Description

Due to a confluence of factors, including a material pending asset divestiture that appears to have gone unnoticed, a lack of analyst coverage and institutional awareness, and a relatively small market capitalization, we believe Richardson Electronics (Ticker: RELL) offers a rare opportunity to purchase an under the radar, niche business with a long history of profitability and meaningful growth opportunities at nearly a zero pro forma enterprise value.  Importantly, Richardson's management team understands the dislocation between market and intrinsic value, and is highly incentivized to unlock this value through share repurchases and dividends.  As a result, we believe that Richardson has extremely limited downside and upside of as much as 70% from today's levels.

Pending Asset Divestiture:

On October 1, 2010 Richardson announced an agreement to sell its RF, Wireless, and Power Division (RFPD) for $210 MM to Arrow Electronics (Ticker: ARW).  RELL has substantial NOLs that they will use to offset some of the $110 MM gain on sale, and expect after tax proceeds of $185 MM.  Post transaction, the remaining businesses are only being ascribed a slight premium to net cash.  We do not foresee any material risks to this transaction closing, which is expected to occur in late January '11.  It has already passed any possible anti-trust concerns with the Department of Justice, and according to CEO Ed Richardson the RFPD sales contract is structured as a "marriage agreement with a no divorce clause". 

For Arrow to terminate the transaction, they will need to demonstrate a material adverse effect occurred within Richardson's RFPD division.  More specifically, as stated in the Conditions to Closing section of the merger agreement, RFPD's trailing twelve month operating income of $20MM would need to be overstated by $7MM, or 35%, or decline by the same threshold before closing.  We see little to no chance of this threshold being tripped, seeing as though Richardson has already received all vendor approvals for the transfer agreement, and no individual customer within this division makes up greater than 10% of revenues.  So absent a major product liability lawsuit or outright fraud on management's part, the deal will close as planned.

Upon consummating the transaction, Richardson's RFPD division will enable Arrow to have a global presence in the high growth wireless and power conversion markets where they have historically been under represented. This is just one of many recent Arrow acquisitions, including the acquisition of NU Horizons Electronics (closed 1/3/11), Shared Technologies (closed 9/9/10), Sphinx Group (closed 6/21/10), and Converge Inc (closed 5/30/10).  We believe Arrow, a multi billion dollar business with a strong balance sheet, ample liquidity, and a long history of completing takeovers, will close their acquisition of RFPD within the next month.

Post transaction, the Company will have two remaining operating segments which you will essentially own for free:

Electron Device Group (~ 2/3 of consolidated sales, ~ $100 MM):

Richardson's Electron Device Group (EDG) distributes, assembles and engineers vacuum electron devices (VED's, i.e. electron tubes) and other components that are utilized in a wide array of  industrial machinery (~38% of sales), semiconductor fabrication (18%), radar detection (16%), medical equipment (13%), broadcast (12%), and other (3%) high power, high frequency applications where semiconductors are not cost effective or reliable.  Electron tubes are quite simply devices used to amplify, switch, or create electrical signals/power.  These products are found in dielectric heating equipment, CO2 laser cutting machines (heat treating, welding, pipe cutting), Lasik eye surgery devices, linear accelerators for cancer treatment, x-ray machines, microwave generators used to cure silicon wafers (semiconductors), avionic and marine radar systems, and broadcast satellites, to name a few.  As one of the few remaining players left with the expertise and global scale in the distribution, maintenance, repair, and installation of electron tubes, Richardson has built a reputable and commanding global presence within this niche, unappreciated market.  Although it varies by application, the average VED has a useful life of approximately 1 - 2 years, and sells for ~$5k - $15k.  Due to the relatively short and predictable useful lives of electron tubes, the market is dominated by repair and replacement orders, which collectively accounts for nearly 75% of Richardson's revenue within this segment.  As a whole, Richardson's EDG segment gross margin has averaged ~32% over the past seven years, and management expects to achieve 35% gross margins within two years in this division through a combination of cost cuts and operating leverage. 

