Description

I believe shares of Frequency Electronics, Inc. (FEIM) are poised to appreciate as new leadership moves beyond a period of supply chain headwinds, takes advantage of increasingly cooperative end markets, begins to benefit from past investments in R&D, and perhaps most importantly, begins to culturally shift the mindset of employees in thinking about narrowing the gap between company profitability and the enormous value FEIM’s can’t-get-elsewhere offerings provide customers.  Perhaps I’m naïve in thinking about an investment thesis in these terms, but without FEIM systems, entire swaths of key civilian and military technology would grind to a halt; yet the company sports a $40mm enterprise value.  To be clear, I believe there’s a significant element of past sleepiness to this company that looks to be changing in real time under Tom McClelland’s new leadership, and thus it’s a bit of a jockey bet.

FEIM only trades around 10K shares a day, has zero analyst coverage, has $60mm mkt cap, with 1/3 of its market cap is in cash ($21mm between cash, investments, and cash surrender value of a life insurance policy).  The stock was written up nearly 8 years ago and shares are down 34% since then on a total return basis.  Note FEIM’s FY ends April, thus we’re currently wrapping up FY 2023.

FEIM is a world leader in the design, development, and manufacture of high-precision timing, frequency control and synchronization products for satellite and terrestrial applications that are absolutely mission critical.  There’s not much out there in terms of IR materials, but below are a few slides from a Jan 2021 Needham deck that give the summary as to FEIM’s capabilities, value chain, specific product portfolio, and customer logos:

FY 2022 was an extremely tough year for the company due to:

•  Government-induced delays in commencing new programs (which is corroborated by nearly every other government supplier I’ve dealt with through Covid);
•  Continued and significant supply chain issues; and
•  Self-inflicted technical difficulties on existing programs.

And, specific to the stock, as we’ve seen with any number of name-- but perhaps especially relevant in smallcap land-- was the punishing and unabating tax loss selling that took place late last year.  While shares have rebounded a bit, and perhaps the “easy money” has been made in the stock, I think this grinds higher over time as revenues grow as LEO constellations are launched, margins improve, and the company’s 0.9x revs EV/multiple expands slightly.  

Gross profit, which has generally run in the 30% range, was breakeven/negative in the last 3 quarters, which is simply not sustainable for FEIM’s value-added products.  In July 2022 FEIM announced what looks to me as the push-out of CEO, Stan Sloane, with the Chief Scientist, Tom McClelland, taking the Interim CEO role. McClelland was named permanent CEO in Jan 2023.  I don’t think the gross margin issues are permanent.  The company already has done a round of layoffs and sees more in cost-outs and ongoing operational efficiencies.  The company is also embracing a more holistic and deeper use of stock as a motivational took to get the mindset of profitability to permeate to lower ranks of the company via a 4 year vest stock grant program based on specific individuals’ performance relative to predefined benchmarks.

If you just listen to Tom’s calls from the time he took the helm it seems clear there’s an improving end market, and supply chain is easing, thus it seems the business has troughed.  Here’s Tom at the opening to the FQ2 (ended 10/31) earnings call from January:

…[T]he results for the second quarter are not where we would want them to be, there are significant indicators that we're on the road to recovery. Revenue quarter-over-quarter has increased. Our backlog of approximately $56 million at quarter end is higher than it has been any time in the last 8 years, as is the book-to-bill ratio of 2.8. In addition, we've booked $4.4 million of new business already in the third quarter.

At the annual meeting, we discussed the satellite industry move to develop systems which utilized a large number of low-cost satellites, which are by design replaced much more regularly every 3 to 5 years rather than the 15-year lifetime required of today's large satellites. One of our key customers, a large government satellite prime contractor, has communicated that they experienced 15% growth in satellite business over the past year, anticipates sustained growth of 10% to 15% annually over the coming years, and as a result, is interested in engaging FEI in development of advanced technology appropriate for what they refer to as proliferated low earth orbit satellite systems, often referred to as large systems of small satellites.

We're experiencing similar overtures from other satellite prime contractors, all of which bodes well for our future space business prospects. All that being said, we still struggle with supply chain issues, persistent inflation. But in both cases, signs of easing are beginning to appear. Continued effort is required to navigate the changing economic and geopolitical environment, but we are confident that we're progressing in a positive direction and look forward to a dramatic improvement in results.

The company is committed to moving towards sustained profitability and cash generation in the near future. We remain debt free and our strong balance sheet allows us to pay the special dividend discussed in a separate press release today, while still maintaining the ability to invest for future growth opportunities.

There are also some moonshots within the R&D pipeline that could deepen FEIM's technological leadership and expand the topline.  As a for instance, here's Tom from the October 2022 AGM: 

We're also pursuing funding for a much more advanced optical atomic clock which could be used in the future to define the fundamental unit of time, the second, [and] can also be used as building block for quantum computing.

Catalyst

• End market recovery
• Government customers back in their offices
• Supply chain easing