Description

Situation overview

Pro-Dex offers a compelling growth story in the form of a capital-light long-term compounder with strong expense discipline, positive net income and cash generation, and a culture focused on repeatable process in the generation of new business opportunities.  While it may appear at first glance that PDEX’s bright future has been priced in (19x trailing P/E and multiples of stock price expansion over the last few years), this valuation gives credit only for the performance already delivered and not for the research/consult/design/produce/market/sell flywheel that the company has built and continues to refine.  The significant increase in the stock price over the last six years is best understood as the transition from “broken problem company priced for disaster” to “apparently fixed company showing promise.”

The company has generated EBIT/TCE exceeding 30% in three of the last four fiscal years and a trailing 12-month ROE of ~30%.  My conservative base case results in a 20%+ annualized return to equity holders over a several-year period as PDEX utilizes its flywheel to grow profitably into a market opportunity exceeding $1 billion.  The company’s board is chaired by investor Nick Swenson who appears to agree, given that he allowed the company to spend $4mm repurchasing shares at an average price of $25.04 in the most recently reported quarter.

Company and industry overview

Pro-Dex, Inc. specializes in the design, development, and manufacture of autoclavable (i.e. can be heat/steam-sterilized), battery-powered and electric, multi-function surgical drivers (e.g. to set screws when installing surgical plates) and surgical shavers.  The company is based in Irvine, CA and employs approximately 120 people.

“Expert” forecasts for growth in surgical procedures and sales of surgical devices range mostly from mid to high single digits driven by population increases, increase in aged population, rising wealth and obesity levels, development of less-invasive surgical procedures, and a seemingly increasing rate of injury.  Pro-Dex’s two latest drivers represent nearly half of its revenue and are used in craniomaxillofacial (“CMF”) and thoracic surgery procedures.  I don’t pretend to be able to size these markets with precision, but surveying a number of different (again, “expert”) reports indicates a CMF device market of $1.5 to $2 billion and a thoracic device market of $5 billion to $7 billion.  However, these figures include surgical equipment other than drivers/shavers such as forceps, spreaders, etc., so only a portion is relevant to PDEX.  The overall market (across applications) for powered handpieces is likely closer to $2 billion, which is in-line with the company’s statement that its addressable market is $1.2 billion to $1.7 billion.  The remainder of PDEX’s device revenue is used in orthopedic surgery which reaches across a few of these body-part categories.  Importantly, the company is continuing to develop new solutions for additional body parts, which will give it access to more of the overall orthopedic device market, which is several tens of billions of dollars.  However, I expect PDEX to continue to focus on areas where it can offer a differentiated solution rather than running at giant market segments that attract large amounts of capital.  With TTM medical device revenue of ~$38mm (including repairs), there is plenty of headroom for growth any way you slice it (at 5% growth, a billion dollar market will create an additional PDEX each year).

PDEX has historically sold its products mainly to large manufacturers and distributors of medical devices (more below on how they are expanding out from this).  These (often large) customers seek out Pro-Dex rather than building in-house because the company has two decades of experience designing and building handpieces and getting them through the FDA approval process, and has enough credibility that the time/expense/hassle of building in-house isn’t justified (still, the company states that it sees inhousing as its largest competitive threat).  This is particularly true for companies whose expertise is consumables like plates and screws but who want a private-label driver to sell with their consumables.  As one might expect, the resulting revenue can be sticky.  In December 2009 the company’s then-largest customer informed Pro-Dex that the customer would be insourcing production of the product that they were buying at that time from PDEX.  Even so, Pro-Dex was still supplying this customer with product in FY12 and repair services for another year after that.

The company has a few immaterial vestigial revenue lines that are either being run without any marketing effort (industrial and scientific) or being gradually wound down (dental and component).  TTM revenue is just about $40mm with net income of $6.1mm (~15% net income margin and 37% gross margin).  Capex is light at $500k to $1mm / year and the company carries ~$13mm in debt bearing interest at under 4%, of which ~$5mm is a property loan due 2030 and the remainder is due 2027 under a credit facility.  PDEX has diluted wtd avg shares of 3.97mm (mkt cap of $117mm at $29.45 stock price) and ~$8mm of cash and investments.

