- Pro-Dex is a contract manufacturer with a significant customer and product concentration on a single line of medical battery-powered drivers.
- The company has recently leveraged operationally and financially by taking debt to build a new factory that should begin operations this year.
- Although revenues and profits have grown for much of the past decade, I am not comfortable with the multiples the company trades at currently.
- Above all, the risk of customer concentration leveraged at the operational and financial levels is too high.
Pro-Dex (NASDAQ:PDEX) is a designer and manufacturer of battery powered surgical drivers located in California. The company has done contract manufacturing of other powered medical and dental products in the past as well.
Although PDEX has grown substantially since it decided to specialize in drivers contract manufacturing, it does not seem like an opportunity at current prices. The main reasons are risk from customer concentration, high debt and expanding manufacturing facilities into an uncertain future context.
With that in mind, the company does not offer attractive yields in terms of net income or R&D capacity.
Note: Unless otherwise stated, all information has been obtained from PDEX's filings with the SEC.
Contract manufacturing of medical devices: PDEX obtains most of its revenue from the manufacturing of battery powered drivers for medical use. However, the company also generates negligible revenues from legacy manufacturing lines in industrial uses. The company's website claims experience in contract manufacturing for aerospace, industrial & commercial, oil & gas, healthcare, security & defense, and communications. This indicates that the company was a general contract manufacturer before.
Growth fueled by increasing concentration: The company started to grow revenues after 2015, when more and more of its contracts concentrated into a single group of customers in medical devices. While in FY15, medical devices represented 67% of revenues, and the largest customer for 49% of revenues, by FY22 medical devices represented 80% of revenues, and the largest customer (not necessarily the same), 69% of revenues.
Medium term relatively secured: The company commented on its FY22 10-K that it had reached an agreement during FY21 with its largest customer to continue supplying products through 2025, and to develop a new generation of products. This provides some revenue security.
Class I, light regulation devices: The company's products belong to the FDA Class I category. These medical devices are much less regulated than other classes. The company has to certify the manufacturing facilities but not the products. In general, Class I devices do not require premarket approval.
High risk of sudden revenue loss still exists: When there is customer concentration, and in general in contract manufacturing, the sudden loss of a customer is a real risk. As an example, the thoracic driver line, sold to a single customer, lost $6 million in revenues (77%) between FY21 and FY22. The company blamed it on excessive inventories.
High administrative burden despite small sales operation: PDEX does not have a big sales operation, given that it has few contract based manufacturing relations. Yet, the company post a substantial SG&A account. Fortunately, it has been kept relatively stable to revenues.
High insider ownership: Two directors of the company own 38% of the company's shares. This is something I generally look at positively too. Management is also not expensive, with the CEO and CFO making $800 thousand in compensation a year.
A strange securities book: As of 1Q23, PDEX holds a securities book of about $2.5 million that is invested in thinly traded securities, marked at fair value through P&L. At least 30% of that is invested in a micro cap called Air T (AIRT) specialized in air transportation, where the two controller directors are also directors and executives. This makes no sense for outside shareholders. Having so much of investments tied to equities has generated volatile non operating income.
Significant share repurchases: The company has consistently repurchased its own shares in the last few years.
Debt to finance a new factory: The company has increased its debt levels substantially in the last two years. This debt financed some working capital and a new manufacturing facility in California, close to where its current facility is. According to PDEX, the new factory will be used to increase production for its current largest client. This is of course an opportunity but also increases fixed expenses like depreciation, overhead, and interest expenses. The facility should begin operations in 3Q23 (March 2023).
The financing consists of a $5.2 million term amortizing loan (2030) paying 3.5%, another $8.5 million amortizing loan (2027) paying 3.9%, and a credit facility for up to $7 million paying SOFR + 2.5%, from which $2.5 million have been drawn. This adds up to $700 thousand in yearly interest expenses that did not exist a few years ago.
Fall in gross margins and problems with a product: The company has increased the portion of revenues categorized as repairs. The category is growing at 50% YoY as of 1Q23 and represents $8 million in revenues, annualized from 1Q23 data.
The problem is that the company then recognizes in CoGS that its margins are lower for these increased repairs because it is upgrading its drills for its largest customer at no additional cost. This gives me two doubts: first, why upgrade the pieces at no cost, unless there is a problem with the products or the customer is truly exercising its bargaining muscle; second, why does revenue grow if the upgrades are not charged. Could this signal that a product was defective or below standards?
A fall in our income proxy, R&D capacity: The fall in gross margins, plus higher depreciation and interest charges has generated a fall in pre-tax income before R&D expenses. I will discuss the validity of this measure for valuing PDEX in the next section.
Income: Looking at operating income is a little better than net income because of the movements in the securities book. As mentioned, although revenues have been growing, operating income has contracted because of lower margins.
On top of that, one has to add interest expenses of about $700 thousand a year, plus depreciation from the new facility, that should add another $300 thousand a year. Most importantly, as the new facility enters operations in around March 2023, the company will have to increase its headcount and other fixed overhead.
The situation is uncertain. If the company can ramp up production and sales fast, then it could expand operating income. However, the bigger structure also exposes it to more risk, particularly related to its customer concentration.
R&D capacity: The situation is similar when removing R&D from operating income. In this case I do not believe R&D is a moat builder, but rather a cost of business. The reason is that PDEX assumes the cost of developing new products for its customers as part of their long term supply contracts. Also, the company includes tooling and upgrade expenses on its R&D costs. Tooling is generally directed toward specific lines and products.
Riskiness: Although the company has some revenue security because of the supply contract with its largest customer until 2025, the situation in general is still risky because of customer concentration, operationally leveraged by the new factory and related overhead expenses.
I do not feel safe paying a 15x earnings multiple on a company that has significant customer concentration and is about to open a new facility. Of course, the story could play out well, but that is very uncertain.
If revenues, and above all, gross margins, do not grow in line with the new depreciation, overhead, headcount and interest expenses, the company will not be able to grow net income.
For that reason, I prefer to be cautious with PDEX, and wait for lower prices, or future developments.
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