Description

Overview:
DDi Corp (ticker: DDIO), a leader in the Printed Circuit Board industry (PCB), is an undervalued, restructured equity at $14.75. After a prolonged downturn in the PCB sector and an ensuing industry-wide capacity rationalization, demand for PCBs has improved leading to higher pricing and volumes. Coupled with high contribution margins from incremental revenue, these positive trends will lead to rapidly improving financial performance for DDi.

Just a warning before we go any further- this investment isn’t for everyone (c’mon what’s not to love about a somewhat commoditized, somewhat levered, just out of bankruptcy, tech company trading at 43x LQA EBITDA)?! No, this isn’t a no-brainer, trades at 40% of cash, no chance you lose money kind of investment. That being said, we think the market has struggled on how to properly value cyclical tech companies, and DDi represents one the few remaining opportunities to participate in a high growth tech story on a fundamentally cheap basis. On a relative basis DDi is cheap to its comps and practically anything else you can name that is even remotely associated with the tech sector. DDi and its two main competitors (TTMI and Merix) basically do the same thing; DDi trades at 2x depressed sales- its competitors trade closer to 3.5-4x sales.

While this may not be an investment fro everyone, we firmly believe DDI is fundamentally a cheap stock. DDi will vastly exceed its Disclosure Statement projections that were made five months ago in a different operating environment. We project normalized EBITDA of $75-$80mm, earnings of $30-$33mm, and FCF of $40-$42mm. At these levels, DDi is trading at 6.6x EBITDA, 11-12x earnings and 11% FCF yield.

On a relative basis, DDi is very cheap. DDi’s focus is on higher-margin, ‘quick-turn’ business, while competitors are focused on lower-margin, volume work. Demand for volume work rebounded sharply this summer, while quick-turn is now showing signs of strength. Although there are slight differences in timing, the same trends impact all three companies and historically the market valued them very similar. Given DDi’s focus on higher-margin quick-turn PCBs, strong industry-wide reputation and capacity to take on additional work, it would even be reasonable for DDi to trade through comps.

As management begins to tell its story, the stigma of bankruptcy falls away, natural holders begin to enter the investment and it becomes clear to investors that financial performance will well exceed the projections currently in the market, we believe DDi stock could double or better.

Background:
DDi manufactures Printed Circuit Boards (PCBs). An example of a PCB is the green board inside your computer on which various components are mounted. DDi specializes on quick-turn work in which PCBs are manufactured for delivery to customers within 10 days or less. Such boards are used in the design, test, and launch of new electronic products. Since the boards are used for new product launches, the board design is often experimental and highly complex. These boards have numerous layers (boards are made with multiple levels, or layers, so that more components can fit onto a smaller board) and one board could cost up to $10,000 (versus $5-10 for a less complex, “cookie-cutter” PCB produced in volume by many of DDi’s competitors). DDi engineers work closely with the end customer to ensure the design properties are met and offer solutions to design problems that the customer engineer might have missed.

Mass production of PCBs for consumer electronics has moved offshore, mainly to Asia, however because of the technology and time-sensitive nature of DDi’s products, quick-turn business has remained in the US and Western Europe. End customers are spending up to $10,000 a board and might require that boards be ready in 24 hours- they are not comfortable sending that business to Asia. Therefore, by focusing on technologically complex, quick-turn PCBs, DDi has succeeded in carving out a niche less affected by foreign competition than some of its more volume-based competitors.

Quick-turn PCB manufacturing displays many favorable industry characteristics including:
1. Growth in electronics and rapid replacement cycle will lead to long-term growth for quick-turn PCBs used in design and prototyping.
2. Significant barriers to entry exist due to technological expertise and manufacturing skills necessary for the production of complex PCBs within days. Customers will pay more to work with a supplier that has proven capabilities and shown timeliness and quality.
3. Operating leverage (50% incremental operating margin).
4. Significant consolidation during 2001-2003.
5. Outlook is strong as equipment manufacturers are ramping up prototyping and design work

DDi also has a low margin, assembly business that is similar to Sanmina’s EMS business. This business acts as a compliment to DDi’s PCB businesses in the US and Europe and is not integral to valuation. This business is working capital intensive and given DDi’s tight liquidty in bankruptcy, has been neglected. We would expect to see growth in this business as liquidity opens up for the Company. Some would say the main purpose of this business is to keep consolidated operating margins down in its SEC filings (read by its customers).

