Description

Nasdaq-traded Sevcon (SEV market cap = $25 million) has issued transferrable rights (Nasdaq SEVRR) to its shareholders that entitle their owners to purchase new $24 convertible preferred shares yielding 4% at a discounted $21.50 price.  Each preferred share requires 7.679 rights trading around $0.34 so a preferred share will cost you about $24.11.  The preferred is convertible into three shares of Sevcon common currently trading around $7.25.

Some rights offerings are designed to raise capital from shareholders and some rights offerings are designed to raise capital from insiders.  This one has some elements indicative of the latter.  In particular, I would note that the company could have simply offered more shares of tradable common at a discount to raise the desired $10 million.  Many investors will find the convertible preferred they chose instead to be unappealing especially as it will not be listed for trading.  Insiders will participate in the offering and there is an over-subscription privilege.  Two directors forced onto the board in Dec 2013 by 34.6% owner Mario Gabelli are partially backstopping the offering.  One is Ryan Morris of Meson Capital who is also chairman of Infusystem Holdings (INFU) discussed on this site.  It sure looks like insiders want this one and I wonder if they didn't intentionally make the offering unappealing so they could get more themselves. 

The $10 million to be raised by the offering will be used to aggressively expand the company's business providing the drive electronics to electric motor driven vehicles (cars, fork lifts, motorcycles, scooters etc), hybrid machines, and industrial machinery.  While this has been a sleepy low-growth business for years, improved battery technology, improved electric motor technology,  and emphasis on fuel efficiency and lower emissions, has turned this into a potential aggressive growth business.  New owners (Gabelli and associates) are pushing to double the company's engineering staff and make acquisitions to take advantage of the companies new opportunities for rapid growth.  The first revenues from a joint-venture with a leading Chinese automotive manufacturer are expected still this year.  There is growth and growth prospects in all their markets, however, except for mining machinery which remains in a mild depression.  After many years of mediocre performance, the debt-free and mildly-profitable company trades at a market cap of $25 million despite $35 million in revenue with current growth and much greater growth prospects.  Furthermore, many business costs are fixed as manufacturing is outsourced so the income statement is highly leveraged to increased revenue.  Upside here is substantial while financial risk from the contemplated aggressive growth investments is mitigated by owning the preferred stock of a debt-free company with long-established business.

Electronics to control electric motors are sophisticated and not a commodity that is easily replicated.  Furthermore, in many cases the electronics are a relatively inexpensive part of a much more expensive machine.  It doesn't make sense for manufacturers to take a chance on new market entrants to save a few dollars.  Engineering expertise in applications is required and customer relationships and a proven track record are important.  England-based Sevcon has been in the business since the 1980's.  This is not a great business but it's not bad either and being an established player in now rapidly growing markets presents opportunities that have attracted investors like Gabelli and Morris.

The 88 year-old company founder owns roughly 10% of the company but otherwise the board of directors has historically owned  little.  The long-time CEO, Matthew Boyle, owns 2.1% likely acquired from options over the years.  My assessment is that the company is simply in the right place at the right time.  They've made electric motor drive electronics but without any remarkable financial success for a long time.  But now the current explosion of electric driven vehicles and hybrid equipment requiring electric motors has come along and suddenly they've got opportunities.  Even then, activists are required to make the company go after the new markets.  The rights offering and aggressive growth investments are likely driven by Gabelli's three director appointees that just joined the board in Dec 2013.

The company's business is simple in that they just make controls for electric-driven vehicles constituting 93% of revenues.  There's some legacy capacitor manufacturing business that makes up the 7% balance.  Toyota and Renault were the largest customers in 2013 at 10% of revenues each.  Many large manufacturer's (GE, Hitachi, Sauer Danfoss) have their own divisions that make their drive electronics.  Sevcon is one of the largest independent maker of drive electronics.  UQM Technologies (ticker UQM) is a pure-play publicly traded competitor also raising capital and expanding in China.  It is smaller, currently unprofitable, and sports much higher valuation multiples than Sevcon.   Sevcon's markets are summarized below from the 2013 10-K.

