Anyone that actively followed small cap stocks in 2004 and 2005 likely heard of Dynamic Materials Corporation (“DMC”). Aside from having an explosive sounding ticker symbol...BOOM...DMC captured the attention of investors with its explosive like returns of 300% and 395% in 2004 and 2005, respectively.
Since 2005, returns have been anything but explosive. At a current share price of $32.70, shares of DMC are trading only $2.60 higher than they were at the end of 2005.
While 2006 didn’t offer much for investors by the way of share price appreciation, the company was busy growing sales by 43%, net income from continuing operations by 86%, and backlog by 65%. Furthermore, the company undertook multiple projects in 2006 that will not only expand capacity at its U.S. operations but also modernize facilities and equipment at its European operations.
So have shares of DMC gone bust or will investors once again enjoy the boom days of 2004 and 2005?
Background
DMC was originally founded in 1965 and incorporated in 1971 as Explosive Fabricators Inc. (EFI). In 1976, EFI became a licensee of Dupont’s explosion welding technology know as DetaClad. In the following year, EFI went public and changed its name to Dynamic Materials Corporation. After twenty years of licensing the Detaclad technology from Dupont, DMC purchased Dupont’s Detaclad operations for $5 million.
In 1998, DMC branched out from its explosion welding business by acquiring three aerospace companies: Spin Forge, AMK Welding, and Precision Machined Products. The three aerospace companies operated as a separate division from the “Explosive Cladding” division. After a strong start, the “Aerospace” division eventually fizzled and DMC sold two of the three acquired operations in 2003 and 2004, leaving only AMK Welding to operate as its own division.
In 1999, SNPE, Inc., a wholly entity of Group SNPE, a French state-owned conglomerate, began acquiring shares of DMC through a series of open market transaction and a direct purchase of common stock. When SNPE, Inc.’s started accumulating shares of DMC, Group SNPE, through its wholly owned entity Nobel Explosifs France (“NEF”), owned Nobelclad, a licensee of Dupon’t Detaclad technology since 1966. Furthermore, Nobelclad had already acquired its Swedish competitor Nitro Metall as well as its U.K. and German competitor. On July 3, 2001 DMC acquired Nobelclad from NEF.
While the above may seem confusing, it is really quite simple. Group SNPE became the majority shareholder of DMC. Around the same time, Group SNPE consolidated a number of clad producers and sold them to DMC, making DMC a global force in explosion cladding.
Today, DMC still operates its Nobelclad and Nitro Metall operations in France and Sweden, respectively. DMC’s corporate headquarters is in Boulder Colorado and the U.S. explosion welding business operates out of Mt. Braddock Pennsylvania. AMK welding operates out of Windsor, Connecticut.
The Explosive Metalworking division accounts for 95% of DMC’s revenues and AMK accounts for the other 5%. As such, most of my analysis will be geared toward the Explosive Metalworking division.
Aside from the company's 10K, Answers.com has some good background on DMC.
Product/Customers
Explosion-welded clad metal plates are the primary product of the Explosive Metalworking division. The metal plates are composed of two or more dissimilar metals that cannot be joined through traditional welding processes. The clad layer is typically a high performance, corrosion resistant, expensive metal such as zirconium, tantalum, titanium, nickel etc. The base layer is typically a cheaper, less expensive, and thicker base metal such as carbon steel.
Unlike other cladding processes, explosion cladding provides a true weld at the molecular level. Furthermore, the individual metals fully maintain their original properties. As such, the end-product retains the corrosion resistant properties of the clad layer and the structural strength of the base layer. In addition, the relative affordability of the base layer relative to the clad layer makes explosion clad more economical than solid metal construction.
DMC sells to metal fabricators, engineering firms, and/or end users in the oil & gas, petrochemical, hydrometallurgy, aluminum smelting, power generation, shipbuilding, metal production, and industrial refrigeration industries. Customers utilize the explosion clad plates in the construction of industrial equipment that is exposed to harsh operating environments characterized by corrosion, high temperature and high pressure.
DMC is usually contracted by the equipment fabricators but frequently the engineering firm will specify the materials of construction. DMC has a strong reputation with the large engineering firms responsible for equipment specifications.
Competition
What competition? By far, DMC is the “dominant force” in the explosion clad industry. According to a recent investor presentation on DMC’s website, DMC is the largest supplier of explosion clad with 35% to 40% global market share. Competition is highly fragmented and competitors around the globe are smaller and technically limited relative to DMC. In its 10K filing, DMC mentions Baclad, a division of Asahi Kasei, as having a competing technology and a recognized local brand name. While the Baclad division is small relative to DMC and more domestically focused, it would be beneficial for investors to monitor the happenings at Baclad. At the same time, Baclad would seemingly make for a potential acquisition candite. A Baclad acquisition would increase capacity and provide a strategic geographic location.
Barriers to entry are fairly adequate to keep potential competitors at bay. For starters, DMC is deeply entrenched in the market with a strong reputation and first class operations. While the patent for the explosion clad process has expired, explosion cladding is highly technical and requires extreme precision. With the high cost of metals involved in the explosion cladding process, mistakes can be costly. To this regard, DMC has over 40 years of experience and proprietary knowledge that gives it a distinct advantage over any would be competitors. Finally, the lack of suitable explosive shooting sites and the inherent difficulty in obtaining related permits further adds to the competitive barriers.
DMC not only competes against other explosion clad manufacturers but also other cladding processes such as rollbond and weld overlay. For the most part, each process has its own specific applications and there is little crossover. As the only process providing a true weld, the explosion cladding process provides the strongest bond and is capable of bonding dissimilar metals. Thus, explosion clad is overly suited for some of the applications that utilized roll bond and weld overlay. Nonetheless, explosion clad is gaining acceptance over the other clad products in some applications normally reserved for rollbond or weld overlay. Furthermore, potential customers may increasingly specify explosion clad over other types of clad as the turnaround time on the other types of clad has increased substantially due to overwhelming demand.
While not discussed in the 10K, the potential exists for a non-metallic material or substance to be developed that would compete with explosion clad. I have not seen evidence of this threat but it remains a possibility. If such a product was developed, it would likely take years of testing before it would be considered for commercials use.
Market Demand
According to Jim Rogers, the author of Hot Commodities and co-founder of the Quantum Fund with George Soros, there were three long-term bull markets in commodities during the 20th century. On average the three bull markets lasted 17 to 18 years. In his book, Rogers walks through the start-up of a lead mining operation as a hypothetical example to illustrate why commodity bull markets last so long. First, he discusses how the long term bull market is preceded by an equally long bear market characterized by low commodity prices, which in turn results in years of underinvestment. Near the end of the bear market and the beginning of the bull market, the years of underinvestment and diminishing supply are met with rising demand. In the early going, it may take years for the shift in the supply and demand dynamic to be recognized and/or acted upon.
In Rogers example, he discusses each obstacle that must be overcome by the lead mining company. First, it can take years of exploration to find new deposits. Once new deposits are found, investors need to be convinced to invest large amounts of capital in a not so glamorous industry. Keep in mind that investors are likely to be a bit leery of investing in a sector that is just coming out of a long-term bear market. Once the company obtains financing, the company needs to get approvals from the government and do battle with the environmentalists. Again, this process can take years and could ultimately keep the project from moving forward. Assuming the company is able to obtain approvals for the mining operation, they have to build the necessary infrastructure to support the mining operations (roads, power, water, mining equipment, trucks, workers, buildings, a method of transit for the commodity, etc.).
Once the mining infrastructure is in place, the processing plant (refinery, smelter, etc.) needs to be built. This process will require additional financing, a new round of government approvals, and even more battles with the environmentalists. If the environmentalists had a problem with the mining operation, they are really going to take issue with the processing plant. At the same time, the processing technology has to go through several phases of testing to ensure it is an effective process for the specific commodity and ore. Once the approvals are in place and the testing is complete, the infrastructure for the processing plant needs to be ordered and constructed. A company on the front-end of the curve might be able to receive their equipment orders in a reasonable timeframe. Others could see lead times of one to two years on some equipment.
By the time the first wave of new capacity comes on-line, the additional capacity is likely going to be barely adequate to meet the demand of when these projects were first started. All the while, demand has grown and the supply and demand situation has barely improved if not worsened. More capacity will continue to come on-line for years to come. Eventually, there will be another shift in the supply and demand equation and it might take a couple years for this shift to become evident. Eventually there will be an overabundance of supply, prices will begin to fall, and a new long-term bear market will begin.
So what does all this have to do with DMC? Let’s not forget that in the midst of all this long-term commodity bull market DMC is selling its explosion clad to customers in the oil & gas, petrochemical, hydrometallurgy, aluminum smelting, power generation, shipbuilding, metal production, and industrial refrigeration industries. DMC is well position to take advantage of the current commodity bull market on a number of fronts. DMC is not selling a commodity but a manufactured product that serves the needs of its customers across the spectrum of the commodities sector.
According to Rogers, the current bull market for commodities started in 1999. In my opinion, the sweet spot for DMC in this bull market is still ahead. Nonetheless, DMC is seeing some of the early effects now. A new refinery has yet to be built in the U.S. in several decades. Refinery fires and refinery accidents have seemingly become regular events. These accidents are the result of refineries running well beyond their intended capacity and years of underinvestment. In the U.S. and around the globe, significant investments must be made not only in expanding capacity, but also in modernizing the existing infrastructure.
Growing Opportunities
With the increase in commodity prices, the opportunities for DMC have grown. For instance, the rise in oil prices has increased the economic viability of developing the oil sands of Canada. Oil from the Canadian oil sands is highly corrosive and has greater refining rneeds than conventional oil. The greater refining requirements and the corrosive nature of tar sands crude will further add to the demand for explosion clad. DMC is clearly positioned to take advantage of this demand. Note the thank you letters on DMC’s website from Suncor and CB&I, two major players in the development of the tar sands.
As a second example, the price of nickel has been moving steadily higher on rapidly rising demand and delays in the introduction of new supplies. Nickel can be produced from either sulphide or laterite ore. About 70% of the land based nickel is in laterites, but laterites only account for about 40% of the worlds nickel production. Sulphide ore is easier to process, but the replenishment rate of sulfide reserves has lagged significantly behind their depletion rate. As such, future nickel production will likely come from laterite ores (reference). With advancements made in the hydrometallurgical process know as Pressure Acid leaching (“PAL”), future laterite nickel projects will likely employ PAL technology. In the last couple of years, DMC has received several large contracts from three PAL laterite nickel projects including: Ambatovy, Goro, and Ravensthorpe. Furthermore, there has been an increased interest in utilizing PAL for the processing of sulphide ores (Voisey Bay and Tati Nickel) over the traditional smelter technology.
