Description

Pro-Dex designs, develops, and manufactures drive motors and controls for powered surgical equipment such as dental drills, screw drivers, and saws for cutting and screw insertion in head and back surgery.  The current market cap of about $9 million reflects a business valuation of less than $5 million after subtracting out cash and investments exceeding  $4 million.  You might guess from that valuation that business performance has been poor recently and you would be right.  Revenues have fallen from $24 million in 2011 to $12 million in 2013 and a run rate of just $10 million in the most recently reported quarter.  But the poor performance is the legacy of prior poor management that had limited new customer marketing efforts even as their 40% of volume customer was winding down their purchases.  Significant changes began in 2012 from pressure applied by a pair of activist hedge funds and then really changed following  a January 2013 proxy battle that turned control over to those hedge funds.  New less expensive management , personnel reductions, and other cost cutting initiatives have cut break-even revenue levels to about $12 million.   These return-motivated hedge funds recently increased their percentage ownership to nearly 40% in a rights offering.  Next generation drive development with unique new features that began a couple years ago with the capability to “transform” the business was demonstrated to a “large customer” in May, 2014.   A July 9th disclosure of an acquisition of a small electronics machining business in Northern California suggests the company is preparing to ramp up production.  This is in contrast to the current market valuation below tangible book that suggests the company is to be liquidated.   A near-term pop in the stock price can be expected if new product sales turn the company profitable.  But there is longer-term opportunity for investors too, and it's not really dependent on a turnaround of a poor business.  The drive business was, in fact, strong and profitable for years.  Poor historical stock performance was due to multiple acquisitions by prior management that did not work out.  This is a medical device business with low capital requirements that benefits from high customer switching costs once their medical device attains FDA approval.   Nasdaq-listed Pro-Dex has significant expertise and share in the market for powered surgical equipment,  and powered surgical equipment is growing .  Improving battery technology is enabling more medical devices to become powered,  the aging of western populations is causing more surgeries, and increasing wealth in emerging markets is leading to more medical device sales.  A long-term high return-on-equity business with the stock price rising to multiples of the current price is a real possibility.  At less than tangible book, with nearly half the market cap in cash and investments, and return-motivated owners in control, the downside appears limited.

Irvine California based Pro-Dex has been making rotary drives for dental drills and surgical cutting instruments since 1971.  The company has experienced engineering staff, testing facilities, precision machining equipment, assembly personnel, and repair capability.    Historically, much of the business has included design, development, attaining FDA approval, manufacturing, and then servicing drives for dental and medical applications.  It doesn’t make sense for every spinning-device medical company to “re-invent the wheel” to design their own electric or pneumatic motor and associated controls.  Companies also don’t need their own service staff and their own people to deal with FDA approval.  So outsourcing the drive to Pro-Dex  makes sense especially for smaller volume medical device customers who don’t have the scale to do this themselves.  Company filings indicate that Pro-Dex has historically been one of the largest makers of rotary drives in the world.  Some of their business has been contract manufacturing making drives designed by other companies.  Southern California isn’t the cheapest place to do manufacturing, however, so the Pro-Dex strategy going forward is to emphasize higher value medical device applications.  Stuart Gallant with 40 years of experience developing medical devices joined the company in February 2014 as V.P. of Engineering and Product Development.   A demonstration for a “large customer” of a new contract-manufactured product occurred this spring, however, so contract manufacturing isn’t completely dead.  Revenue from this new product is expected beginning in the 2^nd half of calendar 2014.  With revenues down to just $12 million and manufacturing facilities capable of $30 million they need all the volume they can get.  They are also open to designing and developing drives to be manufactured somewhere else to make use of their medical device engineering expertise.

Years ago this was a successful business.  Revenues ran $24 million as recently as 2011 with an operating margin of 14%.  Around 2009, the companies largest customer representing 40% of their volume told Pro-Dex they would be taking their design in-house.  It took a few years for this business to wind down but it is now finally gone.  The company historically had not had a marketing department and despite the loss of this large customer the management didn’t create one either.  Highly paid management and directors, none of whom owned significant shares in Pro-Dex, apparently did little to drum up new business.  In 2012, with revenue decline becoming evident in the financials and pressure from activists, the CEO was let go but the board of directors remained.   A replacement CEO immediately hired Frank Noone as V.P. of Sales and Marketing.  In the meantime Nick Swenson of A.O. Partners and Ray Cabillot of Farnham Street Partners were buying up significant shares on the open market near the $2 level.  In January, 2013 they won a proxy battle, fired the CEO, asked the then CFO to also take the CEO role to save money, and immediately set about reducing other expenses.  Shortly after getting control, Swenson and Cabillot began adding to their share holdings from the open market at prices around $2.  They also formed a committee led by the two of them to invest spare cash.  Certain investments including Pro-Dex stock are on the list of approved investments but they don’t reveal the other approved securities.  Long-term investments were valued at $834K in the latest quarterly filings.