Industrial Markets

In these applications, the customers design and manufacture fork lift trucks (FLT), aerial work platforms (AWP), airport ground support (AGS) and mining vehicles. These are, in general, designed for use in off road applications in distribution, construction, transport and mineral extraction.

On Road Markets

Customers in the Company’s on-road markets design and manufacture automobiles, scooters,  motorcycles, buses,  trucks, utility vehicles, sweepers and other applications where either all or part of the power system is electrical.

Growth prospects come from two sources.  First vehicles that have been around for a long time are being designed with increasingly electrified drivetrains to improve fuel efficiency and lower emissions.  Second, improved lithium-ion batteries are making electric versions of machines possible.  Electric motor cycles, scooters, electric  cars, and hybrid vehicles offer cheap transportation without polluting.  Sevcon created a joint venture in Feb 2014 to gain access to the Chinese market.  Comments on the opportunity are below.

"Partnering with Risenbo is a unique strategic opportunity for Sevcon to gain greater access to the world's largest electric and hybrid vehicle market," said Sevcon President and CEO Matt Boyle. "China has long been one of our most important growth regions, driven by increasing product demand in our traditional off-road, industrial, construction and mining markets. This joint venture will open the door for Sevcon to help China's Tier 1 automotive suppliers meet the country's fast-growing demand for zero emission scooters, motorcycles, automobiles and commercial vehicles, as well as hybrid electric vehicles. Working with Risenbo, a respected supplier to the automotive market in China, will enable us to forge new customer relationships in this crucially important geographic market far more rapidly and efficiently than we could on our own."

Rights Offering details

The preferred stock carries a 4% cumulative annual dividend and will be convertible at any time at the holder's option into shares of Sevcon's common stock at an initial conversion price of $8.00 per share, representing a conversion ratio of three shares of common stock for each share of preferred stock, subject to adjustment. Sevcon will be able to require conversion at any time after five years if the closing sale price of the common stock has exceeded $15.50 for 20 out of 30 consecutive trading days.

Common stockholders will receive one transferable subscription right for each share of common stock owned at 5:00 p.m., Eastern Daylight Time, on July 25, 2014. Each subscription right will be exercisable for 0.13022 shares of preferred stock at a subscription price of $21.50 per whole share. This is equivalent to $7.17 per share of common stock on an as-converted basis, a 7.3% discount from the closing sale price of $7.73 per share on July 28, 2014. No fractional shares will be issued, but the number of shares of preferred stock issuable upon exercise of one right shall be rounded up if and to the extent necessary so that each holder may subscribe for at least one whole share. The subscription rights, which will be listed for trading on Nasdaq under the symbol SEVRR, will expire if they are not exercised by 5:00 p.m., Eastern Daylight Time, on September 8, 2014, unless Sevcon extends the rights offering period.

The recent trading price of the stock was $7.25.  So purchasing a preferred share at $21.50 that converts into three shares of common is slightly cheaper than just buying the common.  With the price of the rights ($0.34) you'll pay another $3 for the preferred or $1 per converted common.  So its cheaper to just buy the common ($7.25 verses $8.04).  But the preferred pays a 4% dividend ($0.32 a year per common) and isn't callable for at least five years so you should receive at least $1.60 in dividends.  Those dividends are payable in stock rather than cash at the company's option and aren't taxable if paid in stock.  The business plan is for aggressive growth, however, and competitors (like UQM Technologies) are also trying to expand.  There's significant risk that it doesn't work out.  In that case, the preferred offers downside protection.  For that reason I'd  much rather own the convertible preferred to the common.  I think the common is an attractive purchase too, however, but a riskier one.  I suspect its price is somewhat depressed from shareholder selling to raise money to buy the preferred.

Catalyst