Description

SMTC Corp (SMTX) trades at 4.5x cash earnings and is worth $5.00/share, or +130% from current levels, with the lowest valuation in its industry group despite unique characteristics which should allow for a premium valuation. Namely:

- it has the lowest CAPEX as a percent of revenue among its peers.

- it’s the only company to have a sizable NOL balance - $70mm in NOLS - which if valued at 25 cents on the dollar equate to greater than 1/2 the market value of the company and greater than 1/3 the enterprise value.

- it has among the highest gross and operating margins in its peer group.

Despite being a micro-cap with just a $33mm market cap and $53mm TEV, SMTC is solidly profitable with >$250mm in revenue, $12mm EBITDA, strong free cash generation, and is a stock that can trade (plenty of stock in the float). We believe the stock is materially mispriced based on absolute and comparative valuation metrics and represents a compelling investment for value investors seeking mispriced opportunities.

Basic Info:

Price/ share: $2.18

Shares o/s: 14.6mm basic, 15mm f/d (1.4mm options @ $2.32)

Market Cap: $33mm

Net debt: $19.5mm (excludes $2.5mm cap lease obligations)

Ent. Value: $53mm

EBITDA OP CF CAPEX

2008E $12.0 9.5 (2.0)

2007 $12.5 24.7 (1.9)

2006 $16.0 (9.5) (2.2)

2005 $8.9 9.5 (2.5)

2004 $10.9 5.6 (0.4)

* all numbers in $mm

Valuation:

We hate comps analysis and instead estimate the company’s value to be $5.00/share, or +100% from current levels, based on a 10x multiple off net operating profit after-tax (NOPAT) of $10mm/year. We believe this is reasonable as the Company’s business is stable and consistently profitable, and a cash return yielding 10% is reasonable in this (or any) market. We use NOPAT as it effects for excess D&A vs. CAPEX and also incorporates cash taxes paid on a normalized basis. For our #s we assume SMTX never pays taxes and believe this is reasonable as they have 10 years worth of NOLs once debt is fully paid down (which we expect to occur within 2.5-3 years), thus it’d be 12-13 years before they started to pay cash taxes, and discounting back that far has a minimal impact on our estimates. Our $10mm NOPAT calculation is derived by:

EBITDA 12.5

less D&A (5)

= EBIT 7.5

Less taxes (0) NOLs offset taxes owed

= Net Income 7.5

Add back D&A 5

Less CAPEX (2.5)

= NOPAT. 10.0

* all numbers in $mm

* the $5/share valuation also equates to 6x EBITDA plus 25 cents on the dollar for the NOLS – on the low end of all comps.

History:

SMTX was built up through a series of acquisitions in Canada in the contract manufacturing and assembly space, acquiring critical mass to IPO in early 2000 before the tech bubble burst. The stock peaked immediately post-IPO at a bubble-inflated $150/share, only to immediately collapse with the market and economy (ended 2000 at $80 and 2001 at $6.25). The Company realized significant losses in 2001 and 2002, creating SMTX’s sizable NOL balance – an asset now of value as the Company is profitable. It hired CEO John Caldwell fresh out of GEAC (which he turned around, it was sold soon after his departure) to right-size the company. Profits were immediately restored, with 2005 witnessing a dip as old business was weeded out and 2006 seeing a spike from a strong economy and an increase as final life-cycle orders for some EMC RAID servers were pushed through. ‘07/’08 #s above reflect accurate EBITDA and CAPEX for the business on an ongoing basis.

Business:

It’s an inherently tough, low-margin business, and SMTX has survived by focusing on higher margin niche assembly allowing it to achieve among the highest gross (10-11%) and EBITDA (5-6%) margins in its industry. While the sector has been killed with concerns of business moving away to China, SMTC has addressed this by opening a China operation to appease its higher volume, lower-margin customers. It now has plants in Canada, the US, Mexico, and China. As per most contract mfrs, SMTC has customer concentration, with its top 5 customers accounting for 50-60% of the business. Importantly, it has never lost a single customer, historically taking it on the chin on all levels to satisfy its customers (though customers have shifted as they have been acquired or their businesses declined). SMTX has fairly good customer diversification, as top customers include:

- point of sale electronics for global leader Ingenico

- inventory tracking parts within MARS vending machines

- HD/DVR systems sold to DirectTV through Leitch Technologies

- Bloomberg identity-authorization cards

- components for a large east coast audio-system manufacturer

- a recently publicly announced contract with Thales expected to ramp through ’08

Comps:

