Description

Quick Summary:

We recommend a short position in Daktronics ("DAKT"). DAKT manufacturers large format, custom video displays for a variety of uses from sports stadiums to Times Square. It has ~90% share in professional sports markets (e.g., NFL stadium displays) and 30-50% share in other commercial segments (e.g., digital outdoor billboards or Times Square digital signs). We believe the threat of low-cost Asian competitors eroding margins and market share is under-appreciated by the market. In addition, we believe DAKT is at a cyclical peak, or at the very least a plateau, in the replacement cycle of its screens in its two largest segments. 

Despite recent consecutive quarter declines in margins and revenues, in what we believe is a secular trend, DAKT inexplicably trades at 30x trailing and 22x consensus FYE April 2016 P/E. We can't speak for the holder base, but we believe sell-side analyst don't fully appreciate the headwinds and are overly optimistic on DAKT's earnings potential. Consensus EPS estimate for FY16 for DAKT is $0.34 though we believe $0.23-$0.29 is more likely and achievable.

Given the already high market share and significant headwinds from Asian suppliers, we believe a more appropriate earnings multiple of 12x-14x is warranted. This would imply a share price of $3.0 - $4.75, or a range of $2.75 - $4 off of our estimate for the year. If you take the more optimistic view that recent earnings are indicative of normal cycles dips in the business, the average earnings over a cycle (generously calculated-- see below) is $0.46/share, implying a share price of $5.5 - $6.4 using the same multiples. However you choose to do it, DAKT shares appear richly valued given the headwinds it faces. 

DAKT was previously written up by mtbattie on June 24, 2015. We largely agree with mtbattie's thesis around continued margin compression and possible share loss due to cost advantaged Asian competitors. This should largely supplement his or her piece with some additional detail, particularly around around the replacement cycle. 

Longer Form Summary:

Company Background

DAKT, headquartered in South Dakota, manufactures custom displays used for a variety of commercial and government uses, including scoreboards for pro sports stadiums and road-side billboards. Manufacturing is primarily done in South Dakota. The company is currently run by the founder's son, Mr. Reece A. Kurtenbach.

Segment Financial Summary

Segment Summary

Commercial ('15 Rev/OpIn/% Margin $166mm/$29mm/17%): Manufactures custom LED screens for a variety of commercial purposes from roadside billboards to gas station signs. DAKT also will manufacture "spectaculars", large custom built displays that you might see in Time Square. There's a host of competitors in this space, and various Asian manufacturers are getting more aggressive. Approximately $40mm of revenue in this segment is from selling billboards to OUT, LAMR, and IHRT/CCO, the largest operators. It's estimated that DAKT has historically had 50%+ market share in this segment, splitting the rest with Yesco and other smaller players. 

Live Events ('15 Rev/OpIn/% Margin $232mm/$27mm/12%): Manufacturers and installs large, custom audio-visual systems primarily for large sports venues (professional and college). DAKT also sells to rental companies that run special events (e.g., music venues). The full cost of a high-end installation ranges from a few hundred thousand at a smaller college to up to tens of millions for large NFL stadiums. DAKT dominates the high end market with 90%+ share in premium venues like NBA and NFL arenas/stadiums (e.g., http://www.daktronics.com/en-us/markets/sports/major-league-sports-installation/nfl). Though DAKT has historically dominated this space, a number of recent deals will put pressure on this leading position. The principal competitors in this space in order of historical significant are: Mitsubishi Diamond View, Yesco, and TS Sports. ANC Sports also competes as an integrator and Lighthouse as a manufacturer. In February, Panasonic purchased TS Sports and shortly afterward in March 2015 Samsung purchased Yesco. Sony exited the space in 2006 when if failed to update its signature "Jumbotron" to LED/HD.

High School and Park ('15 Rev/OpIn/% Margin $68mm/$11mm/16%): Manufacturers and distributes scoreboards and timing devices for high schools. DAKT has high market share in this segment and few competitors given the market size.

Transportation ('15 Rev/OpIn/% Margin $48mm/$10mm/22%): Manufacture and sell  digital signs for highways and other transit hubs such as airports and train stations.   

International ('15 Rev/OpIn/% Margin $23mm/$9mm/17%): All international sales that would otherwise fall under the other segments. It also does architectural lighting.

Why this Opportunity Exists

The combination of limited guidance from management, limited sell-side coverage, a misleading high headline backlog and a cyclical, lumpy business has led DAKT to trade away from fundamentals.

(1) Limited Coverage: Three sell-side analysts cover DAKT: Sidoti, Needham, and Griffin.

