|Shares Out. (in M):||46||P/E||9.0x||8.0x|
|Market Cap (in $M):||620||P/FCF||9.0x||8.0x|
|Net Debt (in $M):||-195||EBIT||83||101|
Nam Tai Electronics, Inc. (“Nam Tai” or the “Company”) is an electronic manufacturing services (“EMS”) provider. The Company currently trades for 9x LTM earnings ($1.50/shr), and 4x LQA earnings ($3.20/shr). LQA financials reflect both seasonal strength and likely unsustainable margin levels, however, they also reflects a capacity utilization level of just 30%. Management expects utilization levels to trend towards 75% by year-end 2013, so even assuming significant margin compression, normalized earnings should be north of $2/shr, and possibly as high as $3/shr. Thus, net of over $4/shr in net cash on the Company’s balance sheet, the operating business today trades for roughly 4x normalized earnings.
Nam Tai is legally domiciled in the British Virgin Islands, but operates out of two manufacturing facilities in coastal China. EMS providers operate as outsourced manufacturing partners for a broad range of electronics design and production firms and, like many EMS providers, Nam Tai has produced a broad range of different products over the course of its history. Several years ago, Nam Tai initiated a prescient focus on small form factor liquid crystal display modules (“LCMs”), and has subsequently been riding the huge wave of adoption for these driven by smartphones and tablets. Today, these LCMs account for the vast majority of Nam Tai’s revenue. The Company’s Shenzhen facility produces LCMs for smartphones, and its Wuxi facility produces LCMs for tablets.
EMS are often mediocre businesses, as measured by financial characteristics such as free cash flow and return on capital. Competition can be fierce. As such, it is important to ensure that management is focused on profitable growth and disciplined capital investment. In addition, given the inherent volatility in the business model, balance sheet strength is key. Nam Tai meets all these requirements.
M. K. Koo, Nam Tai’s Executive Chairman and senior operating executive, founded the Company in 1975 and has served in multiple senior management positions since. He currently has a 12% ownership stake. The line managers of the two primary manufacturing facilities have been with the Company for 20 years and 10 years, respectively. Peter Kellogg, a well-known financial investor, holds an additional 14% stake in the Company and has served on the board of directors for over a decade.
Mr. Koo has proven himself to be an able steward of shareholder capital during his extended tenure, and typically moves quickly to shut down underperforming operations and redeploy assets for more attractive returns. During 1Q, Nam Tai finalized the shutdown of its flexible printed circuit business due to ongoing operating losses and lack of a viable path to profitability. Since product or technology concentration can be significant at any given point in time for an EMS provider, it is important to gauge success over an extended, multi-year period. In this regard, Nam Tai has vindicated itself well, having delivered operating margins over the last decade well above industry norms, and reasonably decent average returns on invested capital over the same time period.
Many EMS providers are little more than conduits for electronic companies to outsource their balance sheet management. A combination of low operating margins and high working capital requirements perpetually ensures that these providers only generate meaningful cash flow when the top line is shrinking. In a growth environment, on the other hand, working capital consumes all the company’s operating cash generation. Not so with Nam Tai. Prudent working capital management ensures that a substantial portion of operating cash flow is converted into free cash.
Due to the aforementioned focus on the high growth LCD module business, Nam Tai more than doubled its revenues in 2012 to $1.1 billion, while generating roughly $1.50/share in earnings. Growth accelerated throughout the year, and exited 2012 at a run-rate of $1.9 billion in revenues and over $3.00/share in earnings. Despite this rapid growth, due to significant capacity additions over the prior 12 months, average capacity utilization in the fourth quarter was only about 30%. Although some pricing compression is expected, management expects that it currently has installed productive capacity representing roughly $3.6 billion in annual revenues ($150mm/month/facility), and believes that it will exit 2013 at a utilization rate approaching 75%. Although management has prudently guided to expect margin compression going forward, the substantial expected revenue growth will help offset margin headwinds
I am modeling normalized earnings power between $2.00 and $3.00 per share. Here’s how I get there. Over the past six years, LTM gross margin has ranged from a low of 3.5% to a high of 12.8%. The average has been 8.8%. Management is routinely conservative its outlook, and consistently guides toward an expectation of gross margin pressure. Despite their constant drumbeat of warnings, they have continually figured out how to keep it relatively high. Industry averages probably run between 6% and 8%. Given the Company’s history of exceeding the high end of industry averages, I assume an 8% LT gross margin (top of industry range, but below Company average). Management exercises strong discipline on operating expenses. Between 2008 and 2011, aggregate operating expenses declined on an absolute basis every year. In 2012, operating expenses grew only 17% while revenues more than doubled. Operating expenses are currently running at less than 2.5% of revenues, and revenues continue to expand rapidly. I model 2.0% going forward. So, this yields an operating margin of 6.0%. A 65% utilization rate on $300mm/month in revenue gives us $2.34bn in top line. 6.0% operating margin yields $140mm in operating income. A 25% tax and 45.5mm shares yields $2.30/shr in EPS.
