Description

Sevcon (nasdaq SEV) is known for providing electric motor drive electronics and control software for industrial applications such as forklifts and airport runway machinery.  These markets are mature and cyclical and a glance at a long-term chart shows that Sevcon's stock has bounced up and down but overall is flat for the last 20 years.   But recently the stock has been bouncing up and this is just the beginning of a long-term uptrend.  Things have changed for Sevcon's business and now they are a secular growth story.   The stock price doesn't yet fully reflect the change.  

There are several factors that will drive Sevcon's business performance and stock price higher in the next five years.  First, improvements in power electronics technology are dramatically expanding the markets for the electronics Sevcon makes.  Second, Sevcon's long history in what has historically been just a niche market gives them a nice head start over would-be competitors in a market that now is growing rapidly.  This advantage is multi-faceted with proven product reliability, established customer relationships. technical know-how on efficiently controlling vehicles to save batteries, and most importantly, high production volumes from an established base business that drive down costs and supports sales and distribution.  Third, the company's business model that outsources manufacturing allows them to expand rapidly with the growing market without requiring additional capital.  That same low-capital outsourcing business model also provides tremendous leverage to return on equity as sales rise.  Fourth and finally, the CEO of 18 years, an excellent engineer and operations guy but a poor capital allocator who owns few shares personally no longer controls the allocation of capital.  Activist Mario Gabelli took control of the company by threat of proxy battle in 2013 and then increased his ownership to near 50% in a rights offering by exercising over-subscription privileges in 2014.   Gabelli's representatives on the board of directors will ensure shareholder-focused capital allocation going forward.

Those representatives allocated some of their own personal capital to Sevcon by buying shares on the open market in 2015.  Mario Gabelli voted his bullish stance with his pocketbook by oversubscribing heavily in the rights offering in 2014.  More recently he cited Sevcon as his favorite microcap pick at the Sidoti investment conference in September 2015.  Then his funds were buying up shares in the $9, $10, $11 range in October through early December ( Dec 14 schedule 13D/A).

Sevcon develops drive electronics in Southborough England but outsources the electronics manufacturing to low-cost suppliers in Krakow Poland, Juarez Mexico, and Shanghai China.  They have sales offices in Europe, the United States, Korea, China, and Japan and offer products through distributors in South America, Africa, Canada, India, and Australia.  This network was built over many years to support the roughly $25 million in business for customers in their traditional electric-drive industrial products like forklift trucks, aerial lift equipment, indoor floor care equipment, underground mining equipment, and airport ground support vehicles.  These traditional industrial businesses aren't growing much but provide Sevcon with the high production volumes to support their low-cost manufacturing, sales offices, and distributor relationships.

But now Sevcon has additional business of about $15 million a year in new higher-growth applications.  This business was spurred by several new power-electronics technologies.  Electric motor technology was stagnant for many years.  In fact, a professor at the renowned University of Wisconsin electric motor program explained that most universities stopped training engineers in the field.  There was nothing new and enough older engineers to apply existing technologies into industrial applications.  But today there is an acute shortage of engineers trained in power electronics and this professor regularly receives inquiries from companies hoping to hire his graduating students.  The first technological improvement was the development of reliable integrated gate bipolar transistors (IGBT) in the 1990's.  This permitted very rapid switching of very high motor currents.  Then a low-cost method to exactly measure the position of an electric motor rotor through changes in inductance was developed.  The two technologies together permitted the very rapid switching of very high currents at just the right time in the rotors rotation so that motor efficiency was significantly improved.  This technology has dramatically improved the efficiency of low-cost switched reluctance motors.  They've been around for a 100 years but higher cost permanent-magnet motors have dominated high-performance applications.  Now switched reluctance motors are showing up in production machines at a large cost savings (https://chargedevs.com/features/a-closer-look-at-switched-reluctance-motors/).  Sevcon's participation in switched reluctance motor development is documented here (http://ir.sevcon.com/releasedetail.cfm?releaseid=606277).  A second new technology driving power electronics growth is the ultra-capacitor developed by Maxwell Technologies and others.  Ultracapacitors can receive and store electrical energy at very high rates.  So a bus that needs to stop quickly can use the electric motors to generate electricity while braking the bus and store the energy in ultracapacitors.  Then the stored energy can be used to re-accelerate the bus.  Ultracapacitor costs are falling rapidly now as competitors to Maxwell emerge and the technology continues to improve.  Finally, the development of the lithium-ion battery which can store a lot of energy in a small space has enabled numerous new applications like electric motorcycles and fully electric cars (Tesla, Chevy Volt, Nissan Leaf).  Elon Musk has a well-publicized effort to bring down the cost of lithium ion batteries further by high volume production at the $5 billion Gigafactory in Nevada.  If successful this will further popularize fully electric cars and many other power electronics applications.

The slides from Sevcon's Craig-Hallum investor presentation a few months ago (http://files.shareholder.com/downloads/ABEA-6JAYL5/638130678x0x850875/7E39DA07-6FA5-4DFE-8585-5099BC58BD6B/Sevcon_Presentation_Craig_Hallum_2015.pdf  ) show what has happened recently and what Sevcon expects to happen going forward.  Sevcon's sales have been growing at 14% on average the last five years.  But the addressable market for Sevcon's products are expected to grow from $835 million in 2013 to $5.47 billion in 2020, a 6.5 times increase.  Sevcon has been increasing R&D spending to capture their share of the market.

