Taylor Devices Is A Great Company, But Trades At An Expensive Price
Summary
- TAYD specializes in shock-absorbing devices for construction and aerospace uses, among others.
- The company seems to have a technological moat in these segments. Unfortunately, construction is cyclical and aerospace stagnant.
- With significant operational leverage, the company's earnings move at the rhythm of the construction business cycle.
- TAYD also has a treasure of a balance sheet, with zero debts and $22 million in cash and securities.
- Unfortunately, TAYD trades at an exaggerated multiple to cycle average earnings. The company has not shown that this time the cycle would be different.
MEDITERRANEAN
Taylor Devices (NASDAQ:TAYD) is a designer of shock-absorbing devices, specially dampers for buildings and the aerospace industry, but also for other industrial uses.
The company is a technological leader in the field and it seems to have a moat. However, it suffers from substantial operational leverage, and its building segment seems extremely cyclical.
TAYD has not been able to show across-cycle growth for the past decade, and is now trading at a P/E ratio of 13x based on cycle peak earnings. For that reason, I do not feel comfortable recommending the stock.
Note: Unless otherwise stated, all information has been obtained from TAYD's filings with the SEC.
Business description
Structural shock absorption: TAYD's obtains half of its business from fluid dampers for buildings (photo below), one of the methods for protecting buildings from shocks (like earthquakes). The company is not the only competitor in the area although the market is small. Only two other companies in the U.S. provide fluid dampers, according to the company's FY22 10-K.
One of TAYD's dampers for buildings (TAYD's annual presentation 2022)
Aerospace shock absorption: The company has also consistently served aerospace projects (civil and defense related) since the 1950s. In fact, its structural segment is a spin-off from defense related technology that was declassified in the 1990s.
Positives
Technological edge: Although the company does not have a complete moat based on patents, because it competes on the same product lines with other companies, it does have a technological or technical edge.
There are several indications of this. First, the company contracts with quality seeking institutions like NASA, Boeing or military contractors. The structural dampers also require extreme technical assurances. Second, the company has a plethora of patents in the field (6 valid at the moment). Finally, the company requires specialized facilities (located in North Tonawanda, close to Buffalo) to manufacture and test its products.
Good FCF conversion: The company's FCF generation shows a significant correlation with the company's net income. This means that the company is not hiding costs behind capitalization, or incurring significant working capital buildouts.
Conservative capital allocation: TAYD's management has not issued significant debt nor shares to finance expansion plans. The latest important investment was finished in 2017, and consists of a testing facility for structural dampers.
Strong balance sheet: TAYD has zero debts as of 2Q23 (November 2022), and $22 million in cash and securities. The company also has 100 thousand square feet of industrial buildings close to Buffalo. Using a national average of $100/sqft for industrial buildings, these facilities could be valued at $10 million, yet the company reports them for $3 million less depreciation.
Managers and ownership: The company was helmed by David Taylor, son of the company's founder, until 2018, when he retired. Then an outside managerial team was called. Their compensation is not exaggerated, at approximately $300 thousand per executive per year.
Insider ownership is low, with executives and directors owning 7% of the company, but mostly in options that have not been exercised yet. There are other two significant shareholders with 13% and 9% of the company.
Negatives
Asia was lost to competition: The company did lose to competition in Asia. While the continent represented between 20% and 30% of revenues for most of the past decade, it now represents only 15% of revenues for the past few years. This implies that the continent was lost to competitors.
Cyclic or stagnant: The structural segment is incredibly cyclical, with revenues growing and collapsing at what seems to be the investment rhythm in the construction industry. The structural segment represented revenues of $8 million in FY10, $21 million in FY12, $10 million in FY14, $20 million in FY16, $14 million in FY17, and back to $16 million in FY22.
On the other hand, the aerospace segment is much more stable, but has not grown that much. The revenue figures for the same periods range between $9 and $12 million.
Operational leverage at the factory level: The company has important investments in facilities and manufacturing headcount. This makes its gross margins move in line with revenue cycles.
The effect is significant operational leverage, which gets even more multiplied at the SG&A level. The company has a small sales representative structure, but still spent $6 million in SG&A in FY22. The chart below shows how movements in revenue get multiplied at the gross profit and operating income level.
Anti acquisition clauses: The company has a preferred share rights program (the rights program) that allows the board to create preferred shares and give them to the current shareholders (at expensive conversion prices of $5 per share), in order to avoid a takeover.
Valuation
What to do with the balance sheet: TAYD's price is very different if one considers market cap versus enterprise value, because of the massive amounts of cash that the company is holding.
In my opinion these holdings provide an enormous security cushion, but should not be subtracted from the company's market cap for investment purposes. In order for them to be valuable as a discount, the company should have plans to return them to investors in some way, or maybe to invest them in new profitable businesses.
There are two problems with the return theory. The company's management has not disclosed any plans to return that cash to shareholders and there are anti-takeover provisions that would limit someone's desire to purchase the company and return that cash.
On the investment front, the company's segments are either not growing or highly cyclical. The company would be unwise to continue investing in these segments when it already suffers from operational leverage. Investing in other fields would be risky, and speculating on that basis even more so.
For those reasons, I prefer to consider cash as putting a low end to the valuation (obviously the stock cannot go down forever if the company holds $22 million in cash), but not as cash that an investor could get as a return for its investment.
Growth is not there: The reader should be careful not to judge TAYD's recent growth in isolation from the company's cyclical history. Once it is put into perspective, the recent YoY growth rates are much less impressive. Several signs point towards a cycle peak: revenues and operating profits are close to cycle peaks, and concentration to the structural segment is also peaking close to 60%.
No drivers of growth: TAYD has been in the same lines of business for the past decade. The business description was the same in the 10-K report for FY10. There is no new product or cyclical change (besides the one on construction investment) that would imply the future will be different from the recent past.
Cycle peak and average earnings multiples: If one considers the TTM earnings of the company, it currently trades at a P/E ratio of 13x ($54 million market cap versus $4 million in net income). That does not seem excessive for a company with cash, conservative management and some technological moat.
However, compared to historical average earnings from the previous two cycles, the company trades at a P/E ratio of 26x. With no changes in products or market dynamics, why would this time be different and the cycle avoided?
Conclusions
TAYD seems to have a conservative management and a historical technological moat in aerospace and structural (building) shock absorption. On top of that the company's balance sheet is a fortress, and profits are growing fast on a YoY basis. It does not seem expensive at a P/E ratio of 13x.
However, the company suffers from cyclicality coupled with enormous operational leverage. When these are taken into account (by averaging earnings across the cycle) the multiple increases to 26x.
In my opinion, there are no signs that TAYD has 'broken the wheel' of the cycle and can continue increasing profits in the structural segment indefinitely. Paying those multiples to average earnings seems risky.
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