase its operational cash flow by roughly $0.4 million this quarter to arrive at $0.7 million for the past nine months. This meant continued free cash flow generation. The company used this excess cash to pay down $0.5 million of its long-term debt that originated from the financial crisis and was lent to TAIT by a company that is controlled by the brother of TAIT's CEO. The remainder of the liability should now stand at $1 million. The company most likely make a mistake in their 10-Q, however, as they recorded the payment in cash flow and the balance sheet, but mentioned the following:

As of Sept. 30, 2016, and Dec. 31, 2015, the aggregate outstanding balance on this credit facility was $1,500,000. Effective on Sept. 30, 2016, we executed a fourth amendment to the secured credit facility agreement extending the due dates of the unpaid balances to periods from between June 30, 2017, to June 30, 2019.

I have spotted several mistakes in their reporting in the past (for instance, the Q2 FY 2016 cash flow header says March instead of June), so it should not really be a major issue. You can also see that the company again extended the due date of the long-term liability, which supports the view that the company is unlikely to be forced to pay it down anytime soon.

While cash flow continues to be strong, the company remains unable to shed its troubled inventory levels and keeps on increasing the valuation reserve. The company's days of inventory outstanding is still fluctuating in the usual range, and the gross amount of inventories is also unchanged since last quarter, as seen below.

Should this trend continue, the upside will remain unclear as we can't be sure at what NCAV discount the company will trade due to the likely overvalued inventory levels.

CFO's past

In the comments on my initial article, Seeking Alpha user Pestilence raised an important point, which I previously did not cover. That is that the current CFO of TAIT, David Vanderhorst, has been a director of a company that collapsed under allegations that it was a classic "pump and dump" scheme operating via broker kickbacks for selling the stock of the company. ForceField Energy was run by Richard St. Julien since 2009 (back then it was named Sunsi Energy), and Vanderhorst joined as an independent director in 2011. He was also a member of the nominating, compensation, audit and corporate governance committee.

The pump and dump scheme allegedly operated from December 2009 until April 2015, whereby St. Julien was using different brokers to prop up the stock, as seen in the SEC complaint. This means that Vanderhorst was present for the whole time period of the scheme. He resigned only in September 2016.

What is positive is that Vanderhorst is not named in the main SEC complaint, which states that the schemes were set up by St. Julien. This means that he likely did not actively participate in the fraud. The SEC complaint was a basis for the $131 million charge that the participants are now facing. Despite this, the situation is not much better when it comes to Vanderhorst.

One has to ask why Vanderhorst agreed to work with St. Julien in the first place, when his record was already tarnished by involvement in dubious activities. Namely, in 2009, two years before Vanderhorst joined the board, St. Julien acted as a lawyer of Lafleur, a Canadian who failed to disclose material assets from tax authorities for which he was sent to prison. St. Julien should have played a role in the failure to disclose the assets, as suggested in this "Globe & Mail" article and this legal complaint.

Also, Vanderhorst is named as a defendant in a shareholder class action regarding ForceField. The case is currently on "stay" and might not have an impact on Vanderhorst, but the potential liability is there. Whatever Vanderhorst knew or did not know, it does not help the perception of his ability to oversee a company's operations.

Conclusion

Given the fact that not much has changed since my earlier article, it might be beneficial to continue owning a minor position in TAIT. The downside will likely remain limited, as the valuation did not significantly change. But I continue to believe that some discount to NCAV is likely, due to the valuation reserve and the uncertainty regarding the long-term outlook for the underlying operations.

I would also mention that it is still uncertain what the management is going to do with its significant cash position, which is now roughly the same amount as it was in 2011, when the company last decided to utilize it. Back then, TAIT invested most of the cash into dubious joint ventures. Since then, these have constantly lost value. Should management repeat such investment, it could take away a significant upside argument. This would then be detrimental to the current shareholders.

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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