Along with nickel, pressure leaching technology has been employed for a number of years in the gold industry and is currently being considered by the copper industry. The gold and copper processes, known as Pressure Oxidation Leaching (“POX”) processes, differ from the nickel processes in that the operating environments of the POX processes are oxygen rich. The abundance of oxygen and concern over the safety and suitability of titanium in such environments have limited the use of titanium and titanium clad in the construction of POX autoclaves. Lately there have been a number of studies testing the use of titanium and titanium clad autoclaves in POX environments. Studies are ongoing but this study put together by CESL, a wholly owned subsidiary of mining giant Teck Cominco, has yielded somewhat favorable results. In particular, titanium clad has performed exceptionally well relative to titanium as a result of certain properties of the clad’s base metal (carbon steel) in combination with the titanium. Furthermore, the opportunity exists with clad to add an interlayer of a metal with properties that will further decrease the likelihood of negative events and the impact of those events. Should the use of titanium clad autoclaves gain acceptance in POX processes, DMC will surely benefit. Note that DMC’s John Banker participated in the CESL study (see page 1).
There are a number of opportunities to expand the utilization of explosion clad across various industries and processes. Instead of detailing all of the opportunities, I think this quote from DMC’s 10K sums it up nicely:
“At current energy price levels, many non-traditional energy production methods are potentially commercially viable. These include liquid fuel production processes such as coal gasification, oil recovery from tar sands, and ethanol production from agricultural products. Also methods for transport or transformation of natural gas become viable, such as natural gas liquification and conversion of gas to liquid petroleum products. Virtually all of these processes involve conditions which require clad metal in some of the equipment. The primary clad metals for this market are stainless steel and nickel alloys clad to steel, with some use of reactive metals.”
AMK Welding
AMK Welding provides highly specialized welding services to manufactures of aircraft engines and ground-based power turbines. While sales at AMK increased 38% in 2006, AMK revenues represent less than 5% of total revenues.
While exceptionally strong market conditions in the aerospace and power generation industries will continue to have a positive impact on sales, AMK’s growth over the next several years will be largely dependent on its provider agreement with General Electric (“GE”) for work on GE’s new H System gas turbines. GE recently started shipping H System turbines to a power plant in California and Japan. Shipments on these two projects will likely continue through the first half of 2007.
The H System family of turbines is relatively new. As such, GE is likely still working through issues associated with the early stages of commercialization. Once GE works through these issues, it will be in a better position to aggressively market the H System.
While nothing is certain, I am optimistic that DMC’s relationship with GE will continue to expand.
Management
Mr. Yvon Cariou, President and CEO, has been with DMC since 2000. Under the leadership of Mr. Cariou, DMC purchased Nobelclad and Nitro Metall from NEF, divested itself of underperforming assets to focus on its core business, and undertook several expansion and modernization projects to handle future demand.
Mr. John Banker, Vice President, Marketing & Sales, Clad Metal Division, is recognized worldwide as a guru in the explosion welding business. Starting in R&D, Mr. Banker has been in the business of explosion clad his entire career. If you do some research on explosion clad, you will see Mr. Banker’s name on a number of research papers and reports.
Mr. Richard Santa, Vice President, CFO and Secretary, has been with DMC for over ten years. He was with DMC through the acquisitions, divestitures, and turnaround. In the conference calls, Mr. Santa is clearly well versed in more than just the financials of DMC’s business.
More on DMC management can be found here.
In the past couple of years, management has occasionally exercised stock options and subsequently sold the respective shares in the open market. Furthermore, insider ownership is relatively low. While I normally like to see higher levels of insider ownership, the compensation plan seems appropriately structured to align managements’ interest with that of shareholders’ without being overly dilutive.
In general terms, there is little evidence of correlation between insider sales and stock price performance. In the case of DMC, there is likely an inverse correlation given that management’s practice of exercising stock options and subsequently selling shares took place during the big gains in share price during 2004 and 2005. Finally, the stock options issued to management are part of their compensation package. Management has rapidly grown DMC’s business and positioned the company for future growth. In my opinion, it is their right to diversify their assets and do as they feel is most appropriate with their personal finances.
On a side note, management’s decision to exercise their options and subsequently sell the related shares may have in part been driven by SNPE’s majority ownership position in DMC.
Risks
No investment is without risk and failure to recognize risks associated with a particular investment will ultimately lead to big losses. If I failed to recognize risks associated with investment ideas that I discuss on my blog, I would loose credibility with my readers (however many I might have at this point). I have identified some of the risks that I thought were most worth noting.
Commodity Prices and a Global Downturn
DMC customers are sensitive to the ups and downs of the global economy. Any prolonged downturn in the global economy will likely have a negative impact on commodity prices. To the extent that a global slowdown results in commodity prices falling to a level that DMC’s customers decide to make significant adjustments to their capital spending budgets, there will be a negative impact on DMC’s financial results.
I do not believe an economic slow down in the U.S. will necessarily result in a global economic slowdown that will in turn move commodity prices significantly lower. While the U.S. economy plays a pivotal role in the global economy, its overall influence is decreasing. Furthermore, demand for commodities has largely been driven by the growing middle class in countries like Brazil, Russian, India, and China. Also, lets not forget the supply side of the equation.
As mentioned above, I believe we are in a long-term commodity bull market. As such, short-term fluctuations in commodity prices will not have an affect on the spending plans of DMC’s customers. In the second half of 2006, oil prices fell significantly from their highs of $70 per barrel. Despite the short-term weakness in oil prices, DMC customers maintained their course and DMC reported record booking in December. Unabated activity in the energy sector was clear in the fourth quarter earnings of a number of oil service companies. In early 2007, oil prices fell even further but are now significantly off of their lows. Once again, there is a buzz all around the market about high energy prices.
Use of Explosives
DMC detonates a large quantities of explosives on a daily basis. DMC’s explosion operations could be disrupted in the event of an accident or additional regulations. Such a disruption would likely have a material impact on financial results.
Supply Chain Constraints
Recently, DMC has been working through some issues with suppliers of raw materials. In the last conference call, management said they expected the supply situation to have a negative impact on the first quarter of 2007 relative to the fourth quarter of 2006. As such, management expects first quarter results to approximate the average of the first three quarters of 2006 and then continue to improve throughout the course of the year. At the same time, management indicated they would work to alleviate the supply situation by expanding their supplier network and by handling more of the finish work in-house. While DMC management attempts to alleviate the supply constraints, I suspect suppliers will be working on their end to resolve this issues as well.
As always, investors should read the 10K for a complete discussion of risks.
A Year in Review
Contract News and Backlog
During the year, DMC completed shipments on the $6 million Kuwait Olefins contract (announced with Q2 2005 earnings release), the $7.5 million North America refinery contract, and the $11 million Eastern Europe refinery contract.
In 2006, DMC announced several new contracts including the $11 million Eastern Europe refinery contract noted above, the $8.7 million Ambatovy Nickel contract set to ship in the first half of 2007, and the $8 million Middle East natural gas contract set to ship in the second half of 2007.
In January 2007, DMC announced a single-month record for new orders of $20 million in the month of December. For the year, DMC’s explosive metalworking backlog increased 64% to $68.8 million from $42.0 million.
Option to Purchase
In the first quarter of 2006, DMC sold its option to purchase the real estate associated with its former Spin Forge operation. The rights were sold to the property owner for $2.3 million and DMC recorded a pre-tax gain of $2.2 million.
Au revoir mon ami. C'était amusant
In April 2006, DMC announced that SNPE, its majority shareholder, was selling all of its shares in a public offering. In May, DMC announced the closing of the public offering, in which SNPE successfully sold all of its shares (5.9 million), including the over-allotment of 773,000 shares, at $35.
The SNPE transaction seemed to raise a high level of concern for a number of retail investors. To this regard, it is important to note that the SNPE shares were already outstanding. As such, the public offering was not a dilutive transaction. Furthermore, SNPE’s balance sheet at the time of the transaction was in bad shape and its core businesses were struggling. SNPE’s decision to sell its shares was not a reflection on DMC but more of a reflection on SNPE’s need to improve its balance sheet and focus on its core businesses.
As for me, I was happy to see SNPE leave. For starters, who needs the French Government, or any government for that matter, as a majority shareholder? The removal of SNPE as a majority shareholder put more control in the hands of shareholders, which in-turn made DMC more attractive to institutions. After the transaction, institutional ownership more than doubled. Today, institutional ownership stands at roughly 77%. Furthermore, the SNPE transaction put more control in the hands of DMC management and board. As such, investors could be more coonfident that decisions would be made based on what was in the best interest of DMC and not SNPE. Finally, the departure of SNPE left several board seats available to be filled with DMC selected board members (Cariou, Nicolas, Hueber).
Capital Projects
In December 2005, DMC announced a five-year supply agreement between its AMK Welding division and GE for work on GE’s H System ground-based turbines. In order to meet the anticipated demand associate with the supply agreement, DMC announced a significant expansion to the AMK facility in Windsor, Connecticut. According to management, construction began in 2006 and remains on schedule. Furthermore, DMC announced the hiring of Harold Wiegard as President and General Manager of AMK Welding.
When DMC reported 2005 earnings in February of 2006, management announced a major expansion to its explosion welding facility in Mt. Braddock, Pennsylvania. Management expects the project to double capacity at the Mt. Braddock facility, which already accounts for a large majority of DMC’s explosion welding revenue. The expansion will not only increase capacity but will also add a new line of clad. It is unclear at this point what industries or processes management is targeting with this new line of clad. According to management, the facility is largely complete and they expect to receive equipment through the first half of 2007.
In the most recent earnings release, management announced its capital budget for 2007. The majority of the 2007 capital budget will go towards the modernization of the Nobelclad and Nitro Metall facilities. In 2007, additional spending will be made on the 2006 budget as it relates to the above mentioned expansion projects.
