In his book The Intelligent Investor, value investing guru Benjamin Graham discusses his success with “Net-Current-Asset, or Bargain Issues.” Graham defined these as stocks whose market cap was below the value of current assets minus total liabilities on the balance sheet. From the Depression through the mid-1950’s, many companies fit this criteria and Graham assembled a basket of them in his portfolio. Today, very few companies pass this screen so when we find one, it is worth digging deeper into the fundamentals to understand how the valuation got to be so low.
One such company is Richardson Electronics (RELL), a micro-cap electronics manufacturer in business for over 70 years making power conversion, radio frequency, and microwave components. The company sold off a huge chunk of itself in 2011, leaving it with no debt and a lot of cash and investments on the balance sheet. The company bought back stock through 2016, then acquired International Medical Equipment and Service (IMES) in an effort to expand into the CT tube replacement equipment business.
Today, Richardson’s largest division remains Power and Microwave Technologies ((PMT)), at 78% of sales. Custom display unit Canvys makes up 17% of sales, while Healthcare is the remaining 5%. With key customers in the telecommunications and semiconductor fab markets, PMT earnings have been cyclical, peaking in 2018 and turning down this year. The Healthcare division has underperformed due to the high cost and lead time needed to develop and certify replacement CT tubes. This is complicated further by the fact that the OEM’s have released new tube models, requiring Richardson to spend more time and money on R&D to develop compatible replacements.
Management is confident that the 5G cycle and future upturn in semiconductor manufacturing will be good for PMT. The Healthcare division leader has been fired and the division is now being directly monitored by the CEO and COO. While this past quarter may have marked a bottom in Richardson’s performance, it may take a year or so to tell. In the meantime, earnings have been at or just under breakeven and free cash flow has been negative. The good news is that some of the large cash hoard from the 2011 sale is still around to support continued dividend payments.
Richardson’s recent operational record makes it a risky bet at this point. Additionally CEO Ed Richardson, who is the son of the founder, holds Class B stock giving him 10x the votes per share as the publicly-traded Class A stock. This basically insulates the company from an activist investor or takeover bid. In spite of all this, the company’s current cash position and burn rate are sufficient to support the dividend for several years while we wait to see if improvements occur. At these levels, RELL is a speculative long trade but it should be sold if it gets much above net working capital levels around $7.69/share.
Power and Microwave Technologies – Impacted by Semi Fab
The semiconductor fab industry hit a cyclical peak in 2018, and the PMT division was a beneficiary. The division’s performance was the key contributor to profitable results for the overall company in calendar 2018. (RELL’s fiscal year ends in June.) In the July 2018 conference call, PMT head Greg Peloquin reported strong results but at the same time warned of headwinds in 2019:
In the fourth quarter of FY18, PMT sales were $37.2 million versus $28.8 million in Q4 of FY17. Based on our demand creation, strong bookings in Q3, new design wins, and our unique business model, our business grew 29.1% over prior year. In addition, our gross margin improved to 34.3% compared to 33.2% in Q4 of last year. ... Favorable market conditions in the industrial, semi fab, wireless infrastructure, and power energy markets are leading the way for this growth.”
“We do have some headwinds going into FY19. The semi fab market is showing some slowdown and we’re working closely with our customers to manage this situation. Tariffs on products made in China and sold in the US may also have some effects in the quarter."
Source: Greg Peloquin, 4Q 2018 Earnings Call
After three quarters of Fiscal 2019, the weakness in the semi fab market happened as forecasted. Still, the division head noted growth in other markets and was optimistic about 5G implementation driving future demand:
“In our third quarter of fiscal year 2019 PMT sales were $29.7 million versus $31.9 million in Q3, FY'18. Our gross margins in the quarter were 31.6% versus 33.4% in Q3 of last year. Q3 results were greatly affected by the downturn in the semi-fab market. However, this market decline was partially offset by growth in our base tube business and excellent growth in our new technology partners supporting the RF and power market. This growth is based on a demand creation model, strong booking trends, numerous design wins and our unique global business model. …
Specific to the 5G infrastructure markets, we're continuing to gain traction throughout the world. China is the primary market today as they are slightly ahead in putting in their 5G infrastructure. However, we have ever-growing design wins in the base station, mobile test equipment and SATCOM applications. We have the world leaders in GaN and beam steering technology which is a technology of choice for 5G.”
Source: Greg Peloquin, 3Q 2019 Earnings Call
The semiconductor industry organization, semi.org, confirms the large downturn in 2019, and forecasts getting back to 2018 levels in 2020. This is however, a downward revision from the forecast they published at the start of the year.
Source: Semi.org News Release
Industry watchers also see 5G Base Station Growth doubling in 2020 and continuing to grow for the next several years.