Nam Tai’s business is admittedly lumpy. It is driven by Nam Tai’s ability to provide the manufacturing services that its customer require at a given point in time, and its customers’ ability to provide the products and technologies that the end consumer is demanding at any given point in time. As such, there is a lot that is out of the Company’s control in the short-term. This is, of course, a significant risk. I get comfort, however, from Nam Tai’s performance over the long-term. There have certainly been periods (some lasting several years) when the Company has shown material declines in its top line and operating margins, but the Company has by-and-large remained profitable, grown its top line over time, and generated mid-teens returns on its invested capital over the past decade.
Nam Tai exited 2012 with approximately $200 million of net cash, representing over $4.25/share. Thus, net of its cash, at the current quote of $13.60 per share, Nam Tai sells for somewhere between 3x and 5x normalized earnings. For a company with a strong near-term growth runway, high and stable inside ownership, experienced management, and reasonable returns on invested capital, this is unsustainably cheap. Ideally, as utilization rates climb throughout 2013 and the market gets more comfortable with Nam Tai’s sustainable earnings power, shares should appreciate closer to fair value. In the meantime, the 4.5% dividend yield provides some support.
There is one other embedded upside option worth mentioning. Nam Tai established its manufacturing base in Shenzhen in the 1980s. At the time, which predated China’s hyper growth era, the location was a largely industrial area. In the years subsequent, Shenzhen has developed rapidly (in part given its proximity to Hong Kong), and Nam Tai’s location near the Shenzhen airport now sits in the middle of an area that has just been rezoned for high end commercial development. Nam Tai has already acquired rights to land in a Shenzhen industrial park, and plans to move to a larger facility there over the next couple of years. It will retain the use rights to its legacy property, however, which could reportedly support up to 3mm feet of commercial space. I know nothing about Chinese commercial real estate values, and there will certainly be offsetting expenses to build out and move into the new facility, but I have heard speculation of net incremental values to Nam Tai in the ballpark of a few bucks per share.
When you’re buying a business for a low single digit multiple of earnings, you have to expect some significant risks. Nam Tai does not disappoint. Here are a few:
Customer concentration – Nam Tai’s top two customers are Japan Display Inc. (formed in 2012 from the merger of Toshiba Mobile Display and Sony Mobile Display) and Sharp Corporation (“Sharp”). Together they represent over 90% of Nam Tai’s revenue. Sharp, in particular, is currently in a state of financial distress, which itself presents additional risks. Moreover, both of these customers have internal LCM production capacity, so if demand abates materially you can imagine whose order book is going to get cut. On the plus side of the ledger, Nam Tai has a solid relationship with both customers and has been working actively to diversify its customer base. In addition, Sharp has been working actively to ameliorate its current financial situation, likely through some form of additional equity issuance. Lastly, Japan Display and Sharp, in aggregate, represent enough of overall industry capacity that it’s unlikely their operations will go offline regardless of financial condition. That is, they may need to be restructured financially, but they’ll keep churning out screens, and they’ll likely continue requiring Nam Tai’s assistance.
Technological obsolescence – LCMs have driven Nam Tai’s recent deliverance, and could therefore represent the seeds of its future demise. A new non-LCD technology could render LCMs meaningless. While possible, it’s just as likely that either Japan Display or Sharp is the driver of any new technology. Sharp, in particular, has been on the leading edge of new display technology.
Apple – A high percentage of Nam Tai’s LCMs end up in Apple products. I don’t know how high, but it’s high. Apple product weakness could reflect back to Nam Tai.
China risk – fraud, rule of law, inability to move cash out of the country, etc. If you’re dead set against China, then don’t bother. Personally, I haven’t invested in a China-based company since the whole reverse merger China clusterfuck exploded a couple of years ago. This is the first. I get comfort in Nam Tai from a number of different data points. 1) NTE predated the entire reverse merger fraud bubble. The Company has been public since 1998, and has been listed on the NYSE since 2003. Governance standards are relatively high. If it’s a fraud, it would have to be a really longstanding one. 2) Peter Kellogg has been on the board, and many of the key committees, for over a decade. He’s keeping an eye on his 14%+ ownership stake. 3) 4.5% dividend yield. Gives me comfort that the cash is real. 4) No insider selling. 5) Most of the brazen frauds were characterized by financials that were truly too good to be true. Revenues kept climbing. Margins kept risking. Cash flow was impressive. NTE, on the other hand, bears the scars of having ridden out a couple of cycles. Top line has declined at times, margins have collapsed. If this was a fraud, you would think management would have come up with a better storyline. 6) I’ve spoken with multiple parties that have either visited, or confirmed for me, that the Company’s facilities are real.