Description

DAKT faces structural challenges to its business – namely, price competition from Chinese manufacturers, who collectively are gaining wider consumer acceptance in the U.S., and are moving increasingly “up market” into segments of the LED video display market where DAKT has long enjoyed leading market share.

DAKT’s cost structure puts it at a competitive disadvantage to respond rapidly enough to this heightened competition, and to rapidly declining ASPs.

Finally, DAKT has been window dressing their operating results as much as possible in recent periods through tweaking accounting estimates here and there; consequently, the problems facing DAKT are worse than they seem at first glance.

Summary

Daktronics was founded in 1968 by two South Dakota State Professors, Al Kurtenbach and Duane Sanders - in part to provide job opportunities locally for some of their most promising engineering students (see link).

From these beginnings, DAKT has grown into an international leader in the manufacturing and sales of LED large video displays and electronic scoreboards with approximately $600mm in LTM sales.

Daktronics is best known for the large video displays at major sports stadiums – for example, the integrated LED video and scoring system hanging over center court at the Barclays Center in Brooklyn.

DAKT operates in five segments:

• Live events (i.e. stadiums);

• Commercial (outdoor digital billboards and large displays like those in Times Square);

• High Schools (scoreboards and other digital signage for schools);

• Transportation (i.e. the Departures/Arrival boards at JFK airport), and;

• International (their overseas sales).

Daktronics’s main competitors include:

• Panasonic/Lighthouse partnership;

• Barco;

• Mitsubishi;

• Samsung/Yesco;

• Increasingly Chinese manufacturers (Leyard, Unilumin, Ledman, Absen, Lintronics, and Retop).

Below is an estimate of the addressable market for just DAKT’s largest two segments (Live Events and Commercial), as well as an estimate of DAKT’s current market share:

Source: Analyst estimates

The Commercial and Live Events segments alone represent about 65-70% of DAKT’s sales and operating income.

The balance is made up by High School, International, and Transportation. High School is a smaller, niche market in which historically DAKT has enjoyed a stronghold, given its reputation and history as a manufacturer of scoreboards (~10% EBIT). Transportation (~10% EBIT) segment has recently been in precipitous decline – LTM EBIT in this segment has gone from ~$21mm in April 2013 to $10mm as of April 2015. The balance of EBIT comes from International.

DAKT has far higher market share in the higher-end, bigger projects. This is both due to DAKT’s reputation for quality, as well as their US headquarters, as a disproportionate number of the large stadium projects worldwide take place in the U.S., and often companies prefer to have a U.S.-based sales and service presence for these large, high-profile, and complex projects.

DAKT’s market share is a lot lower (and based on our research, more quickly declining) in the mid to low level projects, and rental market (i.e. screens sold to rental companies – or for “non-fixed installation” business to use industry parlance).

Please note, the above numbers are ex-China sales. China represents about 1/3 of the global market, so China alone is responsible for another $800mm+ in sales, based on our conversations with industry professionals. But these Chinese sales are entirely serviced by Chinese manufacturers – and there is no chance of Daktronics gaining share in this market. In China, there are currently hundreds of LED display manufacturers. Only maybe ten make product in accordance with international standards, according to our research.

Description of Situation

LED Video Display manufacturing is an extremely competitive business.

DAKT has historically operated at skinny GM’s. And they are getting skinnier as time progresses. DAKT’s GM% averaged ~30% from 1998-2008, but since then have averaged just shy of 25%, amid increasing competition from Chinese manufacturers, who have greatly improved the quality of their products.

This is partly because customers have adopted more of a “good enough”, conservative posture towards their cap ex spend for video displays ever since The Great Recession. This has adversely impacted DAKT, given they are the premium-priced brand.

DAKT’s EBIT margins from 1998-2008 averaged 9%, but since then have averaged 4%.  

DAKT’s reputation as the premium product in the market is for good reason. For one, DAKT uses more premium LED components (i.e. they use Nichias products vs. those made by Cree, Chinese and Taiwanese companies) across its product portfolio. But this comes at a cost. Our industry research suggests Cree components can run 20% lower in price vs. Nichias, the Taiwanese options 40% lower, and Chinese options upwards of 50-60% lower than Nichias LED components.