Sevcon R&D Spend

2010:  $3.187 million

2011:  $3.187 million

2012:  $3.745 million

2013:  $4.065 million

2014:  $4.725 million

2015:  $5.886 million (some reimbursed by customer)

The R&D spend leads revenue by two or three years as the development cycle for new applications takes that long before coming to production.  The 2015 earnings ($0.32 per diluted share) were hurt by the increased R&D spend which GAAP requires must be fully expensed as incurred, a distortion of the real economic earnings.   Instead using R&D expenses from three years prior (the $3.745 million that actually generated the 2015 revenue) would have resulted in 2015 earnings of $0.60 per fully diluted share.  Revenue in 2015 was $41.1 million, 15% growth above the prior year excluding unfavorable foreign exchange effects.  The 15% growth consisted of 41% growth in their newer on-road sectors and just 1.5% in their traditional industrial markets.

So to a screener Sevcon looks expensive at 31 times earnings.  But the valuation of 17 times their real economic earnings of $0.60 is quite reasonable in view of their 15% sales growth and prospects for accelerated growth in the coming years.  Furthermore, the company is just an engineering design and development firm with a sales and marketing arm.  They don't manufacture anything and they have few tangible assets (Book value is just $15.7 million or $3.20 per diluted share).   So with a market growing 6.5 times in 7 years, Sevcon could likely finance their own growth of 6.5 times (to $200 million from $32 million in 2013) without dilution.  Furthermore, Sevcon currently earns a 40% gross margin on the products they don't even manufacture.  This is a healthy margin that could result in terrific profitability as revenues rise faster than SG&A and R&D.  One could imagine them earning $80 million in gross profit in 2020 on $200 million in revenue with a valuation of 1.5 times sales or $300 million ($60 a share) representing a 15 multiple on $20 million in profits from a 10% income margin.  That's optimistic but that kind of potential seems to be there.

It's important to note that Sevcon's growth prospects aren't entirely reliant on electric cars displacing the internal combustion engine.  With the improved motor technology and lower costs, power electronics will be showing up in many places where they haven't been before.  Sevcon discloses some information on projects they are working on.  So here's a list of what they've made public although the revenue potential of these projects is generally not revealed.

Sevon Growth Opportunities

1.  Generation 5 (Gen5) controller was just released in 2015.  This will replace the Gen4 electric motor controller that's been in production for five years.  Gen5 is designed with standard parts that are intended to be used in many applications including the traditional industrial markets and the newer applications.  This is intended to get products to market faster by starting with proven components but also to get volumes up by sharing the same parts across multiple markets.  The Gen5 controller is currently being evaluated by a dozen vehicle manufacturers around the world.

2.  SeaKeeper currently uses a sevcon controller driving an electric motor to drive a flywheel on larger boats for roll reduction.  This technology is being expanded to smaller boats again using Sevcon electronics (https://www.youtube.com/watch?v=W9uNrR2Dx-k).

3.  Start/stop motors for a German truck and bus manufacturer.  When stopped the machine turns off the engine.  When the gas pedal is pressed again an electric motor restarts the engine.  This is a large contract with Sevcon spending over $1 million in R&D in 2015 on this project.

4.  Sevcon is working with Agricultural tractor manufacturers and has introduced a range of products to address this market.  Replacing belt-driven (generators) and hydraulic driven components (PTO systems) with electric motors appears to be the opportunity.  This is a big market but Sevcon doesn't say much about their own revenue opportunity other than they believe "motor controller sales into the agri-market could ramp up to many thousands a year by the end of the decade".

5.  Sevcon is "making good progress" on an project to bring growth to their traditional industrial markets.  No details of what this project is has been revealed.

6.  Early in 2014 Sevcon created a 50/50 joint venture named Sevcon (Hubei) New Energy Technology Company with a chinese automotive supplier, Risenbo, as partner.  Shortly thereafter a new manufacturing facility in Malaysia to make products for the Chinese and wider Asian markets was announced.  Proto-type orders were secured in 2014 with production expected near the end of 2015 but there's been no recent update.

7.  A far-east tier 1 auto manufacturer signed a deal for Sevcon's motor controllers in a hybrid four-dour sedan with $50 million in contract potential over a five year period beginning in 2016.

8.  Sevcon shareholders by vote increased the shares authorized from 8 million to 20 million at the 2014 annual meeting.  The company has $8.5 million in cash and no debt and is actively looking for acquisitions.  

Risks

1.  Sevcon's industrial markets are cyclical and sales to these markets were down double digits in the fourth quarter of 2015.  Most of the world's economies are slow or in recession and this could continue to hurt Sevcon's sales offsetting the growth from new markets.

2.  There's a pension plan that is underfunded.

3.  New Competition.  Sevcon's stuff isn't patent-protected.  Their business is protected by their long-standing good reputation, worldwide distribution, and high production volumes to get good cost.

4.  Bad acquisitions.  With low-cost manufacturing, worldwide distribution. and many customer relationships an acquisition of technology Sevcon could market and distribute seems to make sense.  Gabelli is in control so they should be shareholder focused but lots of bad things can happen with acquisitions.

5.  Currency.  Sevcon is hurt by a weakening dollar as about half of sales are to the U.S. but most costs are in British Pounds or Euros.

Catalyst

No catalyst other than continued growth from technological improvements in power electronics