Perceptron: A Fifty-Cent Dollar

| About: Perceptron, Inc. (PRCP)
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Summary

Half of market cap in net working capital / one-third in cash.

Record backlog.

Dominant industry position.

60% upside on conservative assumptions.

Perceptron ("PRCP") is a company with a dominant industry position, record backlog, record cash on its balance sheet, and a new and highly incentivized management team. Despite these positive attributes, the company trades at a fraction of the valuation of its peer group - suggesting multi-bagger potential as investors start paying attention and top-line growth accelerates. More importantly, a substantial portion of the company's current market capitalization is in the form of cash and working capital - limiting downside potential at the current price.

PRCP produces lasers and associated software that are predominantly used to provide real-time measurements of automobiles in the assembly process using a technology called 3-D metrology. Auto manufacturers, particularly in the luxury segment, have very rigorous specifications to ensure that the design of the car and the implementation of that design on the assembly line are as closely aligned as possible. By providing real-time and highly accurate measurements, PRCP's products can eliminate costly assembly line downtime, re-work costs, and scrapping very expensive materials. Despite the fact that PRCP is a small company with a market capitalization of only $100 million, it produces an extremely sophisticated set of lasers and software that are highly engineered and command gross margins in excess of 45%. Here is a video of Perceptron equipment at work in an Audi factory in Germany: Perceptron Audi Door. Of note, PRCP is used by all ten of the top global luxury brands with 45 patents issued or pending on its technology.

The biggest driver of the PRCP's business is when an auto manufacturer introduces a new model. This typically entails a re-tooling of the factory and the purchase of new laser/software technology. During the financial crisis, manufacturers lacked the necessary capital to introduce new models nor was there sufficient demand for the manufacturer to obtain a reasonable return on their investment. As can be imagined, this hurt PRCP's business. I believe the lesson the old management team took from this experience was to stockpile as much cash as possible in case there was another rainy day. Despite declaring a special dividend in 2012 and implementing a modest annual dividend, the cash on PRCP's balance sheet continues to pile up to a ridiculous level that is clearly in excess of what is needed to operate the business. Presently, PRCP has $35 million in cash and investments with zero debt or other long-term liabilities. Moreover, PRCP has $47 million in working capital which can be thought of as a proxy for cash in a liquidation scenario. Keep in mind, the market capitalization of PRCP is only $100 million - so for every one dollar an investor spends to purchase the ongoing business they are getting roughly $.50 as a cash proxy (working capital) already on the balance sheet. Of lesser importance, but still worth noting, PRCP has property and equipment with an original cost of $21.3 million that is being held at a value of $5.5 million on its balance sheet. Given the odd results that straight-line depreciation can produce over time, my gut would tell me that actual value of these assets are likely materially higher than the current holding value. Taken in totality, a rudimentary analysis of the balance sheet makes it abundantly clear that the market is ascribing very little value to PRCP's ongoing business. As will be discussed further, PRCP's on-going business is likely worth a great deal.

According to IHS Automotive, the automotive manufacturing industry is expected to grow at a CAGR of 3.6% between now and 2020. Management mentioned at their investor day they expect organic revenue to be substantially in excess of the overall manufacturing growth rate for several reasons. First, manufacturing growth will be highest in emerging markets where many manufacturers currently are not using a metrology solution. As emerging market customers demand higher quality vehicles and producers hope to export beyond local markets, demand is increasing for PRCP's solutions. PRCP has adapted to this demand by introducing lower priced laser systems (Vector Advantage) with reduced functionality levels relative to systems produced for German or US customers, but still representing a material upgrade relative to having no systems in place. The company has noted strong interest/demand from indigenous manufacturers, especially in the important Indian and Chinese markets. Secondly, Japanese auto manufacturers have historically used a different measurement technology, but PRCP is optimistic they are starting to drive adoption of their products. This obviously represents a massive market opportunity given Japanese production volumes. Finally, and most importantly, PRCP spent years and millions upon millions in R&D dollars developing the state-of-the-art Helix product line. The Helix solution has put PRCP as the forefront of the automobile metrology industry, allowing them to take market share and increase penetration within existing customers. This growth is starting to manifest itself in PRCP's financial data. For instance, the company's backlog is 22% higher today than it was 12 months ago and has more than doubled since the end of 2009. Given auto manufacturers typically give a set period of time in advance of PRCP installing their laser systems, this backlog is likely a harbinger for significant revenue growth over at least the next year. (Note that PRCP's fiscal year 2014 ends in June).

PRCP generated $63 million in revenue over the last 12 months. To be conservative, let's assume that revenues grow at half the rate of backlog growth (11%), to $70 million. During the 3rd quarter of 2014 PRCP's revenues were about $70 million on an annualized basis and they generated a 15% operating margin. This tells us that at $70 million in revenue at a 15% margin - PRCP should generate around $10.5 million in operating income. PRCP also earns about 250k in net interest income from cash on their balance sheet, so pre-tax earnings would likely be closer to $11 million. This puts PRCP at 9x forward pre-tax earnings, or an 11.1% pre-tax yield. This appears remarkably cheap given both the growth profile and the fact that larger competitors are trading at 24-36 trailing pre-tax earnings.