Financials
Balance Sheet
In the past year, cash, restricted cash, and marketable securities increased 171% to $21.0 million from $7.7 million. Including the restricted cash, DMC has $1.73 per share in cash. The restrictions on the restricted cash were scheduled to lapse in the first quarter of 2007.
Including its current portion, DMC lowered its long-term debt from $2.75 million at the end of 2005 to $764,000 at the end of 2006. DMC reported net cash, cash less long term debt, of $20.2 million. Working capital increased over $16.8 million from $21.7 million at the end of 2005 to $38.5 million at the end of 2006. Given DMC’s cash position, low levels of long-term debt and solid working capital position, I won’t bore readers with liquidity ratios.
In spite of its rapid growth, DMC has been successful in managing its inventories and accounts receivable. Accounts receivables increased 38% in 2006, which is lower than the 43% increase in sales. Inventories increased 62%, which is higher than the increase in sales but reasonable given the 64% increase in the backlog.
Income Statement
Sales increased 51% in 2004, 46% in 2005, and 43% in 2006. While sales growth has decelerated a bit over the last three years, backlog growth accelerated from 53% in 2005 to 64% in 2006. Given the acceleration in the backlog and the significant expansion projects expected to be completed this year, DMC is in a strong position to maintain its top line growth. While management is expecting 20% top-line growth, management believes there is room to the upside in their revenue forecast if there is some improvement to the tightness in the supply chain.
Gross profit margins increased from 25.12% in 2004 to 29.56% in 2005 to 37.04% in 2006. The steady improvement in gross margins is largely the result of DMC’s high level of fixed costs spread over higher sales. A more favorable product mix, higher prices, and the shipment of a higher margin contract in the fourth quarter also contributed to increased margins in 2006. It is important to note that management typically works the cost of raw materials into contracts such that fluctuations in raw material costs have a relatively minimal impact on gross margins.
SG&A as a percent of sales went from 12.4% in 2004 to 9.67% in 2005 to 10.51% in 2006. Breaking out SG&A as a percent, general and administrative expenses remained flat in 2006 compared to 2005 at 5.1%. Selling expenses increased to 5.4% of sales in 2006 versus 4.6% of sales in 2005. The increase in selling expenses as a percent of sales was largely driven by commissions and professional fees associated with the large contract shipped in the fourth quarter of 2006.
DMC’s effective tax rate increased from 33.5% in 2005 to 37.05% in 2006. Management expects the effective tax rate in 2007 to be between 37% and 38%.
Net income from continuing operations increased 243% in 2004, 136% in 2005, and 86% in 2006. Earnings per share from continuing operations increased from $0.41 in 2004 to $.86 in 2005 and $1.58 in 2006.
Cash Flow Statement
DMC’s cash flow from operations in 2006 was $16.6 million compared to the earnings from continuing operations of $19.3 million. I like to see cash flow from operations closely approximate earnings. If this is not the case, it is important to have an understanding as to why. In the fourth quarter, DMC had over $3 million in restricted cash on its balance sheet. The restricted cash relates to an advance payment on a large order that shipped in the fourth quarter of 2006. The cash is being held by DMC’s bank in the form of a bank guarantee arrangement between DMC, DMC’s bank, and the customer. The revenue from the related order met the recognition requirements for revenue in the fourth quarter of 2006 and the guarantee agreement was set to expire in the first quarter of 2007, at which time the restriction would be lifted. Including the restricted cash as cash, cash flow from operations exceeded earnings from continuing operations by over $300,000.
When a company has strong operational cash flows, it has the ability to employ that cash flow in a manner that will drive future growth and financial stability. Management can employ cash flow from operations to make acquisitions, increase capacity, add new product lines, pay down debt, pay dividends etc.
Cash flow from investing activities was a negative $2.8 million. The negative cash flow from investing activities is reflective of DMC’s decision to undertake two major expansion projects during the year. When cash flow from investing activities is negative like it is in the case of DMC, investors should see this as a positive sign as it suggests management believes the prospects are good for future growth and they are planning for that growth accordingly.
Cash flow from financing activities was a negative $2.2 million. DMC’s negative cash flow from financing activity is reflective of its continued pay down of long-term debt. Furthermore, it is evident in looking at the cash flow statement that DMC has been paying down debt and financing its expansion projects through operational cash flows and not the issuance of additional shares, which would be dilutive to shareholders.
Valuation / 12-Month Target
Over the course of 2006 and the first quarter of 2007, DMC shares have been consolidating its massive run-up in 2004 and 2005. At the same time fundamentals have been catching up with the valuation. Today, DMC shares are reasonably priced with the potential for significant returns over the next twelve-months.
At a price of $32.70, DMC has a trailing PE of 20.73 (I exclude the gain from discontinued operations from trailing earnings).
Based on analysts’ estimates obtained from Yahoo Finance, DMC is trading at 17.3X 2007 earnings and 14.47X 2008 earnings.
Given DMC’s positive net cash position, I will include EV/EBITDA to my valuation ratios. DMC has an EV/EBITDA of 11.8.
Analysts have a 12-month price target of $44, which represents a 35% gain over DMC’s current share price. Not bad.
Analysts are expecting earnings of $1.89 in 2007. At a twelve month price target of $44 and 2007 earnings estimate of $1.89, I get an implied future PE on trailing earnings of 23. Given DMC’s growth rates, returns, capital structure, increasing backlog, expanding earnings capacity, and favorable market conditions, I believe DMC deserves the PE premium being assigned by analysts.
Analysts’ earnings estimate of $1.89 per share in 2007 represents a 19.6% increase over 2006. Management is expecting revenue growth of 20% in 2007. If the tightness in the supply situation improves, management believes sales could increase more than 20%. If you believe the tightness in the supply chain will plague DMC throughout the year and you believe margins will contract slightly, the analysts’ $44 target is probably a reasonable estimate.
Based on my experience with DMC, management is reasonably conservative in providing forward guidance. In addition, my sense from the year-end conference call is that the supply situation will indeed improve. Given DMC’s current backlog, acceleration in order bookings as evidenced by the record bookings in December, favorable market conditions with regards to the imbalance of supply and demand of commodities, additional capacity coming on-line in the middle of 2007, I believe it is reasonable to assume top-line growth will increase 30-35%. Furthermore, I believe it is reasonable to assume that the higher sales will result in at least some margin improvement. In 2006, net margins from continuing operations were 16.98%. In my model, I have net margins increasing by a modest 67 basis points to 17.65%.
If I take the mid-point of my range for top-line growth, I get sales of $150.4 million in 2007. With net margins of 17.65% and a reasonable level of growth in diluted shares outstanding, I get earnings per share of $2.11. By applying the analysts’ implied future PE of 23, I get a twelve-month target of $48.50 for an increase of 48.32% over the current PPS of $32.70.
Downtowntrader
Downtowntrader, the man with the technical plan, is roaming around Spain doing who knows what. He claims he is working but I don't beleive him. I talked with him today and he said he would try to give his technical analysis on DMC in the next day or two.
Disclosure
I have been long DMC since mid to late 2004. While I have bought and sold some traders shares along the way, DMC is one of the larger holding in my portfolio as a result of the price appreciation in 2004 and 2005.
As always, do your own DD and feel free to offer comments...good or bad. If you actually made it to the end of this blog entry congratulations and thank you.
Regards,
Tuff
Other Sources of Information
10K
WallSt.net Interview
2007 Investor Presentation
Q4 and 2006 Conference Call Transcript
Q4 and 2006 Earnings Press Release
Press Releases
DMC Home Page
Dynamic Materials Corporation (Public, NASDAQ:BOOM)
Wednesday, March 28, 2007
Friday, March 9, 2007
The Naked Truth on AS&E
American Science & Engineering, Inc. (Public, NASDAQ:ASEI)
By now, most people have read or heard about the new airport screening system the Transportation Security Administration (TSA) is piloting at Sky Harbor International Airport in Phoenix, Arizona. When the news first broke in early December, there wasn’t a shortage of media coverage or distortion of facts.
When you heard the news of the TSA pilot, what went through your mind? Were you concerned your image taken at a security checkpoint would somehow find its way onto the internet? Were you concerned the radiation exposure would leave you glowing in the dark like a firefly? If you are an investor, you were probably thinking….What is the ticker symbol of the company that makes the screening machines?
Perhaps you are an investor and it crossed your mind to do a little due diligence but you never bothered for any number of reasons. Maybe you figured the company was a one hit wonder that would fall into bankruptcy if the TSA pilot program was a failure. Or, perhaps you figured the company was behemoth like GE and a large TSA contract would be relatively insignificant in the grand scheme of things. Or, perhaps you figured the company was likely already way overpriced.
If you are an investor and didn’t bother to do a little due diligence, I suggest you take the time get to know American Science & Engineering, Inc. (ASEI).
Not Your Father’s X-Ray Inspection System
American Science & Engineering, Inc. (“AS&E”) is a leading provider of X-ray inspection and screening systems. Founded in 1958, this Billerica, MA (go Red Sox) company has a rich history of scientific innovation that laid the groundwork for its current portfolio of products.
AS&E’s incorporates a combination of its patented Z Backscatter, Forwardscatter, Shaped Energy, and Radioactive Threat Detection technologies along with transmission X-ray technologies into its products to provide customers with the most comprehensive threat detection in the industry. AS&E’s high resolution scanning systems are capable of identifying smuggled goods and various threats to human life such as: traditional explosives; liquid explosives; plastic and metal weapons; radioactive devices; drugs; alcohol; and other contraband. Examples of scanned images can be found at AS&E's image library.
No One Trick Pony
Anyone that assumed AS&E was a one trick pony that would live or die by the success of the TSA pilot couldn’t be any more wrong. AS&E has a complete suite of inspection and screening systems to combat terrorism, drug and weapons smuggling, trade fraud, and illegal immigration. These systems can detect threats that may exist in cargo containers, trucks, cars, parcel, baggage, and mail. Furthermore, the SmartCheck system, the system being piloted by the TSA, is capable of identifying threats and illegal substances on a person’s body. Details of existing products can be found in the Products & Solutions section of the AS&E website.
Building the Pipeline
Despite its existing portfolio of scanning technologies and products, AS&E is not sitting back on its heels. AS&E’s long-term target for R&D spending is roughly 6% of sales. In recent quarters, R&D has been below managements’ long-term target level. The lower level of R&D spending is partly due to a reallocation of R&D resources from internally funded development projects to contract research and development (CRAD) projects. AS&E is making adjustments to its hiring plans and expects R&D spending to return to management's long-term target levels.