How we got here

googie974’s July 2014 writeup provides a good summary of what the company used to be - a dirt-cheap struggling business that had just lost half of its revenue and was in the midst of trying to turn itself around.  In its prior life, the company had highly compensated and ineffective management, minimal marketing efforts, a focus on contract manufacturing rather than product development, weak control over its IP, was in some cases simply a component supplier, and had made a number of bolt-on acquisitions that turned out to be unsuccessful and were wound down or sold.

The Pro-Dex of today is the result of a significant amount of blocking and tackling by the current management team (headed by CEO Rick Van Kirk, previously director of manufacturing, vp of operations, and COO) and under the supervision of Nick Swenson and Raymond Cabillot.  A few key differences include:

---Instead of being a contract manufacturer that produces products (using customer-owned IP) that customers have already spec’d out, Pro-Dex now focuses on developing its own IP and turning it into products that are a good fit for (and can be marketed to) multiple customers.

---Instead of waiting by the phone for potential customers to call with contract work (the general strategy under the old management team), PDEX now has a functional and intelligently incentivized marketing and business development team that works to increase penetration of existing customers by securing introductions to customers’ colleagues in other divisions as well as calls on potential new customers to sell PDEX’s existing products (this has a much shorter sales cycle than a joint development project).

---Instead of pursuing low-value industrial and component work “because it’s revenue,” the company seeks out higher value medical device opportunities (such as its leading-edge torque-limiting driver software) in order to create the most value from its assets and expertise.

---Instead of making poorly conceived acquisitions that might be a good fit, Pro-Dex uses its intimate knowledge of its customers and its own capabilities to invest in its own research (using the kind of prioritization and with a willingness to make difficult tradeoffs that one would expect from a company that is intelligently controlling expenses).

---Instead of a generally lackadaisical approach, the company is focused on constantly trying things.  In fact, their internal motto is “we try things.”  The CEO takes a lot of pride in the fact that they’ve created a collegial environment where ideas can be thrown around, debated, and executed on without political/fiefdom-related obstacles.

Where we are now

So where do all these improvements over the old way of doing things leave us?  The most succinct way I can describe the investment thesis is that PDEX is not cheap on a recent earnings basis, but is cheap because the company has a very significant asset that does not appear on the balance sheet.

This asset is the flywheel formed by Pro-Dex’s expertise, culture, processes, and incentives, which will result in significant revenue growth, margin accretion, and excess cash generation going forward.  While I may end up eating these words, in my mind this is different from just buying a company with a rosy outlook and strong execution because (i) Management’s joy and focus seems to be more on process than on any individual strategies, products, or ideas, and (ii) this flywheel has already started to deliver as evidenced by the company’s ~77% cumulative revenue growth since FY18 and ~279% net income growth over the same period.  While the market has certainly given the company credit for its recent strong performance (the stock is priced at 19x trailing earnings), this price still undervalues how far the company can go in the surgical driver and shaver space, and how solid its execution is likely to be in iterating its way there, given that my conservative base case offers an annual return to equity holders of over 20% (presumably for a long time).

For a few expected wins that are a little more concrete than just “this team is going to iterate their way to success”:

---Torque-limiting applications.  PDEX’s above-mentioned two recent products both use the company’s leading edge (and patented) “adaptive torque-limiting” software, meaning that the driver can sense and adjust torque to ensure a properly seated screw in a variety of applications (different body parts, different screws, old people bones, young people bones, etc.).  This technology took a few years of significant investment to develop and appears to be a differentiator (vs drivers that are programmed to rotate a screw a prescribed number of turns or the historical method of the surgeon hand-tightening the screw after entering it most of the way with the driver).  This technology will serve as a platform that PDEX can customize for a variety of incremental procedures and body parts.

---Sales in Europe.  Pro-Dex has been working for a while on achieving CE marks and other required approvals to sell its products in Europe.

---Development of sales relationships with surgery centers and hospital systems.

