- No major changes to the mid-term outlook for Pro-Dex after its Q2 FY'23 earnings, in my opinion.
- Top-line continues worming higher, but we're yet to see this carry through the P&L to earnings growth.
- The market may have it correctly priced at 12x forward earnings.
- Net-net, reiterate hold.
After the last publication on Pro-Dex, Inc. (NASDAQ:PDEX) in September there's been negligible price change. Shares have moved past my $14 price target but haven't displayed any remarkable technical or fundamental changes to my original hold thesis, in my estimation. Further, investors have priced PDEX at 13x forward earnings, below the sector's 19x, and below the company's 5-year average of 18x. This is certainly intriguing, and there is a potential case for getting PDEX cheap and playing a reversal. For your efforts, there's 7.6% forward earnings yield and 19% trailing ROE on offer, and you'd be going against the quant system's neutral rating as well.
As a reminder, PDEX develops and manufactures autoclavable, battery powered surgical drivers and shavers used in across orthopaedic and cranio-maxillary surgery markets. In particular, it has patented torque-limiting software in its products as a potential differentiator. This isn't a high-growth, nor deep-value name in my opinion. Revenue upsides are consistent yet lag other opportunities, and the market has correctly discounted its market value to 12x forward earnings in my opinion. Therein lies an interesting investment debate with PDEX, but I believe for the time being, there are more rewarding opportunities for investor capital elsewhere. I wouldn't be searching for any upside on $15 with the current available data, and reiterate that PDEX is a hold in my opinion. I'll run through the reinforced points as to why here today.
Q2 no change to long-term route
1. Top-line distribution changes from 2022
It's important to note that PDEX is a slow-growing, mature company established in 1978. Yet, it does persistently grow top-line revenues, to $13.1mm in Q2 FY'23 (this corresponds with Q1 CY 2023). There was some very interesting YoY changes in revenue composition. You can see in Figure 2, that repairs and other turnover made up just 18% of revenue in Q2 FY'22, and 37% of the top-line this year to $4.8mm. This looks to be non-recurring impact as it came from the recycling of hand pieces to its largest customer, moving onto its next gen orthopaedic hand piece. It expects this tailwind in revenues to continue throughout 2023, at the request of its customer.
The bolus of turnover came from medical device and product sales still, with $7mm in quarterly revenues, a total of $23.2mm for the previous 9-months of trade.
2. For scale effects, I'll talk in terms of the trailing 12 months ("TTM") from hereon in, unless otherwise stated. This provides a 12-month lookback window over 12 periods to Q3 FY'20. The firm clipped $48mm in trailing revenue last quarter and pulled this down to $6.1mm in core EBITDA. You'll note below that TTM EBITDA margins have rolled lower since 2020 from highs of 21% to 13% last quarter. This margin haircut is operationally derived, not from higher capital requirements. CapEx has averaged ~$5-$6mm per quarter whereas operating cash flow hasn't shown any upside at all. Sequential revenue growth, shown in the blue line, has also been cyclical, but not stellar, despite the upsides seen since 2022. The potential issue I have with this kind of growth is that it isn't carrying down the P&L, or generating more free cash flow for shareholders. Looking forward, if EBITDA margins continue thinning, without the revenue growth to back this up, it is difficult to see a positive outlook for PDEX's future cash flows. I am not prepared to pay anywhere close to the sector's 19x multiple for this kind of offering.
3. Findings also demonstrate another potential headwind around cash flow and cash collection trends. You'll note in Figure 4 that as revenue walked higher from FY'20-Q2'FY'23 (TTM) operating cash flow prints have dwindled from $3.5mm to negative $0.4mm in outflows last quarter. Inventory movements are partly to blame, however, so too is the increase in accounts receivable, as shown here. The amount of cash flow backing revenues has pinched back from 9-10% in 2020 to negative 1% last period, trends that need to improve in order to catch a buy rating.
4. The question then turns to what these findings mean looking forwards. I'd note several points for discussion here:
One, the rate of cash flow growth matters substantially. I don't expect tremendous valuation lift-off into the future if there's less than 1% of trailing revenues backed by cash today. This needs to improve, because all of PDEX's retained earnings are being reinvested at fairly abysmal rates of conversion to cash. You can see it was recycling well back in 2022, hitting ~$6mm in additional FCF from $0.90mm in retained earnings. However, the trends have remained largely flat since, and there's been no major divergence in incremental FCF to the level of PDEX's retained earnings each period since. I'd like to see more being done here, more FCF or at least operating cash flow from the earnings PDEX is putting back into the business. At this point, the current situation is unsatisfactory in my opinion.
Two, a key point on this is the company's 25,000sqft facility it purchased in Texas back in 2020 to ramp up capacity of batteries and additional products. Per management, the company has basically fitted out the facility and completed most of the required build-out last year. Right now, it's about ensuring the paperwork and validation, verification work is completed so it can come online with no hiccups. Positively, the firm expects that it will start operations at the new facility by Q4 FY'23. This would be a key milestone to pay very close attention to in my opinion. I'll be watching the language on this facility intently going forward, because the ramp up in capacity would be welcomed.
Several points are now abundantly clear following this analysis of PDEX's steady-state and contribution from growth. To name a few:
- Looking again to TTM values, it hasn't been profitable revenue growth for PDEX over the last 2-years.
- EBITDA margins are compressing and I believe this trend could continue going forward if the new manufacturing facility comes online running hot.
- Cash conversion is weakening too and there's negative cash flow backing top-line growth at the moment.
- Added to that, PDEX is recycling retained earnings poorly and isn't allocating capital at sufficiently high rates of return. As such, FCF's have been lumpy and offered no valuation upside.
- I'd also point out the $26mm in equity holding up $47mm in assets which is reasonably sound.
The sum of these parts is not something to be desired in my opinion. I'd prefer to see cash flows strengthening along with top-line expansion, in addition to the profits PDEX is reinvesting back into the business (retained earnings) start to throw off some more cash to shareholders.
Valuation and conclusion
Looking at the market's numbers for PDEX opens up an interesting valuation debate. It is valued at 12.4x forward earnings, below the sector and self-averages, as previously mentioned. You're also paying 2x book value for 19% trailing ROE, bringing the investor ROE to ~9.5%. PDEX at 0.27x PEG suggests forward earnings growth is yet to be priced in to its market valuation.
To push back on this however, I'd remind us all that market valuations (versus intrinsic valuations) are simply a set of expectations. Hence, if PDEX trades at a 50% discount to the sector, the question immediately turns to why. Is there a mispricing here, because the market has got PDEX's forward earnings growth off-centre? In that case, PDEX is worth more than 12x. Or, has the market correctly discounted the flat earnings growth ahead. In that case, the discount. is appropriate. Looking forwards, consensus expects 20% YoY growth in pre-tax income and another 8% earnings growth. This would be remarkable, because it also expects 6% revenue upside. I am aligned with this, but don't have the same kind of carry throughout the P&L. A 5-6% growth in earnings appears more reasonable in my estimation. At 12x EPS estimates of $1.20, you're looking at a price target range of $14-$15, fairly valued at the current market price.
In summary, I believe there are more selective opportunities for investors to place capital elsewhere at this point in time. PDEX is working its way through, but the question of opportunity cost arises, coupled with the investment hurdles discussed here today. I believe the market has correctly discounted the company's stock price at $15 given these headwinds. I would look to the talk on PDEX's new San Diego facility to observe the increase in capacity from its opening. This could present as a tailwind if converted successfully. It is expected from Q4 this year. Net-net, reiterate hold.
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