Description

SMTC's 23% normalized FCF yield will increase to 28% through de-leveraging. At 1.2x bank debt / EBITDA, de-leveraging will happen in the near term. Meanwhile you can buy this business, in the 8th inning of a dramatic turnaround under new management, for 4.5x earnings. 

SMTC Corporation:

• Is uniquely positioned to win in its respective niche
• Recently undertook a dramatic turnaround under the guidance of new management
• Is severely undervalued at 4.5x earnings and a 28% normalized, unlevered FCF yield
• Would trade for $5.30 (130% upside) if it traded in-line with peer multiples
• Can achieve $4 per share (70% upside) through de-leveraging alone (1.2x Bank Debt / EBITDA)

THE COMPANY
SMTC Corporation (SMTX, The Company) is a mid-tier provider of end-to-end electronics manufacturing services (EMS). Services include PCBA production, systems integration and testing, enclosure fabrication, product design, engineering and supply chain management. SMTX has facilities in the United States, Mexico, and China.

Headquartered in Ontario, Canada, SMTC is a Delaware Corporation that trades on the Nasdaq GM. Roughly 80% of revenue is from the Industrial and Communications segments. Management and Directors own 18% of the company, with director David Sanberg (Red Oak) at 11%.

UNIQUELY POSITIONED TO WIN IN THEIR RESPECTIVE NICHE
The EMS Industry is a $220bn opportunity and growing with a long-term CAGR in the mid/high-single digit range according to research outlets such as Frost & Sullivan and InForum. The space is roughly segmented by three tiers:

With revenue approaching $300m, we think SMTX is uniquely positioned as a smaller Tier II with a global footprint. The typical smaller Tier II EMS has 1-2 regional locations whereas SMTX’s customers can benefit from facilities spanning North America, Mexico, and China; as well as a global supply chain, procurement in China / Hong Kong, a strong balance sheet, etc. As an example, a product introduction into the US would start with a gateway facility in the US (engineering, piloting, etc.) which would take place at STMX’s San Jose location. To achieve cost economies, volume production would then be “near-shored” to Mexico at SMTX’s Chihuahua facility. As the program reaches its last couple of years, SMTX can milk more cost out by moving manufacturing to SMTX’s Dongguan or Suzhou facilities in China. This progression is impossible without a global presence.

Unlike larger Tier II EMSs, SMTX can offer a high degree of customer service, hubbing, distribution, configurative orders, etc. whereas the larger players are competing on volume/price and therefore, in many cases, against Tier I players with a lower margin structure.

SMTX’s unique position has provided new management with a solid platform to grow substantially faster than the industry.

DRAMATIC TURNAROUND UNDER NEW MANAGEMENT
After a decade of business rationalization and debt pay-down, the board of directors at SMTX brought in a new team of managers to revive growth, improve profitability, and drive consistency of performance. The new leaders implemented an account management vision, trading out virtually every rep for more qualified managers. The immediate goal was to reduce the cycling of large customers by ensuring that as existing programs were expiring, new programs were being awarded.

Additionally, The Company began putting their best talent in front of existing customers to provide value engineering to demonstrate SMTX’s commitment to being a valuable, long-term partner. This further reach into existing accounts drove new business awards with commensurate revenue increases nearly overnight. In fact, within one quarter of new management’s arrival, revenue increased 61% sequentially (46% organically) and grew steadily from there driving top-line volatility to an historic low.

SMTX’s leading quality service not only drove revenue to a 10-year high, but renewed branding power drove new customer additions to an all-time high in management’s first year. These strategic and tactical moves put SMTX on the leading edge of the growth spectrum (35% y/y, 28% organically in 2012) and several weeks ago Frost & Sullivan awarded SMTX with the 2013 North American Award for Growth Leadership, specifically citing superior customer service strategies.

The Company’s turnaround is nearly complete. Last quarter, management made the decision to shutter manufacturing operations at its Markham, Ontario facility which will be complete by mid-year 2013. Markham contributed 10% of revenue but burned over $2m of EBITDA.

SEVERELY DEPRESSED VALUATION WITH UPSIDE FROM MULTIPLE ANGLES AND LIMITED DOWNSIDE
Management has guided to $14-15m of adjusted EBITDA this year. $15m of EBITDA, which represents the peak of the last decade, translates to $0.51 per share, or a PE of 4.5x. The Company pays only ~$1m cash taxes due to its $80m NOL (protected through 5% ownership gates), and its annual maintenance capex requirement is roughly $3.5m.* On an unlevered basis then, $15m of EBITDA results in $10.5m of FCF on a normalized basis.

We note that $15m EBITDA is likely conservative as SMTX can get most of the way there just by shuttering the Markham facility before new programs mature and contribute positively to gross margin. Additionally, The Company already has the vast majority of 2013 business in-hand.