---Improved “R” (of R&D) and increased manufacturing capacity in new building.  In November 2020 the company purchased a 25,000 square foot building (about the same size as its existing facility for ~$6.5mm) near its existing building.  In addition to increasing manufacturing capacity, this new facility will improve the company’s ability to drive its flywheel with more room to perform product ideation and iteration.  Initially, the company is excited about building out a clean room, developing disposable products, and dedicating space to improving the implementation of batteries in its products.

---Additional products.  The company says it has several irons in the fire as far as new products.  One of these is a ventilator that was an opportunistic project:  JPL published a mostly complete design and PDEX has been able to create a shippable product from the design (expect to start shipping CQ122 and generate $1.5mm of annual revenue).  Another is an ENT-focused shaver expected to launch CQ421 and generate annual revenue of $1mm.

Valuation / expected returns

Downside case

Admittedly, two factors currently prevent PDEX from being a “bet the farm” investment.  While the overall probability-weighted distribution of potential outcomes appears highly attractive (especially over longer time periods), the high level of customer concentration (discussed below in “Risks”) and the full valuation relative (importantly) to historical earnings means that there is a potential for a significant decline in the stock price if the market either overreacts to what appears to be an operational misstep or if PDEX somehow loses a big chunk of business with one of its top customers (again, see “Risks” below).  It would be disingenuous for me to write that a temporary impairment in this stock of more than 50% would surprise me (though I’d likely say that about most microcaps).

However, given that most of the value in this investment opportunity is in the future monetization of the ideate/design/market/sell flywheel that the company has developed over the last few years, losing a piece of existing business or experiencing a near-term downward re-rating of the stock represents a temporary setback and lengthening of the time to resolution rather than a breaking of the thesis.  If your time horizon is multi-year, risk management for this name is leaving dry powder to buy more at a lower valuation rather than passing on it completely.

Base case

As the company expands by (a) growing its volumes with existing customers, (b) finding new customers for its legacy and recently-developed products, and (c) continuing to work with prospective customers to design new products that will already be contracted for sale at the moment development is complete (including in adjacent parts of the body to its traditional product lines), at least 25% and possibly as much as 50% of incremental revenue can flow to net income due to the company’s focus on tight expense control and prioritization of higher margins in evaluating new opportunities.

In my base case, the company adds $4 million of incremental revenue per year in the near-term of which 25% falls to net income (vs adding $4.7mm in FY19 with a 54% contribution margin and adding $7.7mm in FY20 with a 26% contribution margin).  This results in net income growing at just over 16% which, when combined with the ~5% current earnings yield, delivers a return to equity of ~21.5%.  While a 20% annual return is not shoot the lights out territory, the fact that this is a potential hold-forever, compound-forever stock makes this return much more attractive over the long term than something that will deliver a near-term pop to fair value and then need to be sold.  Also to be clear, I think that this is a reasonable base case and that there is upside potential well in excess of what I’ve laid out, both on the revenue side and on the contribution margin side (not to mention potential stock buybacks or other shareholder friendly uses of excess cash).

I’ll reiterate that if you are reading this and thinking that the current yield is tight and price could go down “just because” before PDEX has the chance to deliver significant earnings growth, I don’t disagree, especially given how all over the place valuations for device companies large and small appear at the moment.  However, again given the hold-forever nature of this now-repaired business, I am happy owning it here and would welcome the opportunity to buy more at lower prices.

Also for what it’s worth (maybe not much), management expects to double the size of the company in five years and this outcome would not surprise me at all (in fact, I think it will happen).  If they accomplish this, returns will far exceed my base case.

Key Risks

Customer concentration: There is no getting around the fact that the very high level of concentration in Pro-Dex’s customer base introduces a few potential scenarios where revenue and earnings take a significant step backwards.  While the company is very tight-lipped about which of its largest customers are actually (citing confidentiality agreements) the top couple (several customers are listed in its investor presentation and include Smith & Nephew, Medtronic, Conmed, Stryker, KLS Martin, RTI Surgical, Arthrex, DePuy Synthes, and Storz Medical), its largest customer currently represents ~45% of company revenue while the second largest is ~39%.  Although I discuss above in “valuation” why I think a falling out with a major customer doesn’t necessarily tank the investment, it’s also worth discussing here a bit how the company is managing this risk (i.e. reducing the likelihood of one of these scenarios).  In short, (i) “watching that basket” and (ii) incentivizing itself (an important distinction from “trying” or “wanting”) to find new baskets.