If 2019 is indeed a short downturn for PMT, then RELL has a pathway back to profitability in 2020 and beyond. I would watch industry conditions closely, however. An extended downturn would cause RELL to continue to burn cash.
Healthcare – More Challenging than Expected
Richardson expanded into the healthcare business with the goal of selling diagnostic imaging equipment, particularly replacement CT tubes. CT Tubes last about 3-4 years and cost $180k-$200k from the OEM. More info on these tubes is available here.
Richardson has a tube available now that can be used in Siemens, Toshiba, and Phillips systems.
This tube, called the ALTA 750D took Richardson about a year and a half to develop and test, and cost about $5 million of R&D. Unfortunately, Richardson has found out that many hospitals also use a similar version called the ALTA 750G. These hospitals want Richardson to supply both tubes so that they can get out of their more expensive contracts with the OEM’s. COO Wendy Diddell explained on the 3Q 2019 conference call:
“Typically, these agreements cover several different types of CT scanners as well as other modalities. For example, a hospital may have a Toshiba system in its installed base that uses the ALTA750D, as well as systems that use a slightly different version of the tube that we refer to as ALTA750 G. If the hospital wants to remove the system that use the D version of the tube but need systems using the G under an OEM contract, there is the concern that OEM will raise the price on the remaining systems. Several large hospital groups have told us that they would like to use our tubes when we have both tubes available.
We are addressing this by adding to our engineering resources and increasing our tube development activities. We anticipate having the ALTA750 G available for sale in mid calendar year 2020 after concluding clinical trial.”
Source: COO Wendy Diddell, 3Q 2019 Earnings Call
This is another year of development and approximately $2 million of R&D costs to be competitive in the replacement CT Tube market. Clearly, this was a surprise to Richardson, who fired the head of the Healthcare division before the 3Q earnings call. Ed Richardson and Wendy Diddell are now supervising the business directly.
This development and testing time means that it will be at least one year before Richardson can produce the desired ALTA 750G tube. Since Healthcare is not a large portion of the company’s sales, it won’t be that much of a drag on overall results besides the added R&D expense. It does mean, however that the company’s plan to diversify from the cyclical PMT business remains on hold and the next 12 months may not show great improvement.
Is the Bad News Priced In?
Based on the key issues noted above, the company is basically saying not to expect much near term improvement for at least a year. Nevertheless, the potential for improvement exists if the company has indeed learned their lesson on the replacement CT tube market and if 5G and a recovering semi fab market help boost PMT sales. At this point, that would be a speculative bet, but the still large cash position can support the company for a few years while waiting to see if things improve. The chart below shows Richardson’s sources and uses of cash since 2016.
Data Source: Seeking Alpha data pages
Things were improving in 2018 with good PMT results, but the first 9 months of fiscal 2019 burned over $11 million in cash with not only the operating loss but a large working capital build as the company expands inventories. The CFO had this to say about inventory build:
“Regarding inventory and working capital in general, it's really just part of our business in particularly in the EDG area, we have to stock inventory since it's a MRO type business. We have to have the inventory available when the customer calls. And the other businesses as I noted previously, both the PMG business and the healthcare business our growth strategies and as you can imagine we need to stock inventory there in healthcare. So that we have components inventory so we can build the CT tubes, as well as the equipment business which we have to have the equipment on hand in order to sell it.
And so inventory I think will continue to go up, but not to the level is probably in fiscal 2018, if that's helpful.”
Source: CFO Bob Ben, 3Q 2019 Earnings Call
So, without improvements in net income but a slowdown in working capital growth, the company could still burn around $10 million in Fiscal 2020. At that rate, there is 4-5 years of runway to see some improvement. I am not advocating holding for anywhere near that long, but one year from now (after fiscal 2020 results are reported) the company will still have enough cash to limit any negative reaction. I can see a downside of about $1/share in one year based on cash burn with no operating turnaround. That’s 18.5% downside based on current prices. Looking back to 2018 with better performance in PMT, the stock traded in the $8-$10 range. If the semi fab and 5G markets improve as forecasted, RELL should be able to get back to at least those levels. The $9 midpoint would be a 66.7% improvement over today’s levels. Any good news out of Healthcare would be taken as a pleasant surprise and could support the stock further.
Richardson Electronics is not for the faint of heart. I would wait to listen to the 4Q 2019 conference call coming up in a few weeks. The stock may drop further on lack of good news, although the company has already aired the key issues. If there is some new problem disclosed on the call, I would just walk away. However if it’s simply a realization of the outlook disclosed last quarter, that would be a buying opportunity. I would give the company one year to show real operating improvement and cut my losses if it does not occur. I would take some gains if the stock approaches net working capital value. If the stock makes it back to 2018 levels in the $9 area, I would ring the register completely unless there has been some major new positive development.
Disclosure: I am/we are long RELL. 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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