|Shares Out. (in M):||3||P/E||12.2x||10.2x|
|Market Cap (in $M):||16||P/FCF||8.7x||7.6x|
|Net Debt (in $M):||0||EBIT||2||3|
Before stating the case for our latest investment recommendation, it’s important to provide our macro perspective on the microcap market. To put it mildly, we find the current investment environment to be extremely challenging. Valuations in the micro/nano capitalization arena are at best expensive. We find it almost impossible to find shares trading for significant discounts to fair value.
We usually observe conditions like this just prior to significant market corrections. We are not making a market forecast, as we claim no such ability, but merely making a historical observation. To our chagrin, after thirty years as students of the market we have learned how ruthlessly “Mr. Market” treats market prognosticators.
So, with this cynical perspective why do we like Micropac Industries, Inc. (MPAD)? MPAD has simply been ignored during the recent bull market. MPAD has been in business for about fifty years and distributes microelectronic circuits and electronic components for military, space and industrial applications, a fairly mundane business. It does not sell leading edge semiconductors, but standard products that the government has been purchasing for many decades. Yes, it’s a boring business, but the Company has been making a comfortable living for many decades selling standard electronic products. We apologize, but we must confess that we have an affinity towards boring, predictable businesses that generate consistent cash flows.
The Company’s shares sell for about $6.10 per share. In the fiscal year ending in November 2013 we expect the Company to conservatively earn about $.50 per share. (It earned $.18 per share in 2012, $.64 in 2011 and $1.05 in 2010) It doesn’t sound exciting at about twelve times current year earnings, that is until one considers that the Company has over $4 per share in cash. Adjusting for the cash position, the P/E is four!
I know what you are thinking; the sequester will surely eliminate earnings, but this has not been the case. Sales for the most recent second quarter were up 24%. Earnings increased from breakeven last year to $.15 per share this year. Gross margins improved to 40% versus 26% last year. During the quarter the Company delivered a new order for a custom medical sensor and an increase in sales of various standard solid state relay products. In addition, management expects sales and operating earnings to increase during the second half, relative to last year.
New orders for the second quarter were $5.4 million versus $6.9 million last year, but this reduction is due to a large custom optoelectronic order that was delayed until the third quarter. Backlog remained strong at $9.8 million at the end of the second quarter compared to $9.6 million at the end of the second quarter last year and $9.8 million at the end of the first quarter this year. Hence, business conditions appear to be at least stable and more likely improving.
As implied by a $4 cash balance, the balance sheet is pristine. The Company has no debt. The current ratio is 14 to 1. Net current assets are $6.75 per share, which means the shares of a very profitable Company are selling for a ten percent discount to liquidation value or net current assets! The book value is about $7.50 per share.
So what concerns us about MPAD? First, like many microcap companies, the shares are not very illiquid, as trading volume is light and purchase requires patience. The Company only has a market capitalization of about $16 million and the float is small. An elderly director, 84 years old, Heinz-Werner Hempel holds almost 77% of the outstanding shares, giving him control of the Company. Management control is certainly a negative, but given his age, we believe there is a good probability that he will require some liquidity in the near future and the sale of the Company would not be an unreasonable expectation.
Our second concern is that the Company derives a significant percentage of its business from the United States Government. In fiscal 2012, sales to customers of the Department of Defense and NASA accounted for 65% of sales. Thus, the Company is exposed to fluctuations in defense spending. There is no current indication that there has been a cut back in the Company’s basic products.
So what are the shares worth? We do not believe that a complex Chicago MBA spreadsheet is required to value MPAD. Let’s keep it simple. If we hypothetically say that we will pay about, a very conservative, eight times the $.50 in expected current year earnings for the Company plus the $4 in cash, we get a valuation of $8 per share, over a 30% premium to the current share price. What if we are completely wrong and the Company earns only $.25 this year? Then, at eight times earnings the shares would only be valued at about its current share price. Yes, but the current share price is ten percent below liquidation value, which does not make much sense to us. I guess, this give us a Margin of Safety!
The proposition is very simple with MPAD: We have a tiny Company selling mundane products to large defense contractors that has been consistently profitable over many decades, selling for about four times earnings (adjusted for cash holdings) and at a ten percent discount to liquidation value. Does it make sense to hold a position in this Company in an environment where the market is selling for 18 times projected earnings? We believe there are few opportunities like MPAD in the current market.