However, a simple price-to-earnings ratio does not tell the entire story. Again, PRCP has $35 million in net cash, so the enterprise value is only $65 million. If free cash flow approximates net income this year, this would put PRCP at an EV/FCF yield of 12%. By the end of next year, cash balances should approximate $43, implying a FCF/EV yield of 13.5%. Again, this seems very inexpensive given the growth, margins, and advanced technology that PRCP produces.

Another interesting angle to the PRCP story is the fact that its technology has broader applications than automotive manufacturing. PRCP is headquartered a half hour from Detroit and the majority of its directors have background in the automotive or auto supply industry - so this was a natural customer base for the technology that PRCP developed. However, PRCP's laser technology can be used in virtually any highly engineered manufacturing process where there is limited tolerance for error and scrap and re-work costs are high. After the recent retirement of the CEO and CFO, a new management team has been brought in to lead the diversification effort. The new CEO has experience with the Italian industrial conglomerate Finmeccanica SpA (OTCPK:FINMY) and General Dynamics (NYSE:GD) - large companies with experience integrating acquisitions. At their recent investor day, the CEO stated their goal was for 30% of revenue to come outside of the automotive industry over the next 3 years - it is unclear what percentage of this revenue would come from organic revenue and what would come from acquisitions in adjacent industry verticals. As an example of recent progress on this front, PRCP has recently been quoting high-end appliance manufacturers to install their technology on the assembly line. As some of you may know, a really expensive high-end refrigerator does not have a dramatically different price point, or engineering standard, than an entry-level automobile. PRCP also mentioned potential in the specialty vehicle space (tractors, combines, etc.) as well as increased penetration into other business lines of diversified auto suppliers. I am not apt to pay a lot for this growth potential because a bird in the hand (auto industry) is worth two in the bush (adjacent industries). However, management has been abundantly clear that the Board has tasked them with growing the business beyond automotive, so it's something that investors should have on their radar.

A final point I would make is that there are several large other players in the measurement/metrology/machine vision industry with higher equity multiples, flush with cash, and a stated intent to make acquisitions. Acquiring a small company like PRCP could be highly accretive for one of these companies. First, PRCP likely spends several million dollars in expenses associated with being publicly traded - audit fees, listing fees, Sarbanes-Oxley compliance, director fees, etc. By combining PRCP into a larger entity, the acquiring company would likely realize an immediate step-up in profitability associated with the elimination of these expenses. However, the bigger synergies would come from eliminating redundant functions, leveraging the Helix technology, and cross-selling a more substantial product suite into larger customers. Regardless of synergies, given competing metrology companies (Faro Technologies, Cognex, Hexagon AB) are trading at 24-36x trailing pre-tax earnings, PRCP would be highly accretive to earnings regardless of whether stock or cash were to fund an acquisition.

Valuation:

In regards to valuation, I find it highly unlikely that PRCP would trade below its net working capital. By the end of FY 2015 (Jun 2015), PRCP should have around $55 in million in working capital or ~$6/share. This implies that PRCP is presently trading around 4x our estimate of next year's pre-tax income after deducting net working capital. This appears to be an untenably low valuation.

Considering PRCP will likely grow revenue and earnings significantly in excess of the broader market, it makes sense to use a market multiple plus a consideration of net cash as a conservative starting point to a valuation analysis. On consensus estimates, the S&P 500 is currently trading at 16.5x estimated forward earnings - so applying my $7.7 million net income estimate would equate to $127 million for the ongoing business plus $35 million in existing net cash and investments, or $17.50 per share.

While it is highly speculative, in an acquisition scenario assuming an acquirer was willing to pay a multiple of 25x pre-synergy, pre-tax earnings - similar to multiple of many other companies in the space - this gets us to upside of $30/share. Again, this appears optimistic but isn't entirely unrealistic given where other companies are trading in the space.

Using a scenario analysis where we ascribe a 60% probability to the base case and a 20% probability to the bear case and bull case, we derive an expected value of around $17.50, or over 60% upside from the current price. It goes without saying that this presents a massively favorable risk/reward scenario, in particular because we are valuing company with above-average growth prospects at a market multiple and calculating downside using a conservative liquidation scenario.

Risk: Not intended to be a complete list, but things I keep on my radar

1) The automotive industry is cyclical, as is auto-OEM capital spending

2) The company's margins have typically been below levels discussed herein as have sales levels

3) The company could mess up their balance sheet by making an ill-conceived acquisitions

4) The company's technological lead could be rendered obsolete by competition

5) The company may continue to hoard cash without any benefit to shareholders

6) Some cash is held overseas which likely will cause a taxable event when repatriated

7) The new CEO has limited experience in the auto industry

Disclosure: The author is long PRCP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long PRCP in an investment partnership that I control. I will benefit if the price of PRCP increases. I may change my opinion about this investment position at any time. I disclaim the obligation to notify readers or any party of any such changes. I make no warranty or representation as to the completeness or accuracy of any statements made herein. I will direct Seeking Alpha to donate any compensation from this article to charity.