DAKT also invests more in “product reliability” capacity than most of its competitors, as part of which they rigorously test and stress case their products.

Important to note, LED components are a very significant portion of DAKT’s COGS (some 55-70%). So price differences for this key component is crucial in the ultimate price and margins of the large video display they go into.

Historically, DAKT has insisted on using Nichias components, given DAKT’s reputation for quality – and given the highly-visible places a lot of their displays go (above center court of a large stadium). Also, DAKT typically backs their reputation for higher quality with more favorable warranty terms than their Chinese competitors.

While it is possible that the market simply does not value Nichias components as much now as in the past, and DAKT could enhance margins through moving to cheaper components, such a move is made difficult by DAKT’s warranty offerings. The switch away from Nichias would have to coincide with a complete overhaul of DAKT’s warranty practices (i.e. lessening of their guarantees), and would also risk jeopardizing DAKT’s brand as the perceived quality leader. So in many ways, DAKT is damned if they do, damned if they don’t, given their current place in the market.

For example, DAKT’s warranty reserves as a % of sales were 4.5% LTM Sales as of April 2015. This very high relative to their Chinese counterparts. This added cost further compromises DAKT’s ability to compete on price.

The company will tell you that they often have customers switch to a lower quality brand, only to come back to DAKT once the quality of said competitor’s products let them down. But as LED component costs continue to decline rapidly, and Chinese manufacturers improve the quality of their products – the quality gap between DAKT and Chinese LED video display products is closing fast. Also, DAKT is hesitating to lower their prices in response. The result is consumers’ perceived value of the Chinese alternatives relative to DAKT’s products is much higher at present than ever before.  

Further, as a U.S.-domiciled manufacturer, DAKT’s labor costs are also higher than their competitors. So given the lower wages and benefits, and the lower warranty costs that Chinese manufacturers offer on their products, prices of DAKT products vs. Chinese competitors on the very same product/components can be up to 15-30% different (this is excluding the cost a Chinese manufacturer may have to pay for a U.S. based sales presence or partner, when selling into the U.S.).

When you factor in the fact that Chinese products often include a cheaper assortment of LED components, this price difference becomes even more pronounced.

Finally, according to the company the recent strengthening of the USD has resulted in further pricing pressure for DAKT, in their overseas markets (namely Europe and Australia), as non-dollar based manufacturers have been taking advantage of their now lower cost base vis a vis the dollar by getting more aggressive on pricing of contracts in an effort to take share from DAKT.

Competitive Situation

After extensive industry research, we believe Daktronics is currently facing an abnormally elevated level of competition across all their segments, resulting in depressed gross and EBIT margins.

Further, the lack of an adequate strategic response from Daktronics has put their business model on shaky ground. Given our research suggests current conditions are likely to persist (whereas consensus is currently predicting a normalization of Gross Margins to 24% in the back half of the year), we believe DAKT’s stock price is currently overvalued by 30-50%.

GM Compression

As mentioned above, GM% for DAKT are trending lower, but the decline in GM’s has intensified in the most three recent three quarters:

Management’s explanation for this decline is: product mix, foreign currency, and price competition from “Asian Integrators” (i.e. Panasonic/Lighthouse).

First, larger projects for DAKT are lower margin, and chunky. So the timing of these projects can skew margins in any given quarter. Also, the amount of these projects that include subcontracted work can also skew margins. Subcontracted work happens when DAKT wins a bid – but has to subcontract out a portion of the project to a certain partner, as a condition of the bid, which impacts their margins on the project. Of course, the other explanation for this “mix” issue is that DAKT is losing market share in the smaller, but higher-margin projects at an increasing rate. We believe there is more permanence to this mix shift than management is letting on.

On the last call, the CFO had this to say: “There is some impact to us because of the strong dollar. But it's hard to just maybe see in our financials. It's more on the quoting side where we become a little less competitive in, say Europe and those sorts of areas.” So DAKT either has to drop their price to be competitive (eroding GM’s further to below B/E profitability), or lose the business altogether.

On the third point – this is perhaps the most troubling, and we would argue the most permanent of the three explanations.

