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Deswell Industries: Low Risk High Return Potential

Summary

Deswell is low market cap selling slightly above NCAV.

After years of losses, Deswell is now profitable.

Deswell is based in Macau.

Is Deswell a scam?

Deswell (NASDAQ:DSWL) was founded in 1987 with corporate headquarters in Macau, China and operations in Dongguan, China. I first wrote about Deswell in January of 2014. Back then it was a net-net company that was unprofitable. One of the things I like about Deswell is that it is in a very simple business that is easy to understand. Their financial statements are so simple that in their balance sheet, they list no long-term liabilities.

Deswell

Deswell is a microcap (less than $50 million market cap) company listed on Nasdaq. Many investors are fearful of companies with operations in China due to accounting practices, so I will first focus on that issue before turning my attention on why it is a good investment. Let’s take a look at some of their numbers:

EPS Dividends per share
2004 1.04 0.47
2005 1.02 0.65
2006 0.59 0.63
2007 0.81 0.65
2008 0.57 0.61
2009 0.08 0.24
2010 0.09 0.1
2011 -0.5 0.1
2012 -0.09 0.12
2013 -0.12 0.2
2014 -0.46 0.2
2015 -0.17 0.19
2016 -0.31 0.14
2017 0.09 0.11

As you can see above the company had been losing money since 2011 but has continued to distribute cash to shareholders. These are GAAP numbers but as a check I always try to analyze whether they truly represent the company’s finances. Many investors who rely on GAAP numbers alone end up getting burned badly. For example, Enron displayed impressive numbers to investors before it collapsed. More recently investors have realized that GE’s numbers were not so representative of the company’s true economics. In fact, the SEC has recently opened a probe into GE’s accounting. Let’s see if Deswell’s GAAP numbers truly represent the business by adding one more column to the table above:

EPS Dividends per share EPS – dividends
2004 1.04 0.47 0.57
2005 1.02 0.65 0.37
2006 0.59 0.63 -0.04
2007 0.81 0.65 0.16
2008 0.57 0.61 -0.04
2009 0.08 0.24 -0.16
2010 0.09 0.1 -0.01
2011 -0.5 0.1 -0.6
2012 -0.09 0.12 -0.21
2013 -0.12 0.2 -0.32
2014 -0.46 0.2 -0.66
2015 -0.17 0.19 -0.36
2016 -0.31 0.14 -0.45
2017 0.09 0.11 -0.02

The third column, EPS minus dividends represents the amount of net worth that should be added or subtracted to the company’s net worth. If an individual makes $100 in one day and spends $50, we should expect that the individual should be $50 richer at the end of the day. Similarly, a company that earns X amount in a year and distributes Y amount in a year, should be worth X minus Y more at the end of the year. If year after year this relationship does not hold then we have to wonder what is going on. So let’s see if this relationship has held true for Deswell by adding two more columns to the table above:

EPS Dividends per share EPS-Dividends BV per share Expected BV
2004 1.04 0.47 0.57 6.54
2005 1.02 0.65 0.37 7.09 6.91
2006 0.59 0.63 -0.04 7.16 7.05
2007 0.81 0.65 0.16 7.42 7.32
2008 0.57 0.61 -0.04 7.68 7.38
2009 0.08 0.24 -0.16 7.62 7.52
2010 0.09 0.1 -0.01 7.47 7.61
2011 -0.5 0.1 -0.6 6.87 6.87
2012 -0.09 0.12 -0.21 6.65 6.66
2013 -0.12 0.2 -0.32 6.2 6.33
2014 -0.46 0.2 -0.66 5.58 5.54
2015 -0.17 0.19 -0.36 5.23 5.22
2016 -0.31 0.14 -0.45 4.78 4.78
2017 0.09 0.11 -0.02 4.8 4.76

The fourth column, book value per share, represents the company’s net worth. The fifth column is what we should expect the company’s book value (NYSE:BV) to be given the prior year’s earnings and dividends. For example, in 2004, as seen above, the company earned $1.04 and distributed $0.47 so we should expect the company’s net worth to increase by $0.57 (Column 4: 1.04 – 0.47 = 0.57). In 2005 we should expect BV to be 6.91 (Column 5: 6.54 + 0.57 = 6.91). In reality BV ended up being $7.09, so that is a positive surprise in that one year. By comparing column 4 with column 5 numbers, you get a picture that the company has been keeping it real with its accounting. Column 5 numbers are remarkably close to Column 4 numbers.

