Description

Quick Summary: IEHC is a classic net-net, trading below NCAV and for under six times earnings. Shares have been crushed because of a forced liquidation by the Hummingbird fund, and there are several levers that could create significant value.

IEHC makes Hyperboloid  / Hypertac connectors (see a useful description of what they make and why it's useful in the video at their website). Most of their revenue is related to the military market, though they are trying to expand to both international and the medical markets.

What’s interesting about the product is that it has no real risk of obsolescence. However, the products it eventually goes into (missiles, rocket launchers, etc.) do have obsolesce risk. What’s so great about this is that when one of the products that the connectors goes into does go obsolete and is replaced, this replacement creates a big order for IEHC as the new product almost certainly has Hyperboloid’s in them as well.

However, what makes this business so interesting is not the qualativitive. The business is by no means a horrible one (after tax return on invested capital consistently over 15%), but no one is going to mistake it for the next Coke. Rather than a “wonderful business at a fair price” this is much more a “fair business at an out of this world price.”

First, the financials.

For such a small and old company (founded 1943), IEHC has actually been growing pretty quickly. Revenue came in at $7.8m in 2007 and had grown to $13.3m by fiscal 2012 (a compound growth rate of 14%). Operating profits grew even faster, from $625k to $2.17m (36% compound). While the company has experienced a small revenue decline from fiscal 2011 to today (total revenue will decline by about 5% from 2011 to fiscal 2013, and op. profits from $3m to $2m or so), it shouldn’t take away from the fact that the business has had a very strong recent history.

Despite this strong history, IEHC is trading incredibly cheaply. And the fact that they’ve experienced a small revenue decline doesn’t begin to explain how dirt cheap they are. They don't have much excess cash on their balance sheet, so EV = market cap. IEHC is earning over $0.82 per share in operating income and, assuming a 40% tax rate (which may be aggressive, as I'll discuss later), about $0.50 per share in after tax profits. Put it together against today's share price of $2.27, and you're looking at a company trading for under 3x EBIT and 5x after tax profit. Even “dying” businesses like wireline telecom or dial up internet trade for stronger multiples than this.

There’s plenty of asset protection here as well. NCAV comes in a $3.02 per share, and book value at $3.68.

So now let's talk catalysts.

First, Hummingbird Management has been liquidating and has sold 6% of the company in roughly a 4 month period (from September to December). On a stock as small and illiquid as this (41% of shares are held by insiders, and another holder owns 8%, so only 50% free float including Hummingbird) that has a huge impact, and you can clearly see it in their stock chart, as the price went from just over $4 to a low of $2 before settling in around $2.35.

So the shares are likely depressed by a forced seller. However, there are other catalysts.

The CEO, Offerman, owns 40% of the shares. And he's old (70). Most of the other key employees are also old, including the other two directors (68 and 70, respectively). Offerman's contract allows for him to begin entering the "retirement" phase once he hits 70. While it's true Offerman's son works for the company and he may pass the CEO reigns down to him, it seems equally likely Offerman decides to retire and sell the company, given the age of most of the management team.

Another nice catalyst comes from a potential reduction in WACC. A simple glance at IEHC's working capital relative to sales will reveal that it has been going up over the past few years. Normally, this is a big red flag. However, there's actually a pretty good reason. IEHC was on an expensive accounts receivable financing agreement, and they've used their big boost in profits to reduce the financing. They would have paid this down much sooner, but they also needed to finance their huge growth. This financing pay down is mainly responsible for the working capital "deterioration". Given how expensive the financing was, and that the paydown is now pretty much over, this should have a positive impact on both their profits and cash flow. (Note- IEHC reports interest expense within their operating profit, which is a bit weird and you may want to adjust for that if you go through their historicals). 

However, it also means IEHC can start to consider returning cash to their shareholders with their profits. With shares trading at this low of a multiple, a tender offer, even if done at a significant premium would be highly accretive, or the company could consider paying a dividend. Even if it represented only 50% of free cash flow, it would represent a yield of almost 10% and still allow IEHC significant working capital build up.

You can begin to see a small piece in their most recent financials. Cash has built up by over $400k in the first nine months of this year despite paying down over $100k worth of liabilities. At their current run rate, the company would start looking more like a cash box than an operating business within two years. Given they historically haven't kept any excess cash on their balance sheet, I would look for them to pay out a dividend or make an acquisition well before then.

Also note that IEHC is paying a ridiculously high tax rate- 46% from their 2012 10-k (see page 51). That's insane given most companies pay the federal rate of 35% (and most big companies find a way to pay substantially less than that!). IEHC would benefit tremendously from some type of financial engineering to reduce that payment, whether it’s reincorporating or significantly levering up to make use of an interest shield

Finally, IEHC mentions throughout their annual report that they are the only independent producer of products using the Hyper technology. All of the rest of their competitors have been acquired and / or rolled up into larger players. Given that, it’s hard for me to imagine that there isn’t some acquisition interest here. A national chain could come in and buy IEHC, immediately reduce their cost of capital by ending the silly receivable financing and getting them on a cheap line of credit, rolling up their reporting functions into their own, and reducing IEHC's tax rate to the national rate. Those synergies alone, which are all pretty much automatic, would increase profits by ~30% and easily cover any acquisition premium they need to pay.

Alternatively, IEHC would be very attractive to a company with a bunch of NOLS, who could buy them and shield them from that huge tax burden, which alone would nearly double IEHC's post tax profit!

Either way, IEHC could realize huge value by getting acquired by someone bigger.

There are, of course, some risks here. The biggest is IEHC has both customer and sales rep concentration (see page 8 of their 10-K). But this is pretty standard stuff for a micro-cap, and it's not extreme by any stretch. The other big concerns would include selling into the military market in a fiscal constrained environment, Hurricane Sandy impact (based in Brooklyn, and filed a recent 10-Q late citing Sandy damage), and the recent loss of the small biz hubzone designation (see 10-k for further discussion).

But I think those are all pretty small risks to pay this cheap of a price for a company this strong.

Catalyst