“Integrators” refer to companies like Panasonic that do not manufacture the video display, but provide the distribution and other supply chain logistics for a manufacturer (in the case of Panasonic - Lighthouse).

Panasonic is the sole distributor of Lighthouse Technologies video display in the United States and Canada.

Panasonic’s partnership with Lighthouse allows customers to purchase Lighthouse technology through a more optimized supply chain. Lighthouse Technologies Limited is a Hong Kong-based, global leader in LED display technology that develops, manufactures, and markets LED video display solutions for multiple indoor & outdoor applications, media and entertainment events, and sports arenas across the globe.

As I illustrate below, we believe that Panasonic is able to achieve a significantly more attractive price point than DAKT on fairly comparable products, given their partnership with Lighthouse.

Also, Panasonic, importantly, unlike DAKT, has a massive portfolio of consumer brands. This allows them to think about their large video display business differently than DAKT does. Specifically, Panasonic may try to win a massive live event and stadium project as a “loss leader” for its broader consumer business, by using the stadium placement to increase customer awareness about the Panasonic brand, and hopefully in turn to drive sales of their consumer products, which is where Panasonic’s bread is ultimately buttered.

This allows Panasonic to take an even more aggressive posture versus DAKT in competitive bidding situations (which all large projects are) beyond just the advantages they enjoy due to lower component, warranty, and labor costs. The larger and larger profile of stadium projects as of late make the “loss leader” economics for Panasonic increasingly compelling, which is why this dynamic has been worsening for DAKT lately.

Also, Panasonic, like other Asian competitors, are increasing their sales presence in the U.S. both directly and through strategic partnerships. For example, Panasonic just acquired TS Sports, a company that handles the “sales & service” component of large stadium contracts. This will in turn allow them to win an increasing number of big stadium contracts.

Also, fast-growing Chinese company Leyard, for example, now has a small sales presence in the U.S. One industry professional we spoke to believes Leyard is now doing about $200mm in annual sales globally from almost nothing five years ago.

Unilumin, Lintronic, and Absen all do an estimated $150-$180mm in sales annually. Also, these companies have been innovating in small pixel pitch (i.e. Leyard), or acquiring other innovative manufacturers, like Absen’s acquisition of Viss Lighting for example, or Unilumin’s stake in Radiant. There is a chance that these manufacturers will further increase their sales presence, either via integrators or directly, in the U.S. over the coming years – pressuring DAKT further, particularly in the indoor market.

Price Competition

“The Chinese screen market made such a compelling argument with low cost, decent-quality-products that they destroyed the quest for perfection. It no longer makes sense for Barco to try and out-do them on new product launches, because no one will be able to afford it. This is not a knock on Barco, just an economical truth.” April 2015, Upstagevideo.com/blog (a rental company for large video displays).

“Stiff competition in the traditional LED video display market has led to price wars and shrinking profit margins, driving manufacturers to seek new opportunities.” January 2015, IHS Technology.

“…this year’s demand growth [in the LED market] has been considerably weaker. The main factor behind this is the volatile global economy, which in turn causes big exchange rate fluctuations in several regions. Currency depreciations in Europe, Japan, and the emerging markets have made imports of LED bulb and other electronic products more costly for consumers. Consequently, demands are scaled back and LED manufacturers are now undercutting each other in order to maintain their capacity utilization rates.”  May 2015, Roger Chu, Research Director at LEDinside.

The above three quotes summarize well the current state of the complete LED supply chain.

First, as the third quote shows, the price of LED components are declining rapidly. Since this is a cost input for DAKT, one might think this is a good thing. But it is not. Given the vertical integration of the supply chain in China, and the price transparency for LED components, declining ASPs for LED components are ultimately flowing through to lower ASPs on video displays themselves (as the second quote demonstrates).

Amid rapidly declining ASPs, DAKT has to rapidly grow volumes just to maintain flat sales growth. DAKT’s LTM sales growth as of April 2015 YoY was 12%. DAKT does not disclose volume growth – so it is impossible to ascertain price/volume contributions. But we believe video display ASPs are likely declining 10-15% per year, based on industry research. So ~12% sales growth would suggest 22-27% growth in volumes. This will be tough for DAKT to maintain, especially if economic growth slows.