AS&E’s pipeline of activity is exciting and the successful commercialization of any one of these projects will have a favorable impact on the future success of the company. For the most part, R&D and CRAD projects are not detailed on the company’s website. As such, I have consolidated information from past press releases and conference call comments relative to these programs.
Cargo Advanced Automated Radiography System (CAARS) Program
The CAARS Program is a $50 million development program funded by the U.S. Department of Homeland Security’s (DHS) Domestic Nuclear Detection Office (DNDO). The goal of the program is to develop and deliver a next-generation cargo inspection system that automatically detects shielded nuclear threats at the nation’s point of entries. According to AS&E, a successful performance in the development phase of this program could lead to a substantial procurement contract up to …………….$450 Mmmmmillion (said like Dr. Evil in Austin Powers).
While development contracts on the CAARS Program were also awarded to two other firms (L3 and SAIC), AS&E received over 58% of the funding. When Anthony Fabiano, President and CEO, was asked on the last earnings call why AS&E received a disproportionate amount of the funding, he responded by saying AS&E has a very sophisticated solution that could deliver the best results by a long shot.
Oh wait, what’s that? You don’t want to take the CEO’s word for it? Read this from the DNDO in response to Smith’s Detection Inc.’s protest of the agency’s evaluation and source selection decision:
“The SSA concluded that AS&E’s approach had the potential to provide performance far beyond the [DELETED] industry standard proposed by the other offerors. The SSA further concluded that, in comparison, AS&E’s technology with its ability to portray high Z detections [DELETED] has the potential to significantly improve the accuracy and speed of detection and alarm against threat materials, with an exceptionally low false alarm rate. The SSA recognized that there was a risk associated with the development of AS&E’s technology, but determined that the potential payoff of such a technology outweighed the risks especially when the technology has already been demonstrated in a laboratory environment.”
Note that sensitve details are [DELETED].
(thanks to bobbur11 on the Yahoo board for posting the link)
Ruggedized Z Backscatter Van
Z Backscatter Vans (ZBVs) are commercially available vans equipped with AS&E’s scanning technology. ZBVs are part of the company's Cargo and Vehicle Inspection product group. In November, AS&E announced it received a contract from the U.S. Government to deliver a ‘ruggedized’ Z Backscatter Van for operation in harsh environments. According to management comments in the last earnings call, AS&E would likely be partnering with a manufacturer of armored vehicles, whereas AS&E would provide its scanning technology and its partner would provide the ruggedized vehicle. How this partnership affects revenue and margins will depend on the structure of the partnership agreement but the end result should be an increase in deployment opportunities and earnings.
Management is optimistic that the ‘ruggedized’ ZBV will obtain type classification. Type classification would make the ‘ruggedized’ ZBV a standard budget item as opposed to a special order item. With type classification, the ‘ruggedized’ ZBV would be more readily available for widespread military use. Futhermore, type classification will facilitate the order process for the military agency placing the order and the planning and fulfillment process for AS&E. There is no certainty as to if and when the ‘ruggedized’ ZBV will obtain type classification but the process is underway.
In early March, Stifel Nicolaus issued a research note on AS&E, which was subsequently reported on by SeekingAlpha. According to the SeekingAlpha article, details of the FY07 Supplemental Budget Appropriation bill indicate that the ‘ruggedized’ ZBV is ready for deployment. If the ‘ruggedized’ ZBV is ready for deployment, AS&E will likely receive orders in the near future for both new ZBVs and upgrades to existing fleets.
Other Research Programs
Some of the other programs mentioned by management on the last conference call include long range scanning, a robotic mounted X-ray system, and vehicle-born and human born IED detect and defeat sub-systems. While there are little details on these programs, the opportunities are clear.
Bankruptcy from a TSA Failure?
In looking at the balance sheet and cash flow statement, clearly bankruptcy is not at all a concern. To date, personal scanning products like the SmartCheck system being piloted by the TSA have accounted for only a small portion of the company’s sales. Yet, AS&E has over $118 million or $12.93 per share in cash and short-term investments with only $9.8 million in debt, including current portion of lease financing. Furthermore, AS&E generated $24.8 million in operational cash flow in the first three quarters of fiscal 2007. Operational cash flow in the same period exceeded net income by over $6 million.
AS&E’s positive operational cash flow and large cash position gives the company flexibility to do a lot of things to increase shareholder value such as: buying back shares; paying down debt; funding capital expansion; paying a dividend; or, making an acquisitions. On the last earnings call, one caller asked management if they considered utilizing their cash position to buy back shares. Management said they have discussed the possibility of a share buyback with its board and both management and the board believe there are other opportunities to employ cash that would be more beneficial to the company and its shareholders. In particular, management alluded to acquisition opportunities that would fill vertical gaps that would in turn bring the company closer to achieving its five year plan.
No GE
AS&E’s success does not depend on the success of the TSA pilot. At the same time, AS&E is no GE and a broad scale domestic rollout of SmartCheck would have a noticeable impact on revenue and earnings.
AS&E has a market cap of less than $500 million and annual sales of less than $150 million. A SmartCheck system sells for about $110,000. Multiply that number by the number of airports, by the number of checkpoints, by the number of systems per checkpoint, by a hypothetical penetration rate, and it is clear that a broad scale rollout of SmartCheck in the U.S. would be significant to AS&E.
After doing the above math, consider the fact that a broad scale rollout in the U.S. will get some recognition abroad (i.e. Canada).
Overpriced?
At a price of $52 per share, AS&E is trading nearly 45% off of its 52 week high and has a PE of 22.6x trailing twelve month earnings. On my own pro forma income statement, which reasonably excludes the warrant adjustments (discussed below) and utilizes a 37% tax rate, I have AS&E trading at a PE of just under 20x trailing pro forma earnings. Oh but wait, don’t forget AS&E has nearly $13 dollars in cash per share. Given its large net cash position, a better ratio to consider would be enterprise value divided by earnings before interest, taxes, depreciation and amortization (EV/EBITDA). AS&E trades at a reasonable EV/EBITDA of 8.25.
In my opinion, AS&E is trading at a discount to its fair value and I believe the market is failing to award AS&E for its superior margin performance and returns.
Gross Margins 46.22%
Operating Margins 23.78%
Profit Margin 15.91%
My Pro Forma Profit Margin 16.40%
ROA 14.85%
ROE 17.83%
Furthermore, I don’t believe the share price reflects the future potential of AS&E’s current product line and programs in development, including the TSA pilot.
Why No Love?
Stocks very rarely trade at their intrinsic value. In reality, intrinsic value per share is best thought of as the price a stock will pass through when going from overvalued to undervalued and vice versa. A stock may trade above or below its intrinsic value, which in and of itself is not a static value, for any number of reasons and for extended periods of time.
When a stock is trading at a premium or discount to what I consider to be its intrinsic value, I feel it is important to understand why this may be the case. In the case of AS&E, I believe part of the reason it is trading at a discount to its intrinsic value is the historically low level of predictability of financial results from one quarter to the next. Investors frequently rely on past performance along with a number of other factors to predict future performance. When past performance has a high degree of variability, it is more difficult to predict future results, and this makes investors nervous. There are several factors behind the variability of past financial results.
Timing of Large Contracts
On occasion, AS&E will receive extraordinarily large contracts that have a considerable impact on quarters in which the company recognizes revenue on those contracts. When shipments are made on a large contract in one quarter but not in the same quarter of the subsequent or prior year, there may be a substantial impact on year-over-year comparisons. Furthermore, AS&E is heavily dependent on contracts from the U.S. Government. As such, there is some seasonality to orders relating to government budgets and timing on the availability of funding.
While the company will continue to receive large contracts, I expect the frequency of contracts to increase; thus, removing some of the lumpiness. I believe the frequency of contracts will increase as a result of recently developed products gaining traction in the marketplace and through the diversification of revenues across geographic regions.
Field service revenue is steadily increasing with the growing install base. As field service revenues increase, lumpiness associated with contract revenue will decrease.
Warrant Adjustments
In 2002, AS&E closed on a private placement offering of common stock and warrants. Due to certain cash conversion features associated with the warrants, a liability equal to the fair value of the warrants at the date of closing was recorded on the balance sheet. Each quarter there is a mark-to-market adjustment (adjustment based on share price at the end of one quarter versus the prior quarter) on the value of the warrants. In the fourth quarter of fiscal 2006, the mark-to-market adjustment had a negative impact of nearly $4 million. In the first quarter of fiscal 2007, the mark-to-market adjustment had a positive impact of over $2.1 million. Obviously, these adjustments can distort bottom line results and quarterly comparisons. While the warrant adjustments may be confusing, it is important to note that they are not an actual expense of the business and therefore should be ignored.
The warrants expire in May of 2007.
Variability of Tax Rate
Quarterly tax provisions have had a high degree of variability. This variability has been largely driven by the recognition of tax loss carryfowards and the quarterly warrant adjustments, which are not taxable. As the company has moved substantially to a full tax rate and the warrants will expire in May, the quarterly tax provision should be more consistent going forward.
SFAS123(R)
On April 1, 2006, the company adopted SFAS123(R), which deals with the valuation and recognition of costs associated with stock based compensation. Since the company adopted SFAS123(R), it has recognized over $6 million in compensation costs. As prior periods have not and will not been restated to reflect SFAS123(R), year-over-year results have been difficult to reconcile.
After the fourth quarter of fiscal 2007, ending March 31, 2007, there will be a full year of comparables under the new accounting rule. As such, year-over-year comparisons will be easier to reconcile.
While the above factors have influenced the variability of past financial results, it is clear that these influences will go away or at the least will be mitigated in the future.
Conclusion
Whether or not the TSA pilot is a success or failure, the future looks bright for AS&E. Given the company’s current financial position, past performance, and prospects for future growth, I believe AS&E shares are attractively priced
Disclosure
I am long AS&E and I have to credit downtowntrader for pointing this one out to me a couple of months ago. Maybe he will be kind enough to give a quick technical analysis over the weekend.
One Last Note
SmartCheck is not going to make you glow in the dark and your scanned image is not going to like this image printed by the New York Times. Factual information regarding the TSA pilot is available here and here.