Despite the new effort in Sales and Marketing, revenue has continued to decline as sales to their largest customer wound down.  The sales cycle for new products is typically 6 months to a year to agree on a new product with a new customer and 18 months to two years more to get it developed.  Significant new customers were found in 2012 and 2013 and the company has been developing their next generation rotary drive for the last two years.  The new drive was demonstrated to the customer in May, 2014.  On the latest conference call the CEO is pressed for information about the significance of this new product.  While customer information and sales projections are confidential, the CEO did note the customer was “large” and the new drive technology "significant" as it had features generally not available on devices of this type and that much of the design was proprietary to Pro-Dex.  Revenue from sales are expected in the 2^nd half of calendar 2014 but the CEO noted that the customer would want Physicians to test the new design before giving final approval.  On July 9^th Pro-Dex released an 8-K revealing they had a purchase contract to buy a machining business for electronics and oil industry customers located  in Northern California.  It’s just a $225K purchase but  this is still likely an affirmation that the company is preparing to manufacture a new product.  By purchasing the machining operation rather than contracting out the work, it appears the anticipated revenues are significant and expected to recur for at least a number of years.

In April 2014, a rights offering was completed that raised about $1.6 million.  It was originally intended to raise $3 million and Swenson and Cabillot would backstop the offering by buying up shares that investors declined.  Many investors did decline but the company did not allow Swenson and Cabillot to buy up the shares for fear it would invalidate the company’s tax NOLs.  Swenson and Cabillot did exercise all their own rights.  This was a curious rights offering.  The company has a committee to invest excess cash and then they raise more cash in a rights offering.  A Seeking Alpha article speculated that the real purpose of the offering was for Swenson and Cabillot to increase their ownership.  Even without  backstop purchases, they did in fact increase their percentage ownership as many other investors declined to exercise their rights.  Perhaps the real purpose of the rights offering  was to finance strategic  acquisitions related to the medical device industry as they stated in SEC filings.  The hiring of a medical-device veteran as V.P. when they are trying to run lean confirms they have some kind of plan.

There’s two things about Pro-Dex that temper the investment appeal.  First they are located in Southern California.  Perhaps this is an okay location for attracting good engineers but it’s not the best for low-cost manufacturing.  The second thing is that for your $9 million market cap you're buying $5 million of business assets that are worth more than $5 million and likely several multiples more,  but you are also buying $4 million in cash.  This cash is controlled by Swenson and Cabillot.  I’d much rather just pay $5 million for the business  and control the remaining cash myself.  This issue is tempered somewhat by Ray Cabillot's well-established investment track record.  He has been running Farnham Street Partners for 15 years and frequently has disclosed 5% ownership positions in companies like he has for Pro-Dex.  He has a terrific track record on these investments regularly making multiples on his money in the ensuing few years after disclosing the 5% position.  So I’m pleased to be investing alongside Ray Cabillot in the Pro-Dex business and have confidence he and Swenson will invest the excess cash in some intelligent fashion as well.

In fiscal 2011 with revenues of $24 million the company earned $2.64 million despite bloated management and directors salaries.  With two significant new products and significantly reduced costs, the financials could return to these levels as early as 2016.  If that happens investors will get excited and pay at least 12 times earnings or $32 million for Pro-Dex.  That’s almost four times higher than the current market cap.  If Swenson and Cabillot do something intelligent with the cash one might even do better.  The stock is currently so cheap it seems hard to lose.  But it’s been this cheap for a couple of years now.  Unless something happens you could continue to have dead money;  but something is happening now with the new products.

So this is a decent low-capital business with good growth prospects where Pro-Dex has an established reputation and large market share.  It's trading at an enterprise value around $5 million despite annual revenues of $12 million that are depressed and finally set to rise.  Investors frustrated with continued declining revenues even after new management has been in place for some time have sold the stock down to tangible book value.  But management hasn't failed;  it just takes a long time to develop new products in this industry and prior management left them with no pipeline.  New product sales should show up soon.  Management doesn't disclose the revenue potential of these new products but Cabillot and Swenson recently bought all the shares they could in a rights offering.  The company can support much higher levels of sales with their existing facilities so much of this new revenue will fall to the bottom line.

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