Surely, this cuts both ways – i.e. if price competition abated while demand for DAKT’s products remained robust, margins would obviously improve. But given the cyclical component to DAKT’s business, where we are in the cycle likely, and given they have had to aggressively cut price to drive these volumes to-date, I do not view growing volumes double digits, while maintaining price, as a risk at this point.

Also, DAKT’s growth has recently been coming at the expense of margins. When volume growth eventually slows, the industry is at risk of falling into a death spiral. Keep in mind, DAKT did $581mm in sales in ’09. By ‘10, sales had troughed to $393mm. As of April ’15, sales have climbed back to $615mm. This is a cyclical business.

Also, as noted above, EBIT margins have not recovered – and likely never will - to pre-Great Recession levels. So as DAKT approaches arguably peak-ish levels in sales this go-around, they are on much weaker ground than they were before the last turn in the cycle.

Finally, the first quote highlights how Chinese manufacturers are closing the quality gap in the eyes of consumers – who now feel the Chinese, lower-cost option in many instances is “good enough” – and are opting for that option over the more premium brand (DAKT).

Poor earnings quality a risk

Warranty Expense: DAKT’s warranty reserve as a % of sales has been declining (from 4.9% in the twelve months ending April 2014 to 4.5% of sales in April 2015, providing a 40 bps boost to GM %, over a time when LTM GM% declined 220bps inclusive of that 40 bps tailwind, from 25.7% to 23.5%).

This suggests that DAKT perhaps under expensing for warranties over this time period, providing an unstainable boost to GM’s, and masking the negative impacts from enhanced price competition.

Applying a 4.9% warranty expense % to LTM sales would reduce LTM EBIT by 12.6%.

Interestingly, the biggest change in the most recent year occurred in the “Changes in accrued warranty costs for pre-existing warranties during the period, including expirations”, where arguably management has the most discretion in their estimates.

According to management, declining warranty expenses are due to a focus on product reliability improvements. But product reliability efforts on new products will not change the reliability of products already in their installed base (or therefore their Accrued estimate for pre-existing warranties). So the reduction in reserves looks less because of any enhanced product reliability efforts, and more due to aggressive assumptions (or a reversal of historically conservative reserves – i.e. use of a “cookie jar”).

Regardless, declining warranty expenses may not be a sustainable boost to gross margins – and thus, may further be masking the deterioration in GM’s – if the declines are merely a function of more aggressive accounting assumptions.

Allowances: Allowance for Doubtful Accounts has been trending lower over the last two years providing a (perhaps unsustainable) boost to EBIT. For example, AFDA as a % of A/R was 2.6% in April 2013. In April 2015, it was 2.1%.

If we apply the 2.6% reserve % from 2013 to MRQ A/R of $116mm, 2 year-over-year LTM EBIT growth (FY 2013-15) would have been -0.2% instead of 2.2%. Not a massive difference, but enough of a difference to make EBIT growth toggle from positive to negative over this time.

In summary, DAKT is arguably pulling out every stop they can to window dress their difficult, structural issues that began in earnest a couple years ago, and have recently intensified – namely through more aggressive assumptions on warranty and allowance for doubtful accounts reserves. Both of these have provided unsustainable sources of EBIT growth over the last two years. These actions amount to no more than putting lipstick on a pig.

Deferred Revenues: Deferred Revenue growth has failed to keep pace with the growth in revenues. Deferred revenues are associated with DAKT’s extended maintenance contracts (i.e. service revenue associated with fixing units after they live past their warranty period). The reason this is significant is that this revenue has a very high flow-through to EBIT, when the services are ultimately performed and the deferred revenue becomes revenue.

The declining deferred revenue/revenue ratio could therefore mean that fewer clients are opting to use DAKT to service their units – versus some alternative service provider they find on their own, which would be bad if true, because this is high margin business for DAKT.

Perhaps not coincidentally, LTM EBIT in April 2013 was $31mm, at which time Deferred Revenues peaked at $14mm (including both current and long term deferred revenues). As of April 2015, LTM EBIT was $31mm and Def. Revs were $13mm (so both had failed to grow at all).

