Note: This is a follow-up to the previous Monte Sol write-up on IEC, which you can read here.
The table below shows a relatively comprehensive list of North American exchange-traded electronic manufacturing services ("EMS") companies. These companies are sometimes referred to as contract manufacturers because some or all of the goods they manufacture are ultimately sold by another company, under another brand name.
The P/E ratios for the industry are horrendous. The average is 8x. The market values few industries more cheaply than it values this one. But the market's view is probably fair--contract manufacturing is a terrible business. Most contract manufacturers exist to produce basic consumer and electronic goods at the lowest possible cost. They do this by setting up factories in developing countries where they can hire cheap labor. Since putting together this sort of operation is neither complicated nor expensive, many companies do it. The world isn't running out of cheap labor yet, so there is no real barrier to entry into this industry.
The predictable result - brutal competition - is evident in the pathetic margins these companies earn.
It gets worse. Most of these companies focus on goods like TVs, MP3 players, flash drives, printers, computers - goods that are subject to cyclical demand swings often magnified by inventory cycles. Companies that manufacture these products never know how their order books will look a month from now, and even if they plan prudently they can never get away from recessions. When the world hurts, they hurt.
Minuscule margins and cyclical revenue: It is not hard to see why the market thinks so poorly of contract manufacturers. There is no competitive advantage to be gotten and thus no way to build franchise value. These businesses are hardly worth more than the sum of their paid-in capital and retained earnings. None of them should trade at a material premium to that sum over any sustained period of time.
Or almost none. None except one IEC Electronics (IEC). IEC is included in the first (P/E) table, but excluded from the following two, for reasons that will become apparent in a moment.
Judging by IEC's 6.6x P/E multiple, the market thinks IEC is just another contract manufacturer. The market is wrong. IEC makes specialized electronic components for large, complex end products like jets and trains. Nothing IEC manufactures ends up in a product you can buy on Amazon (AMZN) or at Best Buy (BBY). Rather, all of IEC's work is done for aerospace, defense, industrial, and medical manufacturers. The company's bread-and-butter products are things like customized circuit board assemblies and wire harnesses--very small parts that go into very big machines. These parts must work. An electronic component in a jet cannot fail. Quality control is absolutely essential.
This need for quality assurance has important competitive ramifications. Extremely high quality assurance is hard to find in low-wage countries, so the work IEC performs rarely gets outsourced. A fair bit of it would never be outsourced anyway, for national security reasons. And because the consequences of late or malfunctioning components can be severe, customers much prefer suppliers they already know and trust. This greatly diminishes the number of potential competitors IEC must face, especially for large contracts.
These protections from competition constitute a fundamental difference between IEC's business and the generic contract manufacturing business. They allow IEC to earn a healthy profit margin. Here is the same chart as shown above, but with IEC now included:
One of these is obviously not like the others. 10% vs. 3% is a huge difference. Most of the companies on this list will never sniff 10% operating margins. They are in a separate - and much worse - business than IEC.
The second fundamental difference between IEC and the traditional contract manufacturers is the way economic cycles impact their respective businesses. Here is the 2009 revenue growth table from above, but with IEC now included. Once again, one of these is not like the others. In 2009 IEC grew 33%, much of it organic. Every other contract manufacturer on the list saw a sizable decline in revenue.
Rather than being cyclical, IEC's business is insulated from economic conditions. Why? Boeing, a disclosed IEC customer, has seven years of backlog. Many of IEC's other customers have similarly large order books. This flows through to long lead times for IEC, which currently has almost a year's worth of revenue in backlog.
And because IEC is typically a lifetime supplier of components for a given program/project, it can expect to generate revenue for the entirety of the program's lifecycle. Large backlogs make for predictable and non-cyclical revenue, which enables superior operational and financial planning. This is a fundamental property of IEC's business that is unlikely ever to change. Here is IEC's revenue growth by year since current management took the helm:
So IEC is a niche business that is far superior to its commoditized peers. It earns margins that are three times as high competitors', it is protected from economic cycles, and it has grown like a weed since current management took over.
Yet IEC is priced as if it is an awful business. This is an extreme inefficiency, but not a surprising one given that IEC has a $60 million market capitalization, trades on the AMEX, and is only 10% owned by institutions.
If generic contract manufacturing is the wrong group to lump IEC into, which group is the right one?
The fact is there is no group to lump IEC into for valuation purposes, because its peers don't trade publicly. But two of them-LaBarge and Herley-used to, before both were bought out in early 2011. Each was purchased for about 9x EBITDA and 15-17x EPS by a strategic acquirer (Ducommun in the case of LaBarge, Kratos in the case of Herley). LaBarge is an almost identical business to IEC; they both sell to the same industries, and they both specialize in cable assemblies and customized printed circuit board products. Herley is also quite similar in size and customer base, but it focuses on antenna and radar components. The table below compares the three companies.
All three earn similar margins, and all three survived 2009 with barely a scratch. The similarities do not, however, extend to valuation. IEC trades at a huge discount to the private market value established by the LaBarge and Herley transactions.
IEC trades for sales and profit multiples that are half what LaBarge and Herley were acquired for. In order to square the valuations, IEC would have to trade for about $11.50. That excludes IEC's NOL, which is worth about $0.75 per share.
But even a $12 share price would undervalue IEC shares. IEC's trailing EPS is $0.64, but the company has already reported two straight quarters of EPS in excess of $0.20, and will likely report the third in December. IEC is on track to earn about $0.90 in 2013. Based on 2013 results, IEC will need to trade at about $16 in order for the multiples to line up with the valuations from the LaBarge and Herley acquisitions.
The modified table below includes two added lines. The first shows IEC at private market value based on LTM results, and the second shows IEC at private market value based on my 2013 estimates. In 2013 IEC should also be able to cut its debt in half through heavy free cash flow generation. To keep things simple the table below excludes the NOL in all cases, even though the NOL has real value that is rapidly being realized.
Source: SEC.gov, Monte Sol estimates
And there are plenty of acquirers out there. For Kratos, IEC could make a nice complement to Herley. And with most of the other contract manufacturers having publicly stated desires to grow their "low-volume, high-mix" revenue (IEC's specialty), there should be multiple potential industry suitors.
When I wrote IEC up in March, the stock traded at $4.80. Today it trades at $6, but it is a better investment now than it was then. Southern California Braiding, or SCB, has been successfully integrated, the debt is lower, and profits are higher. What's more, the company is still growing quickly--above 10% organically even in this poor economy, and 15-20% in a better economy, whenever that comes.
If investors must wait a bit for the market to correct its mistaken classification of IEC as a run-of-the-mill contract manufacturer, the value of the business will grow in the meantime.
(click to enlarge)
Source: SEC.gov, Monte Sol estimates
Disclaimer: To the best of my knowledge, all information in this article is accurate and reliable, but I present the information "as is." I will not necessarily update or supplement this article in the future.