Good luck,
Tuff
By now, most people have read or heard about the new airport screening system the Transportation Security Administration (TSA) is piloting at Sky Harbor International Airport in Phoenix, Arizona. When the news first broke in early December, there wasn’t a shortage of media coverage or distortion of facts.
When you heard the news of the TSA pilot, what went through your mind? Were you concerned your image taken at a security checkpoint would somehow find its way onto the internet? Were you concerned the radiation exposure would leave you glowing in the dark like a firefly? If you are an investor, you were probably thinking….What is the ticker symbol of the company that makes the screening machines?
Perhaps you are an investor and it crossed your mind to do a little due diligence but you never bothered for any number of reasons. Maybe you figured the company was a one hit wonder that would fall into bankruptcy if the TSA pilot program was a failure. Or, perhaps you figured the company was behemoth like GE and a large TSA contract would be relatively insignificant in the grand scheme of things. Or, perhaps you figured the company was likely already way overpriced.
If you are an investor and didn’t bother to do a little due diligence, I suggest you take the time get to know American Science & Engineering, Inc. (ASEI).
Not Your Father’s X-Ray Inspection System
American Science & Engineering, Inc. (“AS&E”) is a leading provider of X-ray inspection and screening systems. Founded in 1958, this Billerica, MA (go Red Sox) company has a rich history of scientific innovation that laid the groundwork for its current portfolio of products.
AS&E’s incorporates a combination of its patented Z Backscatter, Forwardscatter, Shaped Energy, and Radioactive Threat Detection technologies along with transmission X-ray technologies into its products to provide customers with the most comprehensive threat detection in the industry. AS&E’s high resolution scanning systems are capable of identifying smuggled goods and various threats to human life such as: traditional explosives; liquid explosives; plastic and metal weapons; radioactive devices; drugs; alcohol; and other contraband. Examples of scanned images can be found at AS&E's image library.
No One Trick Pony
Anyone that assumed AS&E was a one trick pony that would live or die by the success of the TSA pilot couldn’t be any more wrong. AS&E has a complete suite of inspection and screening systems to combat terrorism, drug and weapons smuggling, trade fraud, and illegal immigration. These systems can detect threats that may exist in cargo containers, trucks, cars, parcel, baggage, and mail. Furthermore, the SmartCheck system, the system being piloted by the TSA, is capable of identifying threats and illegal substances on a person’s body. Details of existing products can be found in the Products & Solutions section of the AS&E website.
Building the Pipeline
Despite its existing portfolio of scanning technologies and products, AS&E is not sitting back on its heels. AS&E’s long-term target for R&D spending is roughly 6% of sales. In recent quarters, R&D has been below managements’ long-term target level. The lower level of R&D spending is partly due to a reallocation of R&D resources from internally funded development projects to contract research and development (CRAD) projects. AS&E is making adjustments to its hiring plans and expects R&D spending to return to management's long-term target levels.
AS&E’s pipeline of activity is exciting and the successful commercialization of any one of these projects will have a favorable impact on the future success of the company. For the most part, R&D and CRAD projects are not detailed on the company’s website. As such, I have consolidated information from past press releases and conference call comments relative to these programs.
Cargo Advanced Automated Radiography System (CAARS) Program
The CAARS Program is a $50 million development program funded by the U.S. Department of Homeland Security’s (DHS) Domestic Nuclear Detection Office (DNDO). The goal of the program is to develop and deliver a next-generation cargo inspection system that automatically detects shielded nuclear threats at the nation’s point of entries. According to AS&E, a successful performance in the development phase of this program could lead to a substantial procurement contract up to …………….$450 Mmmmmillion (said like Dr. Evil in Austin Powers).
While development contracts on the CAARS Program were also awarded to two other firms (L3 and SAIC), AS&E received over 58% of the funding. When Anthony Fabiano, President and CEO, was asked on the last earnings call why AS&E received a disproportionate amount of the funding, he responded by saying AS&E has a very sophisticated solution that could deliver the best results by a long shot.
Oh wait, what’s that? You don’t want to take the CEO’s word for it? Read this from the DNDO in response to Smith’s Detection Inc.’s protest of the agency’s evaluation and source selection decision:
“The SSA concluded that AS&E’s approach had the potential to provide performance far beyond the [DELETED] industry standard proposed by the other offerors. The SSA further concluded that, in comparison, AS&E’s technology with its ability to portray high Z detections [DELETED] has the potential to significantly improve the accuracy and speed of detection and alarm against threat materials, with an exceptionally low false alarm rate. The SSA recognized that there was a risk associated with the development of AS&E’s technology, but determined that the potential payoff of such a technology outweighed the risks especially when the technology has already been demonstrated in a laboratory environment.”
Note that sensitve details are [DELETED].
(thanks to bobbur11 on the Yahoo board for posting the link)
Ruggedized Z Backscatter Van
Z Backscatter Vans (ZBVs) are commercially available vans equipped with AS&E’s scanning technology. ZBVs are part of the company's Cargo and Vehicle Inspection product group. In November, AS&E announced it received a contract from the U.S. Government to deliver a ‘ruggedized’ Z Backscatter Van for operation in harsh environments. According to management comments in the last earnings call, AS&E would likely be partnering with a manufacturer of armored vehicles, whereas AS&E would provide its scanning technology and its partner would provide the ruggedized vehicle. How this partnership affects revenue and margins will depend on the structure of the partnership agreement but the end result should be an increase in deployment opportunities and earnings.
Management is optimistic that the ‘ruggedized’ ZBV will obtain type classification. Type classification would make the ‘ruggedized’ ZBV a standard budget item as opposed to a special order item. With type classification, the ‘ruggedized’ ZBV would be more readily available for widespread military use. Futhermore, type classification will facilitate the order process for the military agency placing the order and the planning and fulfillment process for AS&E. There is no certainty as to if and when the ‘ruggedized’ ZBV will obtain type classification but the process is underway.
In early March, Stifel Nicolaus issued a research note on AS&E, which was subsequently reported on by SeekingAlpha. According to the SeekingAlpha article, details of the FY07 Supplemental Budget Appropriation bill indicate that the ‘ruggedized’ ZBV is ready for deployment. If the ‘ruggedized’ ZBV is ready for deployment, AS&E will likely receive orders in the near future for both new ZBVs and upgrades to existing fleets.
Other Research Programs
Some of the other programs mentioned by management on the last conference call include long range scanning, a robotic mounted X-ray system, and vehicle-born and human born IED detect and defeat sub-systems. While there are little details on these programs, the opportunities are clear.
Bankruptcy from a TSA Failure?
In looking at the balance sheet and cash flow statement, clearly bankruptcy is not at all a concern. To date, personal scanning products like the SmartCheck system being piloted by the TSA have accounted for only a small portion of the company’s sales. Yet, AS&E has over $118 million or $12.93 per share in cash and short-term investments with only $9.8 million in debt, including current portion of lease financing. Furthermore, AS&E generated $24.8 million in operational cash flow in the first three quarters of fiscal 2007. Operational cash flow in the same period exceeded net income by over $6 million.
AS&E’s positive operational cash flow and large cash position gives the company flexibility to do a lot of things to increase shareholder value such as: buying back shares; paying down debt; funding capital expansion; paying a dividend; or, making an acquisitions. On the last earnings call, one caller asked management if they considered utilizing their cash position to buy back shares. Management said they have discussed the possibility of a share buyback with its board and both management and the board believe there are other opportunities to employ cash that would be more beneficial to the company and its shareholders. In particular, management alluded to acquisition opportunities that would fill vertical gaps that would in turn bring the company closer to achieving its five year plan.
No GE
AS&E’s success does not depend on the success of the TSA pilot. At the same time, AS&E is no GE and a broad scale domestic rollout of SmartCheck would have a noticeable impact on revenue and earnings.
AS&E has a market cap of less than $500 million and annual sales of less than $150 million. A SmartCheck system sells for about $110,000. Multiply that number by the number of airports, by the number of checkpoints, by the number of systems per checkpoint, by a hypothetical penetration rate, and it is clear that a broad scale rollout of SmartCheck in the U.S. would be significant to AS&E.
After doing the above math, consider the fact that a broad scale rollout in the U.S. will get some recognition abroad (i.e. Canada).
Overpriced?
At a price of $52 per share, AS&E is trading nearly 45% off of its 52 week high and has a PE of 22.6x trailing twelve month earnings. On my own pro forma income statement, which reasonably excludes the warrant adjustments (discussed below) and utilizes a 37% tax rate, I have AS&E trading at a PE of just under 20x trailing pro forma earnings. Oh but wait, don’t forget AS&E has nearly $13 dollars in cash per share. Given its large net cash position, a better ratio to consider would be enterprise value divided by earnings before interest, taxes, depreciation and amortization (EV/EBITDA). AS&E trades at a reasonable EV/EBITDA of 8.25.
In my opinion, AS&E is trading at a discount to its fair value and I believe the market is failing to award AS&E for its superior margin performance and returns.
Gross Margins 46.22%
Operating Margins 23.78%
Profit Margin 15.91%
My Pro Forma Profit Margin 16.40%
ROA 14.85%
ROE 17.83%
Furthermore, I don’t believe the share price reflects the future potential of AS&E’s current product line and programs in development, including the TSA pilot.
Why No Love?
Stocks very rarely trade at their intrinsic value. In reality, intrinsic value per share is best thought of as the price a stock will pass through when going from overvalued to undervalued and vice versa. A stock may trade above or below its intrinsic value, which in and of itself is not a static value, for any number of reasons and for extended periods of time.
When a stock is trading at a premium or discount to what I consider to be its intrinsic value, I feel it is important to understand why this may be the case. In the case of AS&E, I believe part of the reason it is trading at a discount to its intrinsic value is the historically low level of predictability of financial results from one quarter to the next. Investors frequently rely on past performance along with a number of other factors to predict future performance. When past performance has a high degree of variability, it is more difficult to predict future results, and this makes investors nervous. There are several factors behind the variability of past financial results.
Timing of Large Contracts
On occasion, AS&E will receive extraordinarily large contracts that have a considerable impact on quarters in which the company recognizes revenue on those contracts. When shipments are made on a large contract in one quarter but not in the same quarter of the subsequent or prior year, there may be a substantial impact on year-over-year comparisons. Furthermore, AS&E is heavily dependent on contracts from the U.S. Government. As such, there is some seasonality to orders relating to government budgets and timing on the availability of funding.