DDi filed for bankruptcy protection in August 2003 after two years of declining volumes and a continually weakening pricing environment. Bain Capital (former owners of DDi) had levered the balance sheet to make cash acquisitions at peak multiples in 1999 and 2001. As the entire PCB industry was experiencing 80-90% declines in enterprise valuations in 2001 and 2002, management realized their balance sheet was untenable and spent the better part of 2003 negotiating a pre-pack with its creditors. Management did a very good job getting the company through the Chapter 11 process quickly- confirmation of the plan occurred December 2nd and distribution of new equity occurred on December 16th. The bank debt was re-instated, the converts were given almost 90% of the equity and $15mm of new preferred stock and management was given the remaining equity.

The PCB industry is emerging from a protracted downturn in which 40%-50% of North American capacity was removed and pricing deteriorated significantly. Demand for DDi’s services began improving at the end of the September quarter and margins should be even higher than peak margin in 2000 as capacity has been rationalized. DDi is currently operating at only 50-55% utilization versus almost 100% at its peak in 2000. Competitors TTMI and Merix are operating currently at close to full capacity.

DDi has lagged TTMI and Merix because those two companies have significant exposure to the lower margin, volume PCB business that tends to lead a recovery of the quick-turn business (customers like to see their volume business pick up before spending money on prototyping). This trend of volume-based PCB growth outstripping quick turn growth should reverse itself in the first part of 2004. Therefore we would expect DDi to lag its more volume-based competition (TTMI and Merix) in Q4 03 and perhaps Q1 04 revenue growth, but reverse that trend by Q2 04.

To illustrate the strength of the upturn in volume work and the positive implications for future quick-turn demand, the table below lays out Merix’s two most recent quarters and management’s guidance for the current quarter. Merix’s growth is almost all volume (i.e. no pricing improvements).

Aug 03 Nov 03 Feb 04E
Revenue $30.7 $37.0 $42.0
% seq growth 36% 20% 14%

EBIT -$1.9 $1.0 $2.7



Given our conversations with industry experts, we would expect the quick turn business in which DDi participates to grow between 5-10% sequentially from Q3 03 to Q4 03. Sell side estimates are for Merix to see 20-30% volume growth over the next 12 months - we would expect DDi, as the quick turn business really begins to ramp in the 2H 2004, to match or exceed that growth in unit volumes.

Pricing has also seen signs of improvement as DDi experienced some pricing power in Q3 03. Q4 03 should see some improved pricing and we would expect double-digit pricing growth in 2004 (consistent with Merix’s guidance). Prices are currently only half of their peak in 1999/2000- we would expect as utilization of the quick turn capacity grows from its current 50% level toward 70-80% that DDi would be able to raise prices in excess of the 10% to which Merix has guided.

Given these developments, we believe the projections filed five months ago in the Disclosure Statement are much too conservative. The projections called for 2004 revenue and EBITDA of $270mm and $27mm- we believe DDi will vastly outperform these estimates. The next few quarters are difficult to project other than to say they will be significantly stronger on a sequential basis and run-rate Q4 03 numbers should give investors comfort that the above 2004 estimates are much too low.

However, given management’s preoccupation with the bankruptcy, the lagging nature of the quick turn business and the continued weakness of the European end markets, we find it difficult to give any sort of hard estimates for Q4 03 or Q1 04 numbers (nor are they all that important we would argue). We would rather just look at the company at the end of 2004 when the quick turn business will have turned and management will have had a year of operating out of the confines of a bankruptcy and its associated liquidity constraints. We also include peak numbers to show what DDi will look like in late 2005/early 2006 assuming continued strength in the US markets and a European recovery as expected.

The estimates below assume 50% EBIT margin on incremental revenue from unit volume growth and 100% EBIT margin on pricing growth in the PCB business (both consistent with management’s guidance). 5-10% EBIT margins are assumed for the assembly business. The European market is not assumed to recover at all by Q4 04, although we would expect some upturn in that market as early as Q2 04. Europe could provide an additional $2-3mm of quarterly EBITDA by Q4 04 if the market improves as we would expect. We have more detail into how these projections were obtained- any ?'s anyone has I would be happy to answer.

Q3 03 Q4 04 Peak
Rev EBITDA Rev EBITDA Rev EBITDA
US PCB $33.0 $2.9 $50.2 $14.1 $64.4 $26.8
Eur PCB $15.0 $0.0 $17.0 $0.0 $30.0 $8.0
US Assemb $6.0 $0.0 $8.0 $0.5 $15.0 $1.5
Eur Assemb $5.1 $0.0 $8.0 $0.5 $15.0 $1.5
Total $59.1 $2.9 $83.2 $15.1 $115.4 $35.2