To be sure, there are many reasons why the two numbers may not legitimately match for a company. A couple of examples are if the company buys back shares or if it has a one-time write-down in goodwill. However, over the long term, a company with conservative accounting policies should have its net worth increase/decrease by the sum of its earnings (cash flowing in) minus its distributions (cash flowing out). In Deswell’s case since 2004, it has earned $1.60 (sum of the numbers in the first column) and it has distributed $3.94 (sum of the numbers in the second column) therefore we should expect its net worth to DECREASE by $2.34 (1.60 – 3.94). Book value per share was $6.54 in 2004, so we should expect that its book value today should be $4.20 (6.54 – 2.34 = 4.20). As you can see in column 4 the true number is $4.80. Again, this is a pleasant finding for long-term Deswell investors and demonstrates that it has sound accounting practices.

In addition to the above analysis, investors can take comfort in Deswell’s management because of their long and consistent history of returning cash to shareholders. Companies that try to cheat their investors prefer hoarding their cash. Now that we have dispelled the notion that Deswell may not be a legitimate company, let us turn our attention to see if it is a good investment.

From net-net to profits

For most of the time since 2014 since my first article, Deswell has remained an unprofitable net-net. It no longer is a net-net. Let’s take a more detailed look at the numbers since 2014:

2014 2015 2016 2017
Total Revenues 40.9 38.1 44.6 44.5
Margins 8.9% 11.1% 10.8% 16.7%
Net Income -7.5 -2.8 -4.9 1.4
Dividends 3.6 3 1.7 2.2
Total Equity 89.6 84.1 76.8 76.2
Shares Outstanding 16.1 16.1 16.1 15.9
Total Current Assets 61.9 58.2 50.7 56.1
Total Liabilities 11 12.4 10.8 14.8
NCAV 50.9 45.8 39.9 41.3
NCAV per share 3.16 2.84 2.48 2.60
Dividends per share 0.2 0.19 0.14 0.11
PP&E 38.7 36.6 32.4 32

Total revenues have only recently reversed their downward trajectory. Much more importantly margins have improved dramatically from 8.9% in 2014 to 16.7% now. After posting losses for six straight years since 2011, they have finally turned profitable. Shareholder Equity or BV has declined by $13.4 million since 2014 (89.6 – 76.2 = 13.4). This decline is explained by the company’s generous dividends (the dividend yield had been around 10% for much of the time since 2014) and its continued losses. The dividends and losses also contributed to the drop in NCAV. Some investors rightly complained that the dividends amounted to a depletion of assets which for tax purposes was disadvantageous to investors. You can see some of those comments in previous Seeking Alpha articles here and here. The complaints were appropriate because the company was returning their net worth to investors and yet investors were taxed for the cash as dividends. Nevertheless, I was pleased with management’s decision to return cash to investors in those dark years. It made perfect sense to me. They were losing money which implied that they were not using their capital profitably therefore the cash was better in investors’ pockets than in the company’s account. Similarly, a growing and profitable company likely has better uses for cash than investors in the company. Growing companies like Amazon and Facebook should indeed retain all their profits.

I am a fan of net-nets but not all net-nets are worth investing in as I have written in the past. There are ones that should be avoided no matter how far below NCAV they are trading. Deswell, on the other hand, was one that I liked because of management’s actions. Lately, I have even been more impressed by management’s open market purchases of the stock. Take a look below to see how much the insiders have been increasing their stake. Most of these purchases are open market and not through stock options. Richard Pui Hon Lau is the former company CEO and now Chairman of BOD. He owned 11.5% of the shares in 2013. Furthermore the company has been buying back some of its own shares in the open market as you can see from the slight decline in total shares outstanding in the table above. I like when management’s interests are aligned with investors’.

2015 2016 2017
Richard Pui Hon Lau 23.6% 34.0% 41.4%
Chin Pang Li 10.0% 10.0% 10.1%

As the company’s margins have improved and revenues increased, Deswell stopped issuing dividends. In a recent SEC filing, the company stated that

the distribution of dividend will be resumed no later than March 31, 2019.

I was pleased again with the company’s rationality. Now that they are growing again, it makes perfect sense to retain their earnings. The cash is being put to good use.

Conclusion

Deswell has emerged from a money losing net-net to a profitable company. Management’s interests have been aligned with those of the shareholders, and they have a long history of acting in the best interest of shareholders. The potential investment gains are very large for investors. Meanwhile due to the company’s solid balance sheet, their NCAV currently is $2.60 – only slightly below the stock price of $3.01. The floor is not too far below the current stock price.

Full disclosure: I own about 1% of total shares outstanding

Disclosure: I am/we are long DSWL.