Over this same time LTM Sales went from $518mm in Apr. 2013 to $616mm in April 2015. So over this time, EBIT growth has been tougher to come by, particularly without the help from the high-margin service business providing the tailwind to performance that it had in the past.

DSO trend: In recent years, receivables have been growing faster than sales. One possibility is that DAKT is having to extend customers more favorable payment terms to maintain sales growth.

Lack of Strategic Response

Given the heightened competition, what could Daktronics be doing, if anything, to stem the tide? What are they doing?

First, according to my conversations with the company, DAKT feels the steps they need to take are merely incremental ones. They do not believe current conditions call for dramatic shifts in their strategy. Some of their initiatives include: improving utilization of their newly-acquired facility in Ireland (where current sales are only < $10mm annually, but they feel it could be many more times that); becoming more efficient; introducing new “lower-cost” products (where they were targeting other material costs more than LED components – and where this initiative only pertains to the larger projects, where the customer works with a direct sales person); and lowering warranty expenses through creation of their “product reliability” center.

But these steps are not dramatic enough, given the rapidly changing competitive landscape.

Further, DAKT is not positioned to benefit at all from one of the most exciting growth areas in video display – fine pixel pitch (< 2mm) indoor displays. As LED costs, and thus ASPs for consumers, continue to decline, the addressable market for indoor fine pixel pitch will grow significantly, as LED displaces projection and LCD in a lot of indoor applications.

One industry expert we talked to felt we are 12-36 months away from the growth part of the S curve in this new technology, and that this market will dramatically increase the TAM for companies with the requisite technologies.  

There are some exciting upstarts in this space - Silicon Core Technology, for example. DAKT could acquire a company like this to position their brand for what will be a growth market in in the coming years. But as of now, they have shown no intentions to take such steps. As noted above, their Chinese competition are actively acquiring companies in this space. Many of the most attractive targets have been scooped up.

Secondly, DAKT could be offering a more coherent “good, better, best” product portfolio across their entire business (not just on the large projects via direct sales reps on an ad hoc basis). Being the premium priced solution in a market of rapidly falling prices, where your competitors have a distinct cost advantage, and customers are increasingly content with the quality of the “second best” option…DAKT needs more than a knife at a gun fight.

DAKT could mitigate the decline in market share they are facing in markets outside of large stadiums by offering a more coherent “tiered” product portfolio to their customers – so they don’t have to necessarily concede margins to win sales from their more cost conscious customers.

Finally, DAKT should be aggressively moving more and more of their manufacturing overseas. Why don’t they do this?

This is speculation on my part – but the founding partners of DAKT are likely reticent to do so, given the importance their company has to the economy of South Dakota, and because of their understandable pride as a U.S.-based manufacturer. The original intent of their firm was to be a large, local employer of promising, local engineering students in South Dakota. See this interview with founder Al Kurtenbach for more detail.  Moving their operations to China would fly in the face of much of what DAKT’s founding partners and largest shareholders have stood for since the company’s inception decades ago.

In response to questioning on a recent earnings call, CEO Reece Kurtenbach, son of founder Al Kurtenbach, had this to say:

We prepare – fully expect our gross profit will go up. Will that achieve the 25%? We're very hopeful. There's a number of factors. You've got the U.S. dollar, you've got the response of the competitive pressures. We also have the number of cost saving product and process initiatives coming into play. So it's difficult to predict that exact number.

Unfortunately, hope is not a strategy. Answers like these – and management’s lack of a communicated, coherent strategy to address current heightened competition – have earned this management team a reputation for being too slow to respond to changes in the marketplace. The inertia of DAKT in face of increasing competitive threats is likely to persist.

Valuation/How it plays out

While DAKT has already sold off some 35% from its 2011 high – a 21x NTM P/E off what we believe to be unreasonably high forward earnings estimates, especially amid the noted, heightened competitive pricing pressure and slowing end market growth in large, lower resolution display outdoor projects where DAKT is best positioned, is far too rosy an outlook.

We think a 10-12x multiple for a company with no strategy to respond to the changing competitive landscape facing them - is more appropriate. The company currently generates only about $20-25mm in FCF and declining. Based on this earnings power, we think DAKT has 40%+ downside from its current price.