Across big (FLEX, CLS, JBL), mid-tier (PLXS, BHE), and smaller/ SMTX-peer (SIMC, SGMA, NSYS) companies, all comps are in the 6-9x EBITDA range vs. SMTX at 4.4x. The sole exception is SGMA, which trades at 5x EBITDA (but has higher capex/revenue, is more levered, and has poor w/c management and cash flows). Every comp has higher CAPEX than SMTX as a percent of revenue, and therefore despite being the cheapest company in the group on EBITDA, it’s even cheaper when comparing EBITDA less CAPEX. We are in the business of valuing the cash flows of companies, and therefore we view this as an important point – SMTX simply generates more cash relative to its valuation than any of the other companies in this space. Additionally, despite being branded as a bad/ tough business, every company in this space makes money and has always made money. As such, SMTX is the only company with material NOLS (origin of these is explained above). These NOLS are material and are not factored into valuations whatsoever.

Why does SMTX trade at multiples below its peers?

We believe the market holds a negative bias on SMTX for uninformed reasons, starting with its collapse post IPO in 2000 and followed more recently by events in late 2007. Namely, in July ’07 SMTX spiked - we believe due to potential acquisition talk – touching $8/share for a day and trading in the $5-7 range for nearly a month. Subsequent to this:

1) no deal was announced.

2) the quant funds “blew up” (3 large quant funds – Renaissance, Dimensional, and Numeric - owned 10% of SMTX, collectively).

3) SMTX announced a poor Q3, as inventory corrections hit the entire industry due to concerns about the economy. [Note: SMTX knew their customer’s inventory corrections were temporary and – rather than reduce headcount - accepted losses in July and August until September production resumed at 100%. They reported a strong Q4, running near 100% and in their Q1 ’08 call guided to growth in 2008 in revenues and profits vs. 2007.]

Subsequent to this, the largest holder (15% owner, Caisse in Canada) sold its position (see public filings) in December ’07, driving the stock down to the low $1 range, or 3x trailing EBITDA excluding value for the NOLS.

What does the market not recognize?

- Its not the same management team as in 2000

- the Company has de-levered its balance sheet via consistent free cash generation and is now at its lowest debt level since pre-IPO ’98.

- money flows unique to quant funds and to Caisse’s selling drove SMTX stock down to recent lows and we believe had a non-fundamental impact. SMTX has paid down $0.80/share in debt in the past 9 months but trades at the same $2.20/share level it did from August-Nov ’07 (after the artificial spike in July ’07) before the quants and Caisse had an impact. Since then, SMTC provided additional May ’08 guidance for higher ’08 revenues and earnings vs.’07. The stock has not moved.

- let’s assume SMTX is at its bottom valuation (trading at 5.3x EBITDA less CAPEX and the aforementioned 4.5x cash earnings). Although SMTC is not heavily levered (it has 5x interest coverage), equity investors earn an annual return greater than 20% from debt pay-down alone.

- in ’07, SMTC hired Paul Blum to manage working capital and the supply chain. Since then, marked improvements in working capital have been witnessed – this is a better-run company.

- SMTC built inventory in Q1 ’08 to ensure there would be no shortages or disruptions as it ramps China in Q1/Q2. We estimate $4mm can come out of inventory in the near-term as China is up and running – representing $0.27/share, or 12% of the current stock price.

Buy-out Value

A strategic buyer would shut down the Toronto plant and pull SMTC’s lines into their own facility, saving $5-8 million (sober #s, small % of the $225mm+ in costs). The management team is paid well and removing executive comp and high costs of being public (the audit alone is $700,000/yr) would yield another $2mm/yr in savings, getting to $14.5mm/yr EBITDA to an acquirer plus $5-8mm in additional synergies. A buyout or change of control would kill the NOL, but buyouts are done at 5.5x, which represents $5.50+/share. A buy-out is the end-game here.

Other risks, concerns, upside, comments

- if more than 50% of the stock changes hands among 5%+ shareholders over a 3 year period, the IRS considers this a change of control, nullifying the NOL. The last time we spoke with the CFO, SMTX was in good shape on this calculation. However,

- Loss of any key customers has a large impact due to operating leverage. The same occurs on the upside with the gain of new customers.

- strengthening of the US dollar - the Markham, Canada plant has the most employees, thus a large portion of wages are in Canadian $s but sales occur primarily in US $s. We “believe” a 10% shift in currency adds ~ $1mm/year to NOPAT (would need to verify with CFO).

- due to customer cycles, the business appears stronger in Q2 and Q4 of each year.

Disclaimer:

We are currently long this security and this may change without an update. Please do your own research.

Catalyst

- already severely mispriced, eventual correction but in the interim will continue to generate cash, pay-down debt, eventual target sale of Company. If nothing occurs, cash is the catalyst - can use cash flow to repurchase stock, issue dividends, etc