(2) Management Doesn't Provide Guidance: The business sells capital equipment and is inherently cyclical and lumpy due to order timing and mix. For example, revenue/operating income declined from $580mm/$26mm to $393mm/-$7mm form FY 2009 to FY 2010. Management provides minimal to no guidance and so it's our opinion that investors have written recent bad performance off as a mix issue/cycle blip and don't view it as a secular trend. Management doesn't dissuade people of this notion nor do they strongly encourage it.

(3) Cyclical Peak in Live Events: We can't speak for the buy-side, but the sell-side seems to be overlooking a cyclical peak or plateau in the Live Events segment. We developed a database with over 1,000 sports stadiums in the U.S. and the last date each one had a scoreboard update. The data points to slower period ahead for FY 2017, not the consensus of record revenue and earnings.

(4) Record High Backlog Misleading: Sell-side will point to a record high backlog for FQ2 of $183mm, versus the prior year FQ2 of $141mm. This, however, is not an apples-to-apple's comparison. At least $36mm of this is for unusually long lead-time bookings related to new NFL stadiums and isn't expected to be realized until FY 2017. In addition, in Q2 management said they elected to defer production to future periods that they had originally planned on performing in Q2. Accounting for these two items creates an apples-to-apples backlog that's at or below last year's backlog. Management indicated that this would be a reasonable way to look at backlog on an apples-to-apples basis.

Thesis Quick Summary:

(1) Increasing Competition and Margin Pressure

(2) Cyclical Peak in Live Events -- some areas of Commercial

(3) Aggressive Consensus Estimates

(4) Reactive Management

(1) Increasing Competition and Margin Pressure:

mtbattie does a good job exploring why DAKT operates at a disadvantage on cost so we won't rehash it in detail. In short, there are number of Asian suppliers that operate at a price advantage due to better procurement, labor, in some cases scale, and recent strengthening of the dollar. We'll focus instead the recent consolidation in the industry and evidence of the impact on the business.

As mtbattie points out, there's evidence of margin declines in historical performance, presumably from increased competition, though there is a significant amount of noise due to the amount of mix shifts and lumpy projects.

Gross Margin by Operating Segment In Order of Contribution (FY 2008 - FY 2015):

Of particular note is the recent dramatic decline in commercial margins, which is consistent with commentary in the industry we've heard about foreign competition. Management hasn't been able to provide a good explanation for this other than mix.

(a) Evidence of Asian Suppliers Pressuring Margins

DAKT and Customer Call Script Excerpts 

Discussion of the competition in call transcripts from DAKT and customers summarizes how the competition is manifesting:

2009 - DAKT Call Transcript

Question – Jim Ricchiut: Yes, I was wondering if you could characterize the pricing environment just in light of the economy. Are you guys seeing more pricing pressure in some of your markets? And on the competitive side, do you see potentially some of the smaller players struggling a little bit more that you normally would be competing against?

Answer – James Morgan: I'd say we have seen some real aggressive pricing from some of the competitors that we'd say is maybe unusually aggressive; maybe to the extent we question whether it's even sustainable. That's always a hard judgment to make, of course, but – so there is some of that.

This is from a Q3 FY 2009 transcript. Live Events at this point in time for DAKT was the majority of quoted business representing ~50% of revenues. As you can see from the margin chart above, margins in the Live Events segment haven't recovered since. 

You can also see evidence of intense competition on the commercial side. Contrast the call below from 2010 at one of the largest display buyers to the calls from 2013 and 2015:

2010 - LAMR Call Transcript

Question – James Boyle: Okay. And Lamar used to buy most of your digital displays from YESCO and Daktronics, have you or will you add a third provider?

Answer – Sean Reilly: We are talking to a third provider for next year, not in the kind of volume that we are taking from Daktronics and YESCO. Those two guys have done an incredible job of lowering the price of the units, improving the performance of the units, improving the useful life of the units, the operating costs, just across the board, they have been great partners. And they will get 95%, if not 100%, of what we do next year. That being said, there is a company called Barco that has gotten up the curve and it can't hurt the industry and it can't hurt Lamar to have a third vendor that -- working on this product on our behalf. So we are in early discussions with them.

2013 - LAMR Call Transcript

Question – Marci L. Ryvicker: Is it still Daktronics and YESCO?

Answer – Sean Eugene Reilly: No.

Question – Marci L. Ryvicker: Who is it?

Answer – Sean Eugene Reilly: You've got WatchFire is really coming on strong. You've got a Belgian company called Barco which has a good unit. And the unit that we're in beta with is – it's a Chinese-manufacturer but American technology. It's a mesh that they used to wrap buildings, like if you saw the World Cup in South Africa, they wrapped a whole bunch of really cool buildings in Johannesburg with this stuff. They've developed a way to make a poster out of it that they ship whole to our plant, right? I mean it comes already in there, and we go hang it. It's lighter. It's very efficient. And it's cheaper.

