SigmaTron - No Obvious Catalyst, Still Good Value

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Summary

SGMA is trading at a significant discount to its tangible book and has a solid downside cover as NCAV is only 28% below the share price.

The EMS industry going forward is unlikely to be disrupted in a major way. Although smaller players, like SGMA, are getting squeezed on cost, the revenue opportunities are still present.

SGMA’s fundamentals are supporting this as the company grew its revenue by 52% in the past five years offsetting the margin pressure and thus showcasing a stable profitability.

In 2014 the share price appreciated over 300% without any major change in the fundamentals. Similar move happened in 2011.

Since 2014 the share price decreased 60% while the operations are still strong. Despite lacking any precise catalyst, the stock could see a similar upside as it is again undervalued.

Company Introduction

SigmaTron (NASDAQ:SGMA) is a company focused on classic electronic manufacturing services (NYSE:EMS) such as OEM manufacturing of printed circuit boards (PCBs), testing, design and supply chain management for other companies. SGMA provides these services through an international network of facilities located in the United States, Mexico, China, Vietnam and Taiwan. The company was incorporated in 1994 and started trading on the market in the same year.

The company segments the revenue in the following way;

As you can see the main driver of revenues are the household appliances products. In this segment the company also has two of its most significant customers, Electrolux and Whirpool, which accounted for 36.8% and 9.9% of the total FY2015 revenue respectively. This has been slightly different in the past where Spitfire Control Inc. and Life Fitness Inc. have usually accounted for around 30% and 10% of revenues respectively each year until 2012 when Spitfire Controls Inc. was acquired by SGMA. Through this acquisition the company obtained the access to Electrolux and Whirpool.

Investment thesis

I believe that the company is worth buying at the current price due to the following points;

  • While pressured on cost, the company was able to grow its revenue base rapidly and thus maintain a slim but stable profitability. With the advent of Internet of Things and the continuous need for PCBs this is unlikely to change.
  • The stock is undervalued from both a relative and absolute point of view with a price to tangible book being only 0.44., EV/EBITDA under 5 and P/E around 10. The NCAV of the company is also only 28% lower than the share price.
  • While the company lacks a precise catalyst, in the past the shares have surged twice without an underlying change in fundamentals. The most recent surge happened in 2014 and since then the company continued increasing its revenue, yet the share price declined.

The thesis is simple and straightforward as the business is not facing many uncertainties and is operating within a heavily commoditized industry, where the demand is fairly stable.

Profitability going forward

The main challenge that the company is facing is price pressure. As the electronic manufacturing industry becomes ever more commoditized, the main differentiator in the space is cost at which the company can deliver the product. Therefore in the long-run this puts SGMA at a disadvantage due to its size and thus lack of meaningful scale. This is well seen in the margin progression over time.

The margins have declined and stayed constrained at the current levels with no clear possibility of an upside.

When we compare margins to other two similar EMC producers (in size and offering), we can see that the situation is roughly the same. SGMA does though showcase less volatility than the other two players.

While the price pressure is unlikely to go away the company is able to grow its profits through its revenue streams. As we can see the company has been able to almost double its revenue run rate since the financial crisis and handily beat its competitors.

The main factor that helped to maintain this growth was the acquisition of Spitfire Controls Inc. in 2012, which enabled SGMA to extend its services to ODM (original design manufacturer) and extend its client base in home appliances.

The macro trends also helped as home appliances are increasingly digitized and increasingly part of the Internet of Things trend, where the ultimate goal is to create household that is fully interconneted. For example, Electrolux, SGMA's main customer, recently joined Google's initiative to spur innovation in that space. SGMA also seemed to expand its industrial offering, its second biggest segment. The company started to include LED lighting, which again is now a growing part of the EMS industry, in the description of the segment.

The company itself hints that this overall revenue growth is likely to continue as the backlog is improving each year, albeit only a portion of annual orders is represented in this figure.

Moreover the company recently started to add this following commentary onto their reports;

'The Company anticipates that its credit facilities, cash flow from operations and leasing resources are adequate to meet its working capital requirements and capital expenditures for fiscal year 2016 at the Company's current level of business. The Company has received forecasts from current customers for increased business that would require additional investment in inventory. To the extent that these forecasts come to fruition, the Company intends to meet any increased capital requirements by raising capital from other sources of debt or equity.'

While this can pose a short-term risk (uncertain funding, which I will touch upon later), it also shows that the company has the ability to capture new revenue streams and further expand.

Management & Shareholders

Usually when one stumbles upon a similar company to SGMA (close to NCAV, deep discount to tangible book etc.), he/she expects that there will be some kind of management entrenchment present. SGMA presents a refreshing sight as the board seems to be fairly efficient apart from few points.

It does have different classes of directors, which makes it harder for shareholders to vote against the whole board and insiders have been with the company since the very beginning, which could promote a status-quo. SGMA also has severance payments contracts when a 'change in control' (stockholder purchasing more than 20%) would occur, but these are the only potential corporate governance risks that I have found.

There is also a significant amount of ownership that is not disclosed as the mentioned shareholders only own 29% of the company.

