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IEH Corporation (IEHC): A High Return Business Selling At A Bargain Basement Price

|Includes: IEH Corp. (IEHC)

IEH Corporation (OTCQB:IEHC) shares are selling at less than 6x earnings (85% of book value) despite a being well positioned in a stable, growing business with strong barriers to entry, a debt-free balance sheet, and having a current ROE of 15.4%. Further, the company is a designer, marketer, and manufacturer of connectors - an industry which has been consolidating for the past 20 years and continues to consolidate - players like TE Connectivity (NYSE:TEL), Amphenol (NYSE:APH), and Britain's Smith's Group have been gobbling up smaller players while Molex (NASDAQ:MOLX) recently announced a going private transaction. Though shares have risen 59% YTD, if shares were to be valued at 7x EBITDA (or 14x P/E - still a 15-30% discount to industry peers) shares could appreciate 100+%.

IEH is the smallest listed player in the connector industry. The company is based in NY and 40% owned by 72 year old Chairman Michael Offerman. While the industry is dominated by heavyweights Tyco, Amphenol, and Molex, IEH is somewhat insulated from competition as its products are primarily used in defense (55%), civil aerospace (35%), with other (including medical) comprising the remaining 10% of sales. While there are concerns about potential defense spending cuts, the business has been able to hold relatively constant over the past three years and shown growth over a five year horizon -see below:

Year ended March 30,

2008

2009

2010

2011

2012

2013

Revenue ($ '000)

7,805

10,718

12,141

13,823

13,292

13,330

Revenue growth

 

37.3%

13.3%

13.9%

-3.8%

0.3%

Operating Profit ($ '000)

625

1,409

1,965

2,941

2,167

1,780

Operating Margin

8.0%

13.1%

16.2%

21.3%

16.3%

13.4%

Gross Margin

29.2%

30.7%

32.6%

37.1%

33.9%

31.9%

While defense spending (highest margin category) has been somewhat soft, commercial aerospace has been strong (second highest category). In fact, in the first quarter, commercial aerospace strength more than offset weakness in defense spending:

Quarter ended June 30,

2012

2013

Revenue ($ '000)

3469

4090

Revenue growth

 

17.9%

Operating Profit ($ '000)

559

895

Operating Margin

16.1%

21.9%

Gross Margin

34.6%

39.2%

In fact, this was the strongest quarterly report we've seen from IEH in several years. As we've seen from other suppliers to Boeing/Airbus, the commercial aerospace sector is strong. That said, I wouldn't get too excited about any single quarter or even year, particularly for a company like IEH which has a somewhat lumpy component to its reported results. IEH focuses on developing connectors suitable for harsh environments - mission-critical products that will not fail even in extreme circumstances. For instance, it can take the company several years to get added to a new platform in both the defense and civil aerospace business. Not only is there a lengthy design phase but there are multiple testing phases. All in development time for some projects can be as long as ten years! During this time, the company has to spend on both research and development initiatives as well as marketing - all with no promise of revenue. This is actually a beautiful aspect of the business as it keeps competitors out. Given the time spent designing the product into the project and the associated testing, customers almost never change suppliers. It is also worthy to note that aerospace & defense platforms are very long-lived which means that once IEH has cleared the hurdles to be added to platforms it has a little monopoly (in some cases a duopoly as some customers dual source) for many, many years.

While IEH has generated strong operating margins, other niche connectors companies have done even better. For instance Deutsche (owned by private equity firm Wendel and sold to TE Connectivity) consistently generated mid-high 20s EBITDA margins. Again, this is a function of providing a mission-critical component suitable for harsh environments where it is locked onto customer platforms and not subject to competition. Further, during the marketing phase, customers are not super concerned about price given that connectors are a very small percentage of the total cost of the project/end product. Note that Deutsche was acquired by TE Connectivity for $2 billion in late 2011 which represented an enterprise value to revenue multiple of 3x (12x EBITDA). Here is a breakdown of operating margins for other connector companies:

Comparable Operating Margin

2010

2011

2012

TE Connectivity

13.6%

13.4%

13.3%

Smith's Group

17.8%

14.7%

14.9%

Amphenol

19.3%

19.0%

19.6%

Molex

12.4%

11.8%

10.4%

Smith's (UK listed conglomerate) is the best comparable of the publicly traded company as it is also focused on hyperboloid connectors. TE Connectivity and Molex are the least similar competitors as they sell to tougher end markets - autos and consumer electronics, respectively. These are lower margin segments given low margins at customers as well as having shorter platform lifecycles subjecting manufacturers to more competition.

I estimate a normal level of sales for IEH is somewhere in the $13-14 million range (may be higher this year given strong first half but I'm going to use $13.5 million to be conservative, more consistent with the past several years). Applying a 15% operating margin (1 point below 5 year average of 16%) brings me to operating profit of $2.03 million. The company has no debt so we shouldn't see much in the way of interest expense. Taxing operating income at 37% gives me net income of $1.276 million or $0.55/share. Here is where other connector companies are currently trading:

P/E Multiples

 

TE Connectivity

16

Amphenol

20

Molex

24

   

P/E Multiple Sensitivity

Share Price

10

5.5

12

6.6

14

7.7

16

8.8

18

9.9

I didn't include Smith's as their connector business is a small % of the overall company so the multiple at which it trades isn't necessarily reflective of the market's appraisal of the connector business. The Molex multiple of 24 isn't particularly meaningful as the new owners are looking to significantly improve the company's operating profitability. Amphenol and Tyco average out to a 18x P/E. Using 14x (22% discount) which reflects the company's small size, IEH shares look to be worth $7.70, or 100% upside. In a situation where IEH were acquired, something in the $9-10/share range is probably more appropriate, suggesting even larger gains.

As for the downside, with no debt and a book value of $3.95/share, and a net current asset value just greater than today's market cap, there doesn't appear to be much downside in the shares making IEH a highly asymmetric investment at these prices.

I am long IEHC.

Disclosure: I am long OTCQB:IEHC.