While the company will continue to receive large contracts, I expect the frequency of contracts to increase; thus, removing some of the lumpiness. I believe the frequency of contracts will increase as a result of recently developed products gaining traction in the marketplace and through the diversification of revenues across geographic regions.
Field service revenue is steadily increasing with the growing install base. As field service revenues increase, lumpiness associated with contract revenue will decrease.
Warrant Adjustments
In 2002, AS&E closed on a private placement offering of common stock and warrants. Due to certain cash conversion features associated with the warrants, a liability equal to the fair value of the warrants at the date of closing was recorded on the balance sheet. Each quarter there is a mark-to-market adjustment (adjustment based on share price at the end of one quarter versus the prior quarter) on the value of the warrants. In the fourth quarter of fiscal 2006, the mark-to-market adjustment had a negative impact of nearly $4 million. In the first quarter of fiscal 2007, the mark-to-market adjustment had a positive impact of over $2.1 million. Obviously, these adjustments can distort bottom line results and quarterly comparisons. While the warrant adjustments may be confusing, it is important to note that they are not an actual expense of the business and therefore should be ignored.
The warrants expire in May of 2007.
Variability of Tax Rate
Quarterly tax provisions have had a high degree of variability. This variability has been largely driven by the recognition of tax loss carryfowards and the quarterly warrant adjustments, which are not taxable. As the company has moved substantially to a full tax rate and the warrants will expire in May, the quarterly tax provision should be more consistent going forward.
SFAS123(R)
On April 1, 2006, the company adopted SFAS123(R), which deals with the valuation and recognition of costs associated with stock based compensation. Since the company adopted SFAS123(R), it has recognized over $6 million in compensation costs. As prior periods have not and will not been restated to reflect SFAS123(R), year-over-year results have been difficult to reconcile.
After the fourth quarter of fiscal 2007, ending March 31, 2007, there will be a full year of comparables under the new accounting rule. As such, year-over-year comparisons will be easier to reconcile.
While the above factors have influenced the variability of past financial results, it is clear that these influences will go away or at the least will be mitigated in the future.
Conclusion
Whether or not the TSA pilot is a success or failure, the future looks bright for AS&E. Given the company’s current financial position, past performance, and prospects for future growth, I believe AS&E shares are attractively priced
Disclosure
I am long AS&E and I have to credit downtowntrader for pointing this one out to me a couple of months ago. Maybe he will be kind enough to give a quick technical analysis over the weekend.
One Last Note
SmartCheck is not going to make you glow in the dark and your scanned image is not going to like this image printed by the New York Times. Factual information regarding the TSA pilot is available here and here.
Good luck,
Tuff
Monday, March 5, 2007
Time to Build the Watchlist
With the recent breakdown in global equity markets, now is the time to be building your watchlist and looking for bargains. Hurco Companies, Inc. (HURC) is one company investors should be adding to their watchlist.
Introduction
Hurco Companies, Inc. (Public, NASDAQ:HURC)
Hurco designs, manufactures, and sells computerized machine tools and related software. Hurco, founded in 1968, has been around the block a few times and was a pioneer in the application of microprocessor technology and conversational programming software on machine tools. While Hurc’s Computer Numeric Control (CNC) systems are proprietary, they use industry standard personal computer components. Hurco sells their products to independent job shops and short-run manufacturing operations within large corporations in the aerospace, defense, medical equipment, energy, transportation, and computer equipment industry. Hurco machine tools range in price from $40,000 and $300,000.
Sales
After suffering two years of declining sales in 2001 and 2002, Hurco’s sales have been chugging along nicely and the prospects for future growth remains positive.
Despite growing sales over the past four years, the rate of growth has been decelerating. I suspect this trend to shift in 2007 as a result of the accelerating demand in Europe, the introduction of a new product in the first half of 2007, the announced expansion projects in China and India, and the weakening of the U.S. dollar.
Accelerating European Demand
Huro’s sales are diversified across North America, Europe and Asia. Historically, Europe has accounted for the majority of sales. In fiscal year 2006, Europe accounted for 59% of sales versus 34% and 7% for North America and Asia, respectively. With the higher percentage of sales coming from Europe, a shift in European demand has a disproportionate affect on total sales.
Reflective of the disparity of economic growth between North America and Europe, sales growth in North America has outpaced Europe since Hurc’s turnaround in 2003. Recent economic data indicates economic growth is accelerating in Europe and moderating in the U.S. A continuation of this trend will result in a net benefit to Hurco. Early signs of this benefit were evident in Hurco’s first quarter of fiscal 2007. In the quarter, Hurco’s sales increased 47% over the year-ago quarter and management specifically attributed a portion of the increase to improved demand from Europe.
New Product Release
At the recent IMTS 2006, one of the largest industrial trade shows in the world, Hurco introduced five new products. The most exciting product introduced at the trade show was the WinMax Control System, which runs on a Windows based platform. Hurco expects the feature rich control system to maximize efficiency and productivity at job shops around the world by reducing setup time and improving surface finish. At the trade show, Hurco provided hands-on live demonstrations to customers that entered the booth and was very much encouraged by customer feedback.
"I was pleased to see how many customers embraced WinMax and quickly understood its value. For Hurco, WinMax will play a pivotal role in continuing to develop new technologies while taking advantage of trends in commercial technologies that enable our customers to realize measurable productivity gains," said Jim Fabris, President and COO of Hurco Companies, Inc.
The new Winmax Control System will span the entire Hurco product line of machining and turning centers. Winmax will be available in early 2007 and it will be sold as the standard control system on all machining and turning centers. Furthermore, it will be available as an upgrade to products sold within the last five years. Conceivably, Hurco software could be sold for use on non-Hurco machines.
The release of the Winmax Control System is big for Hurco. Lakshminarayana Ganti, an analyst with Thomas Weisel International, likened the significance of the release to Microsoft’s release of Vista (IBD article linked below).
Expanding Presence in China and India
In 2005, Hurco opened a permanent Technical Center in Shenzhen, China, a center for technology and manufacturing. The new location expanded on Hurco’s existing sales office in Shanghai. Hurco opened the Technical Center to serve as an application and service center for Hurco’s customers in China, the largest machine tool consumer in the world.
Recently, Hurco announced it is developing a manufacturing center in Ningbo, China. The Ningbo facility will expand Hurco’s manufacturing capacity beyond its existing manufacturing facility in Taiwan. The new facility will focus on machine castings and components but will have the capacity to be expanded to include sub-assembly operations. Eventually, machines designed specifically for China will be manufactured at the Ningbo facility.
China is the world’s largest machine tool market and grew 20% in 2006 to $12.9 billion. According to Gardner Publishing, worldwide output increased 10% in 2006 and one in every five machines produced went to China (See link to IBD article). Hurco’s expansion into China puts it in a solid position to benefit from the expected continuation of growth in Chinese demand for machine tools. While there are a number of domestic suppliers in China, domestic production is more focused on lower-end tools and not the more complex CNC machines made by Hurco.
Sales in Asia dipped a bit in the first quarter of fiscal 2007. Management attributed the sequential decline in sales to the timing of orders. As such, the second quarter is likely to receive a boost over the first quarter and the year-ago quarter.
In November of 2006, Hurco registered a distribution company in India and it is in the process of establishing a sales office. In its first quarter earnings release, Hurco also said that it participated in the Indian Machine Tool Exhibition 2007. To the best of my knowledge this was the first time Hurco participated in this show. According to management, Hurco’s powerful yet easy to use machine tools are an ideal fit in India where shop owners are faced with high employee turnover and an unskilled to semi-skilled work force.
Weakening U.S. Dollar
As the majority of Hurco sales are outside of the U.S. and paid in foreign currencies, fluctuations in exchange rates will have an impact on sales, which are reported in U.S. Dollars. A weaker U.S. Dollar relative to customers’ base currency, will inflate reported sales, and vice versa.
As of late, the dollar has been losing strength relative to other currencies in both Europe and Asia. Many economists and investors, including Warren Buffet, believe this trend will continue. Recent weakness in the Dollar accounted for 9% of the 47% increase in sales in the first quarter of fiscal 2007 compared to the year-ago quarter. At the Dollars current levels, the exchange rate will continue to have a favorable impact on year-over-year sales comparisons.
For all the reasons mentioned above, I believe Hurco’s sales growth will accelerate in 2007.
Margins
Gross margins and operating margins have been on the rise since Hurco’s turnaround in 2003.
In the most recent quarter, Hurco showed continued improvement with gross margins of 36.96%, operating margins of 17.22%, and pre-tax margins of 17.90%. From quarter-to-quarter margins tend to fluctuate mostly due to product mix but the overall trend is clearly positive.
The above table excludes net profit margin because 2006 was the first year the company was fully taxable. In prior years, Hurco was working through their operating loss carryforwards. As such, the pre-tax margin comparison is the best method of comparing year-over-year results. At a full tax rate, Hurco reported a net profit margin of 10.42% in 2006 and 11.51% in the first quarter of fiscal 2007.
As a software product, Hurco’s new WinMax Control System should boost margins further in 2007. Presumably, Hurco should be able to boost the cost of its existing products given the advanced software that will ship as a standard component on future shipments. Furthermore, upgrades to existing customers should come at a relatively low cost.
My expectation for higher sales spread out over Hurco’s fixed costs along with increased software sales, should lead to continued margin improvement in 2007. While the costs of raw materials have increased, I believe Hurco will continue to have the pricing power to pass these costs onto its customers.
Earnings/EPS
In 2006, Hurco reported earnings of $15.5 million or $2.42 per share compared to $16.4 million or $2.60 per share. When comparing year-over-year earnings, investors should keep in mind that Hurco did not become fully taxable until 2006. In fiscal year 2005, Hurco recorded a net tax benefit of $361,000 compared to a 2006 tax expense of over $7.6 million. Assuming a comparable tax rate in 2005, Hurco would have reported earnings of $10.8 million or $1.70 per share in 2005.
In the trailing twelve months, Hurco’s reported diluted earnings per share of $2.78. For the full-year 2007, analysts expect Hurco to report $3.22 per share for a 33% increase over the $2.42 per share reported in 2006. Furthermore, analysts expect Hurco to report $0.79 per share in the second quarter of fiscal 2007 compared to $.84 in the first quarter.