TEV/EBITDA 44.7x 8.6x 3.4x
P/E na 17.3x 4.5x
FCF Yield na 8% 24%

(all ratios are annualized)
- Europe Q3 03 to Q4 04 revenue gains are currency related)
- US PCB Peak assumes return to 90% of peak volumes and prices of 1999/00)
- Europe Peak assumes return to 90% of peak vol and prices adjusted
for FX changes and acquisitions
- DDi can operate with minimal capex ($7-8mm) until $400-$450mm of
consolidated revenue, meaning FCF is higher than earnings until near
peak levels of prodcution

Valuation
DDi is a cyclical business operating in a high growth sector. DDi’s five-year average consolidated EBITDA (unadjusted for acquisitions, currency moves and capacity changes) is approximately $65mm. Given that 40% of the US capacity has been taken out since 2001, DDi has greatly reduced headcount from its bloated 2000 levels and DDi’s end markets are still among the fastest growing in the US, we believe normalized, average EBITDA is now closer to $75-80mm, earnings of $30-$33mm and FCF of $40-$42mm. This suggests DDi currently trades (on a normalized basis) at just over 6.5x EBITDA, 11-12x earnings and a FCF yield of 11%. Given the high growth of DDi markets, the substantial technology in its products and the historical multiples afforded DDi and other high tech companies, these multiples seem very attractive.

We feel that by Q4 04 when the US business is generating $60mm of annualized EBITDA alone and Europe starts to turn, the market will afford DDi multiples well in excess suggested by current trading levels of the stock. As investors begin to look to 2005-2006 when DDi could generate over $3.00 share of free cash, we could see an argument for a $30-40 stock.

Relative Valuation:
Looking at DDi relative to competitors makes sense as firms have generally shown similar financial performance and the market has valued each firm on similar metrics. The businesses of DDi, Merix and TTMI are substantially the same. Customers often put their business out to bid to each of these three major PCB manufacturers. Merix is the most volume-based of the three, with TTMI a 70/30 split between volume and quick-turn/prototype, and DDi being the pure-play quick turn/prototype player in the industry. Pricing and demand in the quick turn and volume businesses move almost identically, although the quick turn side tends to lag the volume business. The businesses are highly correlated however, and the markets have always valued the businesses similarly.

Given the correlation in operating performance and historical valuation, DDi appears undervalued relative to competitors on all metrics. DDi forecasts are our own and competitor forecasts are from the sell-side. The figures below all demonstrate DDi’s relative cheapness to TTMI and Merix.

DDi is at worst as good of a company, and in our view a better company, with better growth prospects than Merix (or TTMI for that matter). Once the stigma of bankruptcy has been removed and the operating leverage of DDi’s business model becomes apparent to the market, DDi should trade at parity or through Merix and TTMI.

DDi TTMI Merix
CY 03 Mutliples
EV/Rev 2.1x 3.8x 3.4x
EV/EBITDA 57.9x 35.2x NM
P/E NM 95.6x NM

CY 04 Mutliples
EV/Rev 1.6x 2.7x 2.1x
EV/EBITDA 10.2x 12.9x 13.2x
P/E 29.5x 27.1x 45.0x

CY 05 Mutliples
EV/Rev 1.3x 2.5x 1.9x
EV/EBITDA 5.4x 9.4x 10.6x
P/E 9.0x 22.2x 30.1x

Summary
Again, this investment surely isn't for everyone, but we believe that DDi is at depressed levels now due to a lack of investor following, the stigma of a bankruptcy, the lack of a NASDAQ listing (should be 1H 2004) and the lagging nature of the quick turn business versus the volume business. As the business turns and management and the sell side take the DDi story to investors, it is hard to see how the stock will stay at current levels. At $14.75 a share you are buying DDi at 6.6x normalized EBITDA and a 11% normalized FCF yield. Industry fundamentals are improving rapidly and if and when the European side of the business turns, you are buying DDi common for 4.5x 2005/06 free cash flow.

Concerns:
1. Did customers leave during bankruptcy? No. DDi managed the process well and quick-turn work by its very nature does not expose customers to much risk; an order is placed and within 10 days boards are received.
2. Liquidity? DDi is exiting with roughly $10mm of cash and no revolver availability. The firm plans to refinance banks with the goal of gaining additional borrowing capacity. We would expect DDi to delever with a secondary offering in 2004- a chance for management to get its story out to new buyers.
3. Limited visibility. It goes without saying that ‘quick-turn’ work does not provide a long window into future demand. As noted above, indications are currently very positive. We believe valuing DDi on normalized results is appropriate.
4. Dependence on technology end-markets. Should improving demand for communication equipment and related electronics prove incorrect, valuations may recede.

Catalyst

Catalysts:
1. Coverage from sell-side. We believe this to be likely.
2. Continued sector improvement and financial results likely above expectations. Disclosure statement projections should be easily beaten.
3. Valuation convergence with competitors.
4. NASDAQ listing in 1H 2004