Management’s goal is to fully pay-down SMTX’s bank debt which is currently $17.5m, or 1.2x 2013 EBITDA. If SMTX experiences no growth, and finds no accretive acquisitions, they should be able to pay down bank debt in the next six quarters resulting in $17.5m (46% of market value) accruing to equity, all else equal. In addition, SMTX’s 2012 interest expense was $2m. Through deleveraging, that $2m would drop to the bottom line. Even at SMTX’s depressed 4.6x earnings multiple, that would be worth an extra 23% to equity.

As such, just through the deleveraging process, SMTX’s stock should see roughly 70% upside. We add a couple of quarters to the timeline for SMTX to de-lever given some one-time 2013 cash events: $1.6m for earnouts, an extra $1.5m capex to support new customers, and $2.5m to shutter their Markham manufacturing facility.

Potential pull-forward for deleveraging is working capital. Management has indicated they’ll moderate growth in 2013 to ramp new customers and complete restructuring (Markham contributed $30m to revenue in 2012) to improve returns on the business. In a stabilizing growth environment, working capital converts to cash quickly for EMSs. The Markham facility closure will also generate a couple $million in cash. In addition, we view the inventory on SMTX’s balance sheet much like a receivable as The Company acquires inventory pursuant to customer POs. Customers are contractually responsible for that inventory – they either place orders or write SMTX a check. When viewed in this light, SMTX has over 2/3 of its market value in cash and net receivables:

We look to comparables to get a sense for the valuation markets are placing on Mid-tier EMS businesses. When compared against peers, SMTX’s valuation is severely depressed by any measure:

To further put SMTX’s valuation in perspective, the last time Key Tronic achieved similar levels of EBITDA to our 2013 projection for SMTX, that stock traded with a $120m enterprise value, vs. $56m for SMTX.

Finally, acquisitions in the EMS space are highly accretive. Anecdotally, SMTX bought Seksun in 12/12 for roughly 1x EBITDA. With a strong balance sheet and stabilized cash flow generation, The Company could identify more highly accretive tuck-in acquisitions. Tier 3 & 4 EMSs are in a difficult position because they can’t grow past $75-$100m in revenue, they’re typically owner operated, owners are getting up there in age, and their kids are working in finance on the East Coast and don’t want to come home to run the business. Similar to the dynamic arising in other markets (Agriculture, Car Dealerships, etc.), natural acquirers emerge to pick realize the value in these smaller operations.

We would attribute this currently depressed valuation primarily to:

• SMTX uses forward FX contracts to hedge their currency exposure (CAD, MXN) and unrealized changes in fair value of the contracts flow through the P&L. This impacted gross margin by more than 70bps in the fourth quarter although they have no economic impact. 
• Given the record number of new customers and further reach into existing customers, 2H12 saw a record number of new program introductions which come with inherent margin inefficiencies as these programs ramp.
• The Company restated previously issued financials to reclassify its revolving credit facility as a current liability. Although the headline read poorly, this reclassification had no impact on the P&L or statement of cash flows.
• With the closure of Markham, SMTX violated debt covenants; which turned out to be a positive. SMTX had a key fixed charge covenant with PNC and EDC. They knew they’d breach because of the shutdown and restructuring charges and were in discussions with PNC. The result was a waiver of the covenant, and an amendment to erase the covenant altogether and put in a vanilla TTM EBITDA covenant which gives them more flexibility. They didn’t do a good job of explaining this in their 10-K. At 1.0x net bank debt / EBITDA, we’re not overly concerned.

*SMTX’s auditors lumped the recent Seksun and Alco tuck-in acquisitions into capex

COMPANY BACKGROUNDER
SMTX has been around for nearly three decades. In the late ‘90s/early ‘00s the company was generating $800m of revenue. Then, the tech bubble imploded and Contract Manufacturers in the EMS space got crushed.

From 2000 through 2010, SMTX’s management spent its time consolidating operations, shuttering plants, and walking a tightrope of financial constraints that would’ve put many players into the fold of a larger acquirer or out of business. The management team, led by John Caldwell was very financially oriented – debt pay-down, internal cuts, operational efficiencies. By the end of 2010, SMTX had brought its debt to reasonable levels, rationalized plants, and consolidated down to ~20 solid customers.

Performance however, was lacking. Earnings were inconsistent largely due to a cycling of large customers whereby they’d land an account, fail to service them properly or get the next program, and the customer would leave at the end of the program life. The cycling of customers caused a cycling of earnings and the business was assigned a discounted valuation.

During 2010, Caldwell felt it was a good time to move on and the company began a search for new leadership that could begin to grow the business while maintaining a good turnaround and operational mentality. Both Alex Walker and Claude Germain were on the board of directors (Alex from ’08 and Claude from ’11) and were asked to step into a co-CEO roll temporarily. After four months of getting closer to the business, they agreed to stay on full time.

Programs are often five years in length so customers are constantly awarding new business to CMs. The account management changes put SMTX on the leading edge of the growth spectrum nearly overnight.

DISCLAIMER 
This report is neither a recommendation to purchase or sell any securities mentioned. The authors may or may not have a position in any security discussed in this report. Further, the authors may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be correct as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The authors undertake no obligation to update this report based on any future events or information.

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