I am not sure why analysts are expecting a sequential decline in earnings. Perhaps analysts believe earnings will moderate a bit after the benefit of the IMTS trade show in the prior quarter. Another possibility is that analysts might be expecting customers to delay purchases until after the release of WinMax. Regardless, analysts clearly believe the company is poised for growth in the full-year. The current quarter ends on April 30. If Hurco releases WinMax early enough in the quarter, we may see analyst up their estimates for the quarter.
At a share price of $40, Hurco’s trades at a multiple 14.39x trailing earnings, 12.22x analysts’ 2007 earnings, and 10.50x analysts’ 2008 earnings.
Balance Sheet
Hurco has over $32 million in cash and roughly $3.8 million in long-term debt. Net cash per share totals $4.46. The company has $62 million in working capital and a long-term debt-to-equity ratio of 5%. Hurco’s solid balance sheet puts it in a strong position to weather a downturn.
Cash Flow Statement
As evidenced by the growing cash position, Hurco has not had a problem generating cash. More importantly, cash flows from operating activity have closely approximated earnings and cash flows from financing activity have been limited. In fact, Hurco has been paying down debt and has been restrained in issuing new shares. Over the last year, diluted shares outstanding have increased a modest 1.42%.
Management
Michael Doar was elected Chairman of the Board and CEO of Hurco in November, 2001. Previously, he was vice-president of sales and marketing of Ingersoll Contract Manufacturing, a subsidiary of Ingersoll International. Doar held various management positions with Ingersoll International beginning in 1989.
James D. Fabris was elected President and Chief Operating Officer on November 14, 2001. Mr. Fabris served as Executive Vice President of Operations from November 1997 until his current appointment and previously served as a Vice President of Hurco since February 1995.
John G. Oblazney was elected Vice President, Secretary, Treasurer and Chief Financial Officer in September 2006. Mr. Oblazney served as the Chief Financial Officer of Carrier Corporation's Light Commercial Business, a division of United Technologies Corporation, since December 2005. Prior to that, Mr. Oblazney served in various other financial positions with Carrier Corporation from 2000 to 2005. Prior to joining Carrier Corporation, Mr. Oblazney was employed for six years with Cooper Industries and employed three years by an international public accounting firm.
In his early years at Hurco, Doar managed the company through some tough times. He not only pulled Hurco through the storm, he positioned the company for better days ahead. Doar has been in the machine tool industry for a long time. He has done a commendable job at Hurco and has earned the trust and confidence of investors.
Competitors
Hurco competes with many companies in the U.S. and abroad. Most of Hurco’s competitors are larger and have greater financial resources. Hurco relies largely on its patented software (i.e. WinMax control software), proprietary features, and strong reputation to distinguish itself from its competitors.
Hurco lists several U.S. and international competitors in its 10k. While various research reports and investment websites identify a number of other competitors, these companies do not provide a reliable comparison for a number of reasons. Hardinge, Inc. (HRDG) is probably the best company for comparison purposes.
Despite Hurco’s superior margins, capital structure, and returns, Hurco trades at a slight PE discount to HDNG.
Ownership
Institutions hold 61% of Hurco’s total shares outstanding, or nearly $3.9 million shares of the $6.39 million shares outstanding. Last quarter, institutions were net sellers to the tune of 144,000 shares, which is seemingly insignificant in the broad scheme of things. Royce & Associates, an institution identified by Motley Fools as one to watch, is the largest institutional shareholder with 772,350 shares.
Yahoo and several other websites report insider ownership at around 20%. On March 1, 2007, Richard Niner, a Director, filed a Form 4 indicating he sold 500,000 shares. I suspect Yahoo and the other websites have not been updated to include this recent transaction. If this is the case, insiders now own roughly 13% of Hurco’s outstanding shares, which is still high for a non-founder run company. While the Niner sale is worth noting, I am not overly concerned at this point. From what I can tell, Niner is not a machine tool guy and he is still the largest natural shareholder with nearly 232,000 shares. I suspect Niner sold his shares to cash-in on a very nice gain and to further diversify his assets. I don’t believe his decision was based on his expectations for the company or the machine tool industry. Again, my opinion on this matter is purely speculative.
Other than the Niner transaction, there have been no other insider transactions of particular significance. Investors should watch for additional insider and/or institutional transaction over the next couple of months.
Conclusion
Since its turnaround in 2003, Hurco has enjoyed several years of impressive growth and share price appreciation. Furthermore, Hurco has expanded its product line, strengthened its balance sheet, and diversified its sales across a number of regions.
The biggest risk to Hurco’s future is a global economic slowdown. While the diversification of Hurco’s sales across various regions will reduce the negative impact of regional weakness, there is no hiding from a global slowdown. Despite the recent downturn in global equity markets, I believe the global economy is poised for continued growth. I agree with Mr. Bernanke that the U.S. will continue to see slower growth in the first half of 2007 but growth will accelerate in the second half of the year. I believe Asia, in particular China, will continue to grow at a rapid pace and Europe will continue to strengthen. In this scenario, Hurco will prosper.
With the current correction in equity markets, Hurco is a good stock to put on your watchlist. I would wait for things to shake-out in the market before taking a position. I am not sure the opportunity will present itself, but a buy in the $35 or $36 range would be nice.
For those looking for a technical take on HURC, downtowntrader promised he would give his view on HURC later tonight.
Disclosure
I am long Hurco since 2004 when it was introduced to me through the Motley Fools Hidden Gems Newsletter.
Source Documents
Hurco History from Hurco Website
Yahoo Key Statistics (HURC)
Yahoo Key Statistics (HDNG)
HURC Q1 Fiscal 2007 Earnings Release
HDNG Year-End and Q4 2006 Earnings Release
Latest 10K filing
Richard Niner Form 4
Yahoo Analyst Estimates
NASDAQ Holding Summary
Recent IBD Article
Wallstreet Journal Article from 2003 (Hurco low point)
Monthly Survey of Machine Tool Consumption (Note that U.S. consumption was positively impacted in September and October by the largest U.S. trade show)
Introduction
Hurco Companies, Inc. (Public, NASDAQ:HURC)
Hurco designs, manufactures, and sells computerized machine tools and related software. Hurco, founded in 1968, has been around the block a few times and was a pioneer in the application of microprocessor technology and conversational programming software on machine tools. While Hurc’s Computer Numeric Control (CNC) systems are proprietary, they use industry standard personal computer components. Hurco sells their products to independent job shops and short-run manufacturing operations within large corporations in the aerospace, defense, medical equipment, energy, transportation, and computer equipment industry. Hurco machine tools range in price from $40,000 and $300,000.
Sales
After suffering two years of declining sales in 2001 and 2002, Hurco’s sales have been chugging along nicely and the prospects for future growth remains positive.
Yearly Sales Growth
| Fiscal Year | Sales (in millions) | Growth over Prior Year |
| 2003 | $75.5 | 7.16% |
| 2004 | $99.6 | 31.83% |
| 2005 | $125.5 | 26.05% |
| 2006 | $148.5 | 18.33% |
| TTM (thru Jan 31) | $163.5 |
Despite growing sales over the past four years, the rate of growth has been decelerating. I suspect this trend to shift in 2007 as a result of the accelerating demand in Europe, the introduction of a new product in the first half of 2007, the announced expansion projects in China and India, and the weakening of the U.S. dollar.
Accelerating European Demand
Huro’s sales are diversified across North America, Europe and Asia. Historically, Europe has accounted for the majority of sales. In fiscal year 2006, Europe accounted for 59% of sales versus 34% and 7% for North America and Asia, respectively. With the higher percentage of sales coming from Europe, a shift in European demand has a disproportionate affect on total sales.
Reflective of the disparity of economic growth between North America and Europe, sales growth in North America has outpaced Europe since Hurc’s turnaround in 2003. Recent economic data indicates economic growth is accelerating in Europe and moderating in the U.S. A continuation of this trend will result in a net benefit to Hurco. Early signs of this benefit were evident in Hurco’s first quarter of fiscal 2007. In the quarter, Hurco’s sales increased 47% over the year-ago quarter and management specifically attributed a portion of the increase to improved demand from Europe.
New Product Release
At the recent IMTS 2006, one of the largest industrial trade shows in the world, Hurco introduced five new products. The most exciting product introduced at the trade show was the WinMax Control System, which runs on a Windows based platform. Hurco expects the feature rich control system to maximize efficiency and productivity at job shops around the world by reducing setup time and improving surface finish. At the trade show, Hurco provided hands-on live demonstrations to customers that entered the booth and was very much encouraged by customer feedback.
"I was pleased to see how many customers embraced WinMax and quickly understood its value. For Hurco, WinMax will play a pivotal role in continuing to develop new technologies while taking advantage of trends in commercial technologies that enable our customers to realize measurable productivity gains," said Jim Fabris, President and COO of Hurco Companies, Inc.
The new Winmax Control System will span the entire Hurco product line of machining and turning centers. Winmax will be available in early 2007 and it will be sold as the standard control system on all machining and turning centers. Furthermore, it will be available as an upgrade to products sold within the last five years. Conceivably, Hurco software could be sold for use on non-Hurco machines.
The release of the Winmax Control System is big for Hurco. Lakshminarayana Ganti, an analyst with Thomas Weisel International, likened the significance of the release to Microsoft’s release of Vista (IBD article linked below).
Expanding Presence in China and India
In 2005, Hurco opened a permanent Technical Center in Shenzhen, China, a center for technology and manufacturing. The new location expanded on Hurco’s existing sales office in Shanghai. Hurco opened the Technical Center to serve as an application and service center for Hurco’s customers in China, the largest machine tool consumer in the world.
Recently, Hurco announced it is developing a manufacturing center in Ningbo, China. The Ningbo facility will expand Hurco’s manufacturing capacity beyond its existing manufacturing facility in Taiwan. The new facility will focus on machine castings and components but will have the capacity to be expanded to include sub-assembly operations. Eventually, machines designed specifically for China will be manufactured at the Ningbo facility.
China is the world’s largest machine tool market and grew 20% in 2006 to $12.9 billion. According to Gardner Publishing, worldwide output increased 10% in 2006 and one in every five machines produced went to China (See link to IBD article). Hurco’s expansion into China puts it in a solid position to benefit from the expected continuation of growth in Chinese demand for machine tools. While there are a number of domestic suppliers in China, domestic production is more focused on lower-end tools and not the more complex CNC machines made by Hurco.