I know what you're thinking...didn't the tube business become extinct decades ago?  For many applications, the answer is yes, as the vacuum tube has been replaced by solid state devices in your LCD television and computer monitor, among others.  However, after several rounds of consolidation in recent years, the size of this underreported market stands at $1.4B today, and is by no means expected to disappear (or shrink for that matter) anytime soon.  According to Lance Wilson, director of VED reporting authority ABI Research, "These specialized vacuum electron devices may at first seem anachronistic, but in some cases there is no other way to generate such high levels of RF power within an acceptably small space. Certain microwave and millimeter wave VEDs can generate megawatts, and it would take tens of thousands of transistors to do that."  The VED market's overall size has remained steady at ~$1.4B over the last five years, and is expected to remain approximately flat over the next five based on projections from ABI.    

Importantly, despite static market expectations for the overall VED market, we believe that Richardson has the ability to significantly enhance share in upcoming years by (i) leveraging their existing supplier base and customer relationships to further penetrate existing end markets and (ii) entering new end markets where they have historically been under represented.  For example, Richardson's largest customer within the EDG segment, Thales SA, the world's largest VED manufacturer, recently awarded EDG an exclusive contract to distribute all of their industrial power grid tubes, both on original distribution and the more lucrative repair/replacement business.  The company estimates that these new programs, once fully converted, will add approximately $15MM-$20MM in additional recurring revenues within the next 18 months (implied +15%-20% revenue growth vs. FY10).  Moreover, at status quo, Richardson only participates in the industrial tube market, which accounts for approximately $400MM of the $1.4B electron tube industry.  The remainder of the market is comprised of traveling wave tubes used in more advanced medical, military, and broadcast applications, where the addressable market opportunity for Richardson is as large as $250MM.  While the company is just beginning to discuss further distribution opportunities with Thales SA and CPI (second largest VED manufacturer) in these end markets, we believe there is a high likelihood that Richardson is successful in winning at least a portion of this business.  We expect to receive further updates from management on this front throughout 2011.  Year over year revenue growth within this segment has been +25%, and with the new Thales agreement mentioned above, meaningful growth is expected in FY11 and beyond. 

As a whole, we view the Electron Device Group as a misunderstood, hidden gem of a business with dominant market share, strong pricing power, substantial growth opportunities, and very low cap ex requirements such that segment level ROIC may be as high as 45+%.

Canvys (~ 1/3 of consolidated sales, ~ $50 MM):

Canvys assembles and distributes integrated display products and digital signage.   Integrated displays are sold to OEMs in a variety of end markets, such as medical devices and industrial equipment.  Additionally, ~25% of this segment is sales of grey scale monitors used by radiologists to analyze x-rays.  Digital signage includes LCD displays such as the touch screen concierge you find in many hotels and casinos.  This is a very large potential opportunity, with a multi billion dollar addressable market.  However, the market is fairly new, and intense competition has recently dampened profitability.  Historically, Canvys has generated annual sales as high as $95 MM/year.  Post crisis, however, revenues have dropped to ~$50 MM/yr, as demand for touch screen displays and digital signage had softened during the downturn.  Over the last seven years, this segment has averaged gross margins of ~23%.  The Company's focus within Canvys will be to grow their OEM segment, which is substantially less competitive than the digital signage business.  The product life cycle in the OEM business is longer, because once an integrated display is included in a design, it will be required for as long as that equipment is still being sold.  As essentially all of the company's profitability on a pro forma basis is currently being generated by their EDG segment, we view the turnaround opportunity at Canvys as another potential source of future incremental profitability.

Valuation:

As disclosed in Richardson's 14A filing dated 11/26/10, the Company's pro forma (post transaction) fiscal 1Q11 annualized income statement looks as follows:

Management indicated to us that the pro-forma SG&A and Support Function expense line items of the remaining EDG & Canvys businesses includes at least $5.0MM of redundant employee and other miscellaneous costs (office supplies, bank fees, etc) that are associated with RFPD and will ultimately be eliminated post divestiture.  By eliminating these costs, we believe the Company should easily be able to attain their 2011 fiscal year end (FYE = May 31) EBIT margin target of 5.0%. 