2015 - LAMR Call Transcript

Answer – Sean Eugene Reilly: Great questions. So, yeah, when we put up the first one in Baton Rouge on I-10 around our office in 2004, 2005, I forget when it was, a digital billboard cost $500,000...It was quite elite, but got very interesting and very exciting. And there were projections of oh, my god, can you do this everywhere?... We put them up as fast as we could keeping in mind each one is a little construction project, right... So a large one that we put on the interstate now cost give or take $180,000... The first generation units tended to last about seven years. The generation we're putting up today, we're getting a good 10 years out of them and that's a warranty 10 years from our supplier...

Like I said, in the markets where in Lamar land, in the markets where we're approaching 30% penetration with a digital product, it seems to be a place where our management says, I'm happy. I'll let you know if I need another one, but right now, I've got sufficient tenant demand for the ones I've got...

These excerpts demonstrate (1) ASP declines-- DAKT has certainly offset this with price but gross margin dollars are still less; (2) More innovative competition taking share; (3) saturation in digital billboard market which represents ~25% of the commercial segment; and (4) lengthening of the useful life of products (more relevant to cycle peak point below).

Industry Expert Commentary:

We've spoken to a few billboard providers and the commentary has been consistent that DAKT, while representing a gold standard, is too expensive and Asian suppliers have caught up on quality (where it counts) and beats DAKT on price. In the Live Events space, customers value DAKT's full service offering and customer support but are keenly aware of how much cheaper Asian competitors are. The entrance of Samsung and Panasonic to the space may push customers to try alternative vendors (more on this below). Commercial billboard buyers were consistent that DAKT is simply too expensive in most cases.

(b) Recent M&A - Cost Advantaged Vertically Integrated Competitors: 

Panasonic and Samsung purchased two DAKT competitors, Yesco and TS Sports within a month of each other in early 2015. These competitors will now have a significant cost advantages in both raw material/electronics and labor due to the new partnerships. A manager at a consultancy that works with NFL stadiums, among others, on audio/video upgrades, said the Samsung entrance into the market is the more interesting of the two acquisitions. According to this expert, large sports venues are very interested in what Samsung could bring to the table in a partnership. Of particular concern to DAKT would be the possibility of Samsung providing equipment at cost in exchange for branding around the stadium. Also of interest is the idea of "connected" stadiums. For example, Samsung tablets, wifi, etc. spread through a stadium. The breadth of the Samsung organization makes it a very attractive partner compared to a local South Dakota business like DAKT. According to this consultant, there's already significant changes in operations taking place at Yesco (the Samsung acquisition and DAKT competitor). It's also expected Samsung/Yesco will become much more aggressive in the commercial space, where DAKT has historically split share with Yesco. Interestingly, management has had virtually no comment on these acquisitions or how they plan to adapt... 

(2) Likely Peak in Live Events and Plateau in Commercial:

 For some context on this point, we think that if this business weren't cyclical, the margin compression thesis would likely be adequate to make this a good short. However, we were concerned that margin compression would be drowned out by a run up in the Live Events segment, historically the most cyclical. Research we've done points to the opposite, a slowdown in the Live Events space and portions of the commercial space.

(a) Live Events

Roll-Forward of Stadium Upgrades Points to Decline

We compiled a database of over 1,000 sports stadiums and the year each stadium's scoreboard was last updated. We then rolled forward the database, assuming that stadiums will be upgraded in the 8-12 year time frame that DAKT says is average for a cycle. Based on these data, we have a reasonable degree of certainty that there will be a slow-down or plateau in scoreboard upgrades and the Live Events segment. It's not possible to determine exactly how this will translate into revenue for DAKT given different dollar figures associated with different stadiums, sports, leagues etc. but the trend will likely be downward for the next one to two years. For example, in the last few quarters, DAKT has described it's performance in football stadiums (Q1 FY '15), basketball (Q2 FY'16) and baseball (Q4 FY '15) as record years-- this likely isn't sustainable unless there are significant shifts in upgrade cycles or dollars spent per upgrade. Given DAKT's already high market share in this segment, growth is unlikely to come from higher market share.

Here's our roll forward from this database. Please note we've adjusted the stadium upgrades to match the DAKT fiscal year (i.e., we're in the middle of 2016). 

Key: 

Booked: Represents stadiums upgrades that have already been announced

Max: DAKT claims the average upgrade cycle for a display is 8 - 12 years. Max looks back 10 years at a four year window (i.e. for 2020 looks at 2008 - 2012) and then picks the year with the largest number of stadiums that haven't been upgraded and uses that.