Sales in Asia dipped a bit in the first quarter of fiscal 2007. Management attributed the sequential decline in sales to the timing of orders. As such, the second quarter is likely to receive a boost over the first quarter and the year-ago quarter.
In November of 2006, Hurco registered a distribution company in India and it is in the process of establishing a sales office. In its first quarter earnings release, Hurco also said that it participated in the Indian Machine Tool Exhibition 2007. To the best of my knowledge this was the first time Hurco participated in this show. According to management, Hurco’s powerful yet easy to use machine tools are an ideal fit in India where shop owners are faced with high employee turnover and an unskilled to semi-skilled work force.
Weakening U.S. Dollar
As the majority of Hurco sales are outside of the U.S. and paid in foreign currencies, fluctuations in exchange rates will have an impact on sales, which are reported in U.S. Dollars. A weaker U.S. Dollar relative to customers’ base currency, will inflate reported sales, and vice versa.
As of late, the dollar has been losing strength relative to other currencies in both Europe and Asia. Many economists and investors, including Warren Buffet, believe this trend will continue. Recent weakness in the Dollar accounted for 9% of the 47% increase in sales in the first quarter of fiscal 2007 compared to the year-ago quarter. At the Dollars current levels, the exchange rate will continue to have a favorable impact on year-over-year sales comparisons.
For all the reasons mentioned above, I believe Hurco’s sales growth will accelerate in 2007.
Margins
Gross margins and operating margins have been on the rise since Hurco’s turnaround in 2003.
Recent Margin History
| 2003 | 2004 | 2005 | 2006 | |
| Gross Margins | 27.57% | 30.43% | 33.91% | 35.90% |
| Operating Margins | 2.91% | 8.47% | 13.15% | 15.24% |
| Pre-tax Margins | 1.88% | 7.60% | 12.81% | 15.56% |
In the most recent quarter, Hurco showed continued improvement with gross margins of 36.96%, operating margins of 17.22%, and pre-tax margins of 17.90%. From quarter-to-quarter margins tend to fluctuate mostly due to product mix but the overall trend is clearly positive.
The above table excludes net profit margin because 2006 was the first year the company was fully taxable. In prior years, Hurco was working through their operating loss carryforwards. As such, the pre-tax margin comparison is the best method of comparing year-over-year results. At a full tax rate, Hurco reported a net profit margin of 10.42% in 2006 and 11.51% in the first quarter of fiscal 2007.
As a software product, Hurco’s new WinMax Control System should boost margins further in 2007. Presumably, Hurco should be able to boost the cost of its existing products given the advanced software that will ship as a standard component on future shipments. Furthermore, upgrades to existing customers should come at a relatively low cost.
My expectation for higher sales spread out over Hurco’s fixed costs along with increased software sales, should lead to continued margin improvement in 2007. While the costs of raw materials have increased, I believe Hurco will continue to have the pricing power to pass these costs onto its customers.
Earnings/EPS
In 2006, Hurco reported earnings of $15.5 million or $2.42 per share compared to $16.4 million or $2.60 per share. When comparing year-over-year earnings, investors should keep in mind that Hurco did not become fully taxable until 2006. In fiscal year 2005, Hurco recorded a net tax benefit of $361,000 compared to a 2006 tax expense of over $7.6 million. Assuming a comparable tax rate in 2005, Hurco would have reported earnings of $10.8 million or $1.70 per share in 2005.
In the trailing twelve months, Hurco’s reported diluted earnings per share of $2.78. For the full-year 2007, analysts expect Hurco to report $3.22 per share for a 33% increase over the $2.42 per share reported in 2006. Furthermore, analysts expect Hurco to report $0.79 per share in the second quarter of fiscal 2007 compared to $.84 in the first quarter.
I am not sure why analysts are expecting a sequential decline in earnings. Perhaps analysts believe earnings will moderate a bit after the benefit of the IMTS trade show in the prior quarter. Another possibility is that analysts might be expecting customers to delay purchases until after the release of WinMax. Regardless, analysts clearly believe the company is poised for growth in the full-year. The current quarter ends on April 30. If Hurco releases WinMax early enough in the quarter, we may see analyst up their estimates for the quarter.
At a share price of $40, Hurco’s trades at a multiple 14.39x trailing earnings, 12.22x analysts’ 2007 earnings, and 10.50x analysts’ 2008 earnings.
Balance Sheet
Hurco has over $32 million in cash and roughly $3.8 million in long-term debt. Net cash per share totals $4.46. The company has $62 million in working capital and a long-term debt-to-equity ratio of 5%. Hurco’s solid balance sheet puts it in a strong position to weather a downturn.
Cash Flow Statement
As evidenced by the growing cash position, Hurco has not had a problem generating cash. More importantly, cash flows from operating activity have closely approximated earnings and cash flows from financing activity have been limited. In fact, Hurco has been paying down debt and has been restrained in issuing new shares. Over the last year, diluted shares outstanding have increased a modest 1.42%.
Management
Michael Doar was elected Chairman of the Board and CEO of Hurco in November, 2001. Previously, he was vice-president of sales and marketing of Ingersoll Contract Manufacturing, a subsidiary of Ingersoll International. Doar held various management positions with Ingersoll International beginning in 1989.
James D. Fabris was elected President and Chief Operating Officer on November 14, 2001. Mr. Fabris served as Executive Vice President of Operations from November 1997 until his current appointment and previously served as a Vice President of Hurco since February 1995.
John G. Oblazney was elected Vice President, Secretary, Treasurer and Chief Financial Officer in September 2006. Mr. Oblazney served as the Chief Financial Officer of Carrier Corporation's Light Commercial Business, a division of United Technologies Corporation, since December 2005. Prior to that, Mr. Oblazney served in various other financial positions with Carrier Corporation from 2000 to 2005. Prior to joining Carrier Corporation, Mr. Oblazney was employed for six years with Cooper Industries and employed three years by an international public accounting firm.
In his early years at Hurco, Doar managed the company through some tough times. He not only pulled Hurco through the storm, he positioned the company for better days ahead. Doar has been in the machine tool industry for a long time. He has done a commendable job at Hurco and has earned the trust and confidence of investors.
Competitors
Hurco competes with many companies in the U.S. and abroad. Most of Hurco’s competitors are larger and have greater financial resources. Hurco relies largely on its patented software (i.e. WinMax control software), proprietary features, and strong reputation to distinguish itself from its competitors.
Hurco lists several U.S. and international competitors in its 10k. While various research reports and investment websites identify a number of other competitors, these companies do not provide a reliable comparison for a number of reasons. Hardinge, Inc. (HRDG) is probably the best company for comparison purposes.
HURC Versus HDNG
Trailing 12 Month Comparison
| HDNG | HURC | |
| Sales | $326.6 million | $163.5 million |
| Gross Margins | 30.66% | 36.53% |
| Operating Margins | 7.07% | 15.95% |
| Net Margins | 4.27% | 10.91% |
| EPS Diluted | $1.58 | 2.78 |
| Share Price | $23.00 | $40.00 |
| PE | 14.56 | 14.39 |
| (Cash – LT Debt)/Share | ($6.93) | $4.46 |
| LT Debt-to-Equity | 43% | 5% |
| ROA | 4.57% | 14.92% |
| ROE | 9.24% | 24.50% |
Despite Hurco’s superior margins, capital structure, and returns, Hurco trades at a slight PE discount to HDNG.
Ownership
Institutions hold 61% of Hurco’s total shares outstanding, or nearly $3.9 million shares of the $6.39 million shares outstanding. Last quarter, institutions were net sellers to the tune of 144,000 shares, which is seemingly insignificant in the broad scheme of things. Royce & Associates, an institution identified by Motley Fools as one to watch, is the largest institutional shareholder with 772,350 shares.
Yahoo and several other websites report insider ownership at around 20%. On March 1, 2007, Richard Niner, a Director, filed a Form 4 indicating he sold 500,000 shares. I suspect Yahoo and the other websites have not been updated to include this recent transaction. If this is the case, insiders now own roughly 13% of Hurco’s outstanding shares, which is still high for a non-founder run company. While the Niner sale is worth noting, I am not overly concerned at this point. From what I can tell, Niner is not a machine tool guy and he is still the largest natural shareholder with nearly 232,000 shares. I suspect Niner sold his shares to cash-in on a very nice gain and to further diversify his assets. I don’t believe his decision was based on his expectations for the company or the machine tool industry. Again, my opinion on this matter is purely speculative.
Other than the Niner transaction, there have been no other insider transactions of particular significance. Investors should watch for additional insider and/or institutional transaction over the next couple of months.
Conclusion
Since its turnaround in 2003, Hurco has enjoyed several years of impressive growth and share price appreciation. Furthermore, Hurco has expanded its product line, strengthened its balance sheet, and diversified its sales across a number of regions.
The biggest risk to Hurco’s future is a global economic slowdown. While the diversification of Hurco’s sales across various regions will reduce the negative impact of regional weakness, there is no hiding from a global slowdown. Despite the recent downturn in global equity markets, I believe the global economy is poised for continued growth. I agree with Mr. Bernanke that the U.S. will continue to see slower growth in the first half of 2007 but growth will accelerate in the second half of the year. I believe Asia, in particular China, will continue to grow at a rapid pace and Europe will continue to strengthen. In this scenario, Hurco will prosper.
With the current correction in equity markets, Hurco is a good stock to put on your watchlist. I would wait for things to shake-out in the market before taking a position. I am not sure the opportunity will present itself, but a buy in the $35 or $36 range would be nice.
For those looking for a technical take on HURC, downtowntrader promised he would give his view on HURC later tonight.
Disclosure
I am long Hurco since 2004 when it was introduced to me through the Motley Fools Hidden Gems Newsletter.
Source Documents
Hurco History from Hurco Website
Yahoo Key Statistics (HURC)
Yahoo Key Statistics (HDNG)
HURC Q1 Fiscal 2007 Earnings Release
HDNG Year-End and Q4 2006 Earnings Release
Latest 10K filing
Richard Niner Form 4
Yahoo Analyst Estimates
NASDAQ Holding Summary
Recent IBD Article
Wallstreet Journal Article from 2003 (Hurco low point)
Monthly Survey of Machine Tool Consumption (Note that U.S. consumption was positively impacted in September and October by the largest U.S. trade show)
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