Production Slowdown At Taylor Devices Is A Blessing In Disguise

| About: Taylor Devices, (TAYD)
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Key takeaways

  • Taylor Devices (NASDAQ:TAYD) is a hidden value play as lower production due to recent renovations results in a temporary decline in EBITDA, which distorts the valuation.
  • The lack of analyst coverage (and general investor following) means there is no one besides management to explain that this renovation is a net positive. As a result, the stock is left to the mercy of investors focused on sharp (but one-off) top and bottom line declines.
  • Going forward, the combination of a production rebound, return to a normal capex run rate and new orders should drive a significant rebound in EBITDA and free cash flow.
  • The downside is limited by the strong, debt free balance sheet and diverse revenue stream while growing demand for its critical products provides upside potential.

Company overview

TAYD sells shock absorption, rate control and energy storage devices used in vehicles, machinery, equipment and structures by industrial, construction and aerospace/defense customers. The products include seismic dampers, Fluidicshoks, crane and industrial buffers, self-adjusting shock absorbers, liquid die springs and vibration dampers.


The difference between a speed bump and a gorge

The recent sharp revenue and income declines are more of a speed bump on the road to growth rather than a gorge signaling a permanent decline (e.g. bricks and mortar bookstores prior to the "tipping point" for Amazon). In the mrq, revenue declined 29% and operating income declined 64% as a result of facility renovations and moving production equipment to a new campus, which interrupted production as the machines had to be installed and set-up again.

Investors should focus instead on the following four takeaways. First, management said in the most recent shareholder letter that the new campus is fully operational as of 11/18/13 so production should have already begun to ramp up. Moreover, this renovation allowed TAYD to terminate a lease for a separate facility costing $63,504 annually as well as provided expanded assembly and product testing areas. Furthermore, TAYD was able to complete this renovation without being burdened with a high debt load (e.g. debt free with access to an undrawn $6 million line of credit).

Second, the growth outlook remains positive as evident by the fact that the sales value of the backlog rose 27% to $16.5 million. This is not an insignificant accomplishment as typically a renovation of this size would give customers pause. Management cited multiple positive developments including the successful testing of a new patented modular panel damping system that allows buildings to accept extremely high shaking levels without damage and 16 new orders for seismic and wind control dampers. Its products are used in many applications with either secular demand drivers (e.g. protecting buildings against earthquakes; demand rose after major earthquakes in Asia) or industries with recently strong (and expected to continue for the next several years) growth prospects such as railroads.

Moreover, management said revenue rose in the aerospace and defense segment driven by repeat production orders and major development programs such as the commercial manned space vehicle program for NASA, the European missile defense system, the JLENS aerostat experiment, U.S. Navy X47B Drone aircraft and a "substantial" order from the U.S. government for missile shock isolators used to equip the launch canisters. The fact that some of these orders are part of long term programs and/or a follow on to previous orders highlights the strong contract performance and lower vulnerability to broader defense cuts than may be previously assumed. Furthermore, government contracts are typically fixed-price, which provides the opportunity for higher margins than cost-plus (and most importantly there is a history of staying within budget).

Third, TAYD has a diverse revenue stream as its products are used in many different applications, which reduces the effect of poor performance in any one area. For example, management said that the U.S. construction market for seismic dampers is improving slowly while revenue in the Asian market was flat.

Fourth, and most importantly, the return of capex to a lower and more normal run rate as well as strong revenue growth (e.g. making up for lost production and new orders) should drive a significant rebound in EBITDA and free cash flow, both of which were temporarily depressed as shown in the charts below.

Moreover, capex is reduced given that major R&D is funded by its aerospace customers or the federal government while research product testing was only $300,000 in FY13.

Valuation

A peer comp analysis is difficult given that many of its competitors are either private or part of a larger company (e.g. UTC Aerospace Systems which is part of United Technologies). However the below comp is relevant to the extent that it proves the investment thesis.

For example, TAYD would appear to be only slightly undervalued at best compared to ITT and UTX (both industrials, albeit significantly larger and more diversified, with similar end markets and products). However, as previously mentioned EBITDA is temporarily depressed, which results in an artificially inflated multiple.

Even if capex only declines 50% to a ~$1.4 million run rate, the multiple would decline ~3x turns. This assumes no revenue growth from the current depressed level or margin expansion (a real possibility given the recent renovations). Moreover, the recently higher EBITDA margin level (e.g. 12% and 16% in FY12 and FY13, respectively, compared to 12% and 9% for FY10 and FY11) should continue, which deserves a higher multiple.

Another benefit to the completion of the renovations is that share repurchases may resume as there were none in FY13 and only 9,200 shares repurchased in FY12. In November 2013, the board voted unanimously to continue with the current repurchase agreement (e.g. $419,815 available).

Risks

  • There is customer concentration risk given that one customer (Sinodynamics Enterprise) accounted for ~29% of total revenue in FY13 while the top five accounted for ~52%.
  • There are many companies that provide seismic protection technologies, many of which have greater resources.
  • Lower defense spending would negatively affect results. This risk is mitigated given that the senate recently signed a spending bill (which President Obama is expected to sign) to fund the government through its current fiscal year. However there are two related risks. First, the upcoming fight over the debt ceiling (again) next month is almost a "recurring black swan" (but not really because everyone knows about it). Although the risk of the debt ceiling not being raised is low, it is not zero. Second, and from a public policy standpoint, the current attitude that "nothing makes you more productive than the last minute" regarding funding key government programs is fiscally irresponsible* and not healthy for defense contractors in the short or long term. For example, if this continues, the market may begin to place a permanent "political uncertainty discount" on the entire industry rather than treat any current political risk as a one-off.
  • While the fixed price contracts offer the highest profit potential, there is also an increased risk of cost overruns, which would reduce margins.

*I am not blaming any particular party, group or individual in congress or the executive branch. I am simply making a general statement (which is my opinion) regarding a potential risk.

Conclusion

The target price is based on a 9x multiple assuming a $1 million increase in EBITDA from the ttm level.

The stop loss should be placed below the support at ~$7.90. The time frame is 12-24 months, which may be back-end weighted as it may take several quarters for the production rebound to take affect.

Disclosure: I 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.