Royce is the biggest shareholder and has been since 2010. They sold part of their ownership during the price appreciation 2011 and 2014. The same goes for FMR. Cyrus Tang, a prominent businessman in various manufacturing & commodity businesses, actually funded SGMA in the very beginning and most likely helped the company to gain its footing. He also sells from time to time, mostly when the share price appreciates.

The employees of the firm hold all together around 5.3% of the company with Mr. Fairhead, the founder of the company, having the largest stake. The insiders are mainly selling as can be seen below.

While this is not necessarily positive, I would not see it as negative either as the real problem would be if they were to be selling when the share price is down, which they do not. The insiders also did not own much from the very beginning, where the combined ownership was around 14% with Mr. Fairhead owning 6.0%.

Favourable Valuation

As you can see below the company seems to be undervalued on its own as the price to tangible book is only 0.46, EV/EBITDA of roughly 4.5 and P/E around 10.

The bulk of the company's tangible book value is in its inventory as it accounted for 53.1% of total tangible assets in the latest quarterly filing. This could be potentially worrisome if the company should write-off a significant portion or potentially hold the inventory at inflated values, but as we can see, 57.63% of the inventories consists of raw materials, which are not likely to be illiquid or inflated in value.

Moreover the company's inventory turnover and cash conversion do not suggest that the company would be inept at handling these assets.

As we can see both CCC and DIO decreased from the highs of the financial crisis and been relatively stable ever since. The company did not comment on the recent volatility in the DIO figure.

Furthermore, when we compare SGMA's valuation with the other two competitors we can see that the market seems to discount SGMA, while the company is presenting better fundamental picture.


Lastly I would like to point out that the share price have appreciated in the past twice without a clear move in the fundamentals.

I believe that in both instances the investors were taking an advantage of the favourable valuation of the company as the stock was trading near its NCAV. Now it seems that the stock is again in a similar valuation territory without any deterioration of the underlying fundamentals.

Risks to the position

  • Contracts

If SMGA were to lose the five biggest customers the revenue stream would shrink by 62.5%. These customers are not connected to the company through long-term contracts and thus the risk could occur rather quickly. While this risk is clearly present, the status-quo is sometimes too hard to change for either the manufacturer or a customer and thus this is likely to occur only if SGMA were to have any significant issues with its production or customer services. I have not found any instances of such events in the past.

  • Margins

While the revenue is likely to grow, if other (dominant or larger) players in the EMS market start to further pressure SGMA on price, not only they could lose the aformentioned customers, but could see further lowering of margins. I believe that some margin pressure is likely to be present, but the bottom line is going to stable as the revenue growth will be offset this in the foreseeable future.

  • Financing & Liquidity

The company is currently operating a $30 million credit line with Wells Fargo, which is the company's main source of liquidity as their cash position sits around only $3.5 million. The credit line has been prolonged and increased several times in the past, but if the company were to start facing either of the two previous risks, the company could easily find itself facing liquidity issues as well. The credit line agreement normally runs for 2-3 years and is collateralized by a majority of the assets.

As mentioned, the company also stated that they are going to 'face' increased demand and as such they might need to raise capital in order to acquire enough inventory. The company mentioned this for the first time a year ago and the latest commentary shows that the company was able to get an offer for another credit line, but rejected it.

'The Company has received forecasts from current customers for increased business that would require additional investment in inventory. To the extent that these forecasts come to fruition, the Company intends to meet any increased capital requirements by raising capital from other sources of debt or equity.

The Company selected an investment banker for the purpose of completing a capital raise. In the second fiscal quarter of 2016, the Company entered into a conditional term sheet agreement for a 60-month credit facility of up to $15,000,000 and subsequently terminated that agreement.

If a capital raise is not completed, the Company has determined that it might be required to repatriate from offshore cash and fiscal 2016 foreign earnings, to meet certain domestic funding needs, but does not anticipate needing to repatriate prior earnings based on current forecasts.'

The company does not comment on why they rejected the agreement, but it is probable that SGMA is able to handle the increased demand from its operational cash flow and/or existing financing (the Wells Fargo credit line has around $6 million left unused). What it did show though is the fact that the company has foreign earnings that are not being repatriated into the US. These earnings are normally reinvested into the foreign subsidiaries, but could potentially be a source of added liquidity in the worst case scenario. The cumulative unremitted earnings are now reported to be around $12 million as of April 2015. The company mentions the number only in 10-Ks.

Conclusion

As we have seen although there are several fundamental risks that are present in the company, they are unlikely to manifest any time soon. Thus the valuation of the company and the ability to maintain its profitability going forward is presenting a stronger argument.

Lastly, I would not accumulate the desired position all in one go. I would wait with the initial purchase until the company reports its 10-K for FY2015 this Wednesday. If the company showcases a continuation of all the trends and does not show any issues with regards to the need for further financing then I would initiate with 50% of the desired position. After the next quarter in September, I would buy 30% of the position if the company does not showcase anything negative and the share price have still not seen any major moves. I would finish the accumulation in December, when the company files its Q2 of FY2016.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SGMA over 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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