With respect to “watching the basket(s),” the company benefits from the very painful experience of not sufficiently watching a basket in the past (under a prior management team) and losing its then-largest customer.  In FY11, PDEX generated revenue of ~$27mm, of which ~45% was provided by this customer.  This customer decided to insource the manufacturing of the products that PDEX supplied to them causing (in concert with a couple of other issues) the company’s revenue to decline to $10.8mm by FY14 (this was about the time when PDEX was last written up on this site, as a dirt cheap broken situation that had a chance of recovering).  As a result of almost disappearing during that time period, the company today spends significant energy servicing their top customers “like mad” and believes they are considered a critical supplier.  The company is also proactive about obtaining future volume commitments from these customers, having just extended its contract (including volume minimums) with its largest customer for the next 4.5 years (through CY2025).

In terms of finding new baskets, perhaps the most important thing to know is that the CEO’s bonus compensation is dependent on hitting the overall budget plan and, more importantly, growing the percentage of PDEX’s revenue represented by its smaller customers.  The CEO has in turn passed that incentive down to the sales staff who are incentivized in part on selling into new customers and markets, and the company’s newer product designs.

I’ll note that customer concentration can work in the company’s favor as well given its current size and the revenue opportunity that an individual customer product contract can represent within only a few years.  For example, the ~$33mm of TTM revenue represented by PDEX’s top two customers was only less than $9mm in FY16.

Finally, while I think the risk of again losing a significant amount of revenue with a top customer is low, it is worth noting that in the FY11 to FY14 period when revenue declined ~60%, the company was able to cut operating expenses by ~45%, resulting in an operating loss of only ~800k in FY14.  This kind of resiliency is what we’re looking for from a long-term compounder - the ability not only to invest in accretive new opportunities, but to survive any of the bumps that occur along the way.

Increased competition: While it appears that PDEX has done an admirable job in recent years making sure that it is carving out a defensible niche, both by keeping its customers happy (revenue to PDEX’s largest customer has doubled since FY17, while revenue to customer #2 is up more than 6x) and by providing market leading products, competitors could devise alternate approaches that skirt the company’s IP (the most valuable IP at present appears to be the company’s torque-limiting software).  PDEX’s small size could be an “innovator’s dilemma”-type advantage here in that they can invest significant resources into a market that might not be worthwhile to a larger device company.

Potential FDA-related issue: No specific risks (the company states that “no claim has been made to date by the FDA regarding any of our products or processes”), but always something to be aware of with device companies.

The flywheel...just stops working: The problem with betting on a company’s intrinsics.  Everything I’ve learned about the company implies that they have built a very efficient machine to engage with customers and find opportunities to partner on new products with attractive economics.  However, to deliver my base case return, the machine has to keep working (note that this is lower risk than betting on a machine that has not yet worked at all).

Large shareholders: Chairman Nick Swenson owns 27% of the company’s shares and Director Raymond Cabillot with Farnam Street Partners owns 11% of the shares.  Thus far the active involvement of these two over the last several years has been extremely beneficial (potentially existential).  However, with their large holdings they could potentially influence the company in a self-serving manner.  Swenson and Cabillot are 2/3 of the company’s “Investment Committee,” which invests PDEX’s “surplus capital” (~$4mm as of most recent Q).  ~$1.3mm of this capital was invested in Air T, which Swenson and Cabillot are on the board of (and Swenson is the CEO of).  If this were a larger amount, I’d be more concerned about it.  Something to keep an eye on.

Catalyst

---Start shipping ventilator and ENT shaver

---Begin sales in Europe

---Quarterly earnings - continue expanding existing customer relationships, adding new customers, and leveraging expense base as revenue grows