Longer term, management expects to achieve EBIT margins similar to their pre-transaction level of 7+% through a combination of fixed cost leverage and EDG segment margin expansion as the mix shifts to an even higher percentage of repair/replacement business.  The remaining businesses require very limited CapEx on an ongoing basis; based on management guidance we expect less than $2 MM per annum in maintenance capital expenditures.  Using our more conservative assumption, RELL's pro forma income statement will look as follows:

After the sale of RFPD closes, we believe the Company will use the majority of their cash for stock buybacks and/or special dividends. In fact, on the October 7th earnings call, CEO Ed Richardson stated; "...share repurchases and dividends will be our first consideration."  The Company recently authorized a small share repurchase program (500k shares); however we believe they are ready and willing to do substantially more.    Additionally, RELL will look at small bolt on acquisitions.  Ed was adamant when we spoke with him that they would not make a blockbuster acquisition, and are not willing to overpay.  Although they have acquired a number of companies over the years, they have never purchased another public company, and have made it their focus to find small bolt-on's they believe they can grow.  In our discussions with Ed, he has highlighted his substantial equity ownership in the Company (~17%); obviously he is highly incentivized to do the right thing for shareholders.  We encourage any readers of this write-up to give Ed a call.

The Company is currently trading at a slight premium to net cash.  Therefore, we believe the downside for the Company is extremely limited.  Given their plan to distribute a substantial portion of their cash to shareholders, we value the Company at cash plus their remaining businesses.  We calculate Richardson's pro forma (post divestiture) enterprise value as follows:

• Current net cash of $9.9MM as of most recent quarter ending 8/28/10. 
• Expected gross sales proceeds of $210MM for RFPD, net proceeds of $185MM after utilization of NOL's, per management. 
• Additional working capital adjustment of +$6.0MM owed to Richardson by ARW from merger agreement through end of F1Q11, per management.
• Expected F2Q11 FCF and 1.5 months of F3Q11 expected FCF (inclusive of RFPD) of $12.5MM, similar to F1Q11 actual FCF generation given lack of pronounced seasonality.  We assume Richardson will own this segment till deal close in mid-Jan, 2011.

Although a distributor of electron tubes and customized displays is unlikely to ever garner a high flying multiple, we believe a 8X EV / EBIT (12X in our bull case) is fair, if not conservative.  In our base case, this values the stock at $14.85, and $19.84 in our bull case.  Although it is not reasonable to claim that any stock cannot go down, we would point to the post transaction tangible book value of $12.81 / share as another backstop.  Therefore, we believe the Company has nearly zero downside, with expected upside of 26%-68%.

Additional Points of Interest:

• No sell side coverage, with the exception of boutique broker Craig Hallum, which has made no attempt to understand the pro forma valuation, and has instead decided to suspend coverage until after the RFPD sale closes.
• Pro forma ROIC (blue book definition) of 33% @ 5% EBIT margin assumption and post transaction balance sheet
• While not included in our models, Richardson's owned headquarters in LaFox, IL, which is approximately 45 miles outside of Chicago, includes 242k sq/ft of manufacturing, warehouse, and corporate offices that reside on 96 acres of owned land.  Management believes the property to be worth $20-$25MM in today's market, but still wouldn't sell at this price.  They've owned the property forever and it's currently on the books for ~$4MM.
• Inventory turns have improved by almost 30% since FY05 as a result of operational improvements in purchasing as well as more disciplined inventory management
• Split cap stock, with Class A shares (14.9MM) trading publicly and Class B shares (3.0MM) owned entirely by CEO Ed Richardson.  Class B shares entitled to 10 votes per share, convertible into Class A's on a one for one basis, effectively giving CEO total voting control.  However, given that Class B common stock cash dividends are limited to 90% of the amount of common stock cash dividends, we believe the Company is more incentivized to buy back stock than initiative a special dividend post transaction. 
• Next earnings release date: 1/5/11 a/f market

Catalyst