Scenario #1: Price competition continues, gross and EBIT margins continue to decline, Transportation segment continues its rapid decline, deferred maintenance contract revenues continue to come under pressure. DAKT takes inadequate strategic steps to address their problems.

Scenario #2: Price competition abates, product mix improves to more higher-margin products, decline in Transportation segment normalizes, warranty obligations as a % of sales continue to decline. Live Events and Commercial show double digit top-line growth. International growth continues.

Under Scenario #2, if we assume sales grow to $700mm by end of 2016 from $616mm LTM, at 7% EBIT margins, and 33% tax rate, this would equate to $0.74 in EPS. At an 18x multiple, this would mean $13.34 per share target price, or 15% upside. We assign a far lower probability to this “bear” case for the short, and think the risk/reward here is attractive given the structural issues facing DAKT – and their lack of a strategic response.

Why it’s Mispriced

Lack of coverage – Currently only 3 sells-side Analyst cover DAKT (Griffin Securities, Needham, and Sidoti & Company). Needham rates DAKT as a “Hold”. The other two have a buy rating on DAKT, and price targets from $14-16. Given this dearth of coverage, DAKT does not get a lot of attention.

Lack of pure comp – DAKT’s primary competitors are either private companies, are domiciled offshore, or are small parts of much bigger corporations. Because there is no US-listed, public comp, knowledge of the competitive environment facing DAKT requires extensive, primary research (which we have done).  

To give you a sense of this dynamic, EQRV <GO> on Bloomberg for DAKT defaults to: Immersion Corp., Knowles Corp., and Vicor Corp. as their peer group. These companies are NOT competitors of DAKT. DAKT’s peer universe – and the progress this group is making relative to DAKT – is slipping completely under the market’s radar.

No Guidance – Not only is there no public comp, but management also does not provide guidance. They are also very cagey and ambiguous about the threats to their business. The company told me other than “competition” (literally just that one word with no edifying explanation), that they could envision no long-term threat to their company. Again, they would provide no insight to what they meant by competition. A company unwilling to admit the extent of the threats facing them are in my opinion unlikely to respond to those threats with the severity and speed necessary.

Risks

US Dollar Weakens – as noted above, the USD strengthening exacerbates DAKT’s competitive problems, and makes them less likely to win bids on contracts overseas. To the extent this trend reverses, all of DAKT’s problems will certainly not be solved – but it will help.  

Price competition abates – should the supply chain in China “right-size” and some capacity gets taken off-line, perhaps the pricing environment would become more rational. But given the strategic reasons for competitors like Panasonic (see “loss leader” commentary above) to stay aggressive on contracts, and given growing Chinese companies’ (Leyard, etc.) desire to win share globally, a more rational pricing environment is a risk we do not assign a high probability to over the more intermediate term.

DAKT acquires a fast growing player in the low pixel pitch/indoor technology area – If DAKT were to acquire an innovative, upstart in fine pixel pitch indoor area, this would not remedy their near-term, deteriorating FCF, but may enhance their longer-term viability.

DAKT moves more of their manufacturing capacity to lower cost regions – DAKT could cut into their competitors current cost advantage by moving more of their supply chain abroad. Given the reasons mentioned above, I do not see this happening under the company’s current leadership, as I do not see the current leadership changing their mindset.

DAKT introduces a more coherent “good, better, best” product/pricing strategy – this is perhaps the most likely of the risks, as DAKT has already attempted to do some version of this in parts of its business. But it remains to be seen how extensive this will be – and if implemented, what kind of margins they could capture on their “good” and “better” product lines.

This report (this “Report”) on Daktronics Inc (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold short positions tied to the securities of the Company described herein and stand to benefit from a decline in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their short exposure to the Company’s securities or establish long positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

Catalyst

Next quarterly earnings report - if GM’s continue to deteriorate the stock will surely sell-off, given the current expectations for an improvement in GM % relative to their more recent trend line.

Potential dividend cut - DAKT’s 3.43% dividend yield surely attracts income-seeking investors. But if the deterioration in GM % continue, I believe DAKT’s dividend will be difficult to maintain. Any cut to the dividend would likely scare off DAKT’s last remaining, sleepy, stalwart investor base.