Average: Same as Max but instead of taking the max, it takes the average of the four year window.

Min: Same as Max but instead of taking the max from the four year window, it takes the min.

The consultant we spoke to anecdotally confirmed this trend saying there has been higher than normal upgrades in the last one to two years and expects this to slow down in coming years.

(b) Commercial:

This was discussed above in part 1(a). Management claims commercial customers are delaying investment decisions. Outdoor billboard companies such as OUT, LAMR, and CCO/IHRT have indicated they've reached a plateau in digital board upgrades from saturation and or increased regulatory hurdles to installing new digital billboards.

(3) Aggressive consensus estimates:

Sell-side analysts, call for FY16 2H revenue of $291mm, the highest second half in revenue in the company history. Sell-side is also expecting DAKT to increase gross margins YoY for the second half by 200 bps, presumably because it conveniently gets to flat year end margins. Again, management provides no guidance...

($mm)  

Historical Revenues by Half ($mm)

We model $270mm in 2H revenues (still high do due to a few projects that were bumped from FQ2 to FQ3) and 23% gross margins, which generously assumes that all the segments revert to historical average margins except for the international segment where the currency headwinds are the worst. This estimate yields a 2H EPS of  $0.11 or $0.29 for the year. If you assume the margins trends for commercial and live events persist, earnings for the year go to $0.23, roughly half of 2015.

(4) Reactive Management:

Management appears largely reactive and has not or perhaps cannot articulate a strategy to overcome these competitive headwinds. They have had limited or no commentary on the acquisitions in the industry and claim to not know what these competitors are aiming to do. They don't provide any sort of guidance on where the upgrade cycle is. They haven't made a serious attempt to move manufacturing abroad. They don't have a strategy to combat currency headwinds.  

Perhaps some of this is it's still a family run business (though inside ownership has steadily declined) and the family is loyal to the local community. As a result, they hesitate to disrupt its community relationship by off-shoring design and manufacturing.   

One has to assume that Pansonic or Samsung would have approached DAKT, the market leader, before its smaller competitors. Management wouldn't comment besides to say that would be a reasonable assumption an outsider could make. We suspect they were approached but declined to sell or partner, again, due to the concern around disrupting the community. This may also be because there's very limited severance given to executives upon a change in control. The CEO (founder's son) owns <1% of shares outstanding and receives $174k, representing ~32% of his annual compensation upon a change in control.

Valuation:

We believe an appropriate multiple for a business facing these sorts of headwinds on ASP and market share shouldn't be more than 12x - 14x p/e. Given 2016 consensus (which we believe is high), that yields a share price of $4-$4.75 or a downside of 46% - 36%. This may be overly negative given the first half of the year may have been particularly affected by the lumpiness of the business.

Another way to look at it is average earnings over the cycle. DAKT grabbed market share after 2006 when Sony exited the Live Events business with its signature Jumbotron. Averaging FY2007 - FY2015 and generously excluding FY10 (CY09) and not making any adjustments for the decay in the margins, the average operating profit over the period is $31mm. Assuming a 35% tax rate and using the current share count of 43.9mm, that yields a average cycle EPS of ~$0.46, which is roughly equivalent to FY15 earnings. Applying the same multiple to that yields a share price of $5.5-$6.4 or downside of 15%-27%. Adjusting that historical operating earnings figure for the decline in margins would further decrease that price target.

Risks:

(1) Buyout: If Samsung or Panasonic do well with their acquisitions, a buyout of DAKT from one of Panasonic/Samsung's competitors (Sony?) becomes an increasing concern. However, as discussed in the management section, it doesn't appear that management is interested or incentivized to do this.

(2) Activist: This could be an attractive target for an activist though management's apparent recalcitrance and the massive disruption to operations to reshape the business may appear too risky at this price. 

(3) Management Moves Operations Offshore: As discussed, management seems reluctant to do this. There has been plenty of opportunity.

(4) Weakening Dollar

(5) Lumpy Business: The business has historically been lumpy and the market reaction to earnings have been significant. It's not hard to see a scenario where a few whale projects get landed in a particular quarter and the market extrapolates this performance into the future. 

(6) Dividend Yield Stock: Management's primary use of capital is dividends and the company converts the majority of its earnings into cash flow. The stock likely trades on its rich dividend yield of 5% and may not re-rate to account for the headwinds facing the business until the dividend is cut which could be some time given the company is unlevered.

Catalyst

Catalysts:

(1) Continued Earnings Weakness

(2) Samsung/Yesco Strategic Plans/Stealing Share

(3) Digital board upgrade cycle decline