Description

Overview

Taylor Devices, Inc. (“TAYD”, “Taylor” or the “Company”) designs, develops and manufactures shock absorption devices.

The Company essentially serves two end-markets: construction and aerospace & defense. Construction historically accounted for the majority of the Company’s revenue. However, in the last year, A&D orders have accelerated and now account for over 80% of the Company’s all-time high backlog. FY 2023 (fiscal year-end is May 31st) saw the Company post its highest ever revenue, gross profit, gross margin, operating income and operating margin. And the momentum has continued into the first half of FY 2024 with LTM gross profit up 8% and operating income up 15% versus the record-setting FY 2023. Despite the all-time high performance, I believe the Company is well below peak earnings.

The recent performance has been overseen by a new CEO and a new Vice President of Operations, both hired in 2019. New management has executed on a number of operational improvements and materially reduced the amount of capital required in the business. At FYE 2019, the Company had net working capital of $19.8mm (59% of sales) and as of Q2 2024 the company had NWC of $8.5mm (21% of sales), all whilst total revenue grew 22% over that period.

And on 1/10/24, in their Q2 2024 10-Q the Company announced that they have agreed to buyback 459,015 shares (approximately 13% of outstanding shares) from a large shareholder.

Pro Forma for the buyback, the Company has slightly over $25.0mm of cash and short-term investments and, excluding cash, currently trades at 8.4x trailing P/E. Applying a 10.0x multiple to my estimate of FY 2025 pre-tax earnings, I believe TAYD will be worth $38 by FYE 2025, that represents 30% upside from today and a 21% IRR.

Business Description

The Company was founded in 1955 by Paul Taylor and much of its early business was developing products for NASA to support the Apollo missions.  

The Company produces the same product in a variety of use cases. These shock absorbers can be on a massive scale (think large buildings, they are in SafeCo Field in Seattle and the San Francisco Bay Bridge) or smaller (they are in the landing gear for several series of unmanned drones, including the Predator drones, a contract they won in 2007 and continue to produce for today). 

Historically, the Company has been highly levered to construction, limiting the appeal of the Company and making it inherently cyclical. Adding to the unpredictability of financial performance was the fact that construction projects often lasted multiple years and were accounted for through percentage of completion accounting.  This caused some lumpiness in the mid 2010’s, 2016 was an all-time high in revenues but that was partially attributed to the decrease in backlog, revenues could just as easily have been pushed into 2017 and backlog remained higher:

However, as of FYE 2023, A&D represented 81% of the Company’s record-high backlog. In the first six months of FY 2024, A&D has been driving the performance of the Company and has represented 59% of revenue for the period:

The Company’s record performance is even more impressive when you consider that the Company has just produced the best 12-month period in its history, with the backdrop of Construction (i.e. “Structural”) being down 37% YoY in 1H 2024.

Furthermore, since COVID, the A&D industry has operated well below its long-term trendlines.  Factory shutdowns and economic uncertainty caused the industry to divert from its long-term production levels. Despite recent upticks in industry production, the industry is still substantially below normalized levels.  See the below graphs that indicate the US Aerospace industry is operating below 2017 levels (TAYD’s A&D revenue is up 50% from 2017):

More anecdotally, all of the large A&D companies are citing significant tailwinds for their businesses going into 2024 and 2025. Lockheed Martin cited on their Q3 call that they were experiencing historically high levels of backlog, and they reiterated on the call that the value chain remains constrained and they would otherwise be growing at higher rates. Northrop Grumman cited all-time high backlogs on their Q3 call and a 1.5x book-to-bill ratio.  NOC said they would be in catch up mode for at least the next 18 to 24 months to keep up with growing demand, CEO Kathy Warden even suggested that they may expect double digit growth rate “not necessarily in 2024, but into 2025”. General Dynamics reported a 1.4x book-to-bill ratio in their aerospace division on their Q3 call, also contributing to their all-time high backlog.  

Despite these record high backlogs, if you extrapolate the 2007-2019 CAGR’s for backlog for each of these companies from pre-COVID levels, the industry demand is actually 10% below normalized levels.

The bottom table just takes each companies 2007-2019 CAGR and applies it to their 2019 backlog level. This is not just a case of backlogs increasing from supply chain disruptions. This also illustrates the long-term demand of the industry and the relative lack of cyclicality. Below are revenues for the same periods:

For TAYD, their A&D business has been growing significantly faster than their mega-cap peers:

A&D is not operating at some cyclical peak, and construction has already shown significant weakness, hence why I do not believe this is some cyclical company trading off of peak earnings.

On the management front, from its founding in 1955 through 2019 the business was run by the Taylor family. First by Paul Taylor, the founder, who was then acrimoniously replaced by his son, Doug Taylor, in the early 1990s (there was a board room coup that was well covered by the Buffalo News if you are interested). In 2019, Taylor brought in its first outside CEO in Company history, Tim Sopko. Subsequently to Mr. Sopko, the Company hired Todd Avery as its Vice President of Operations.  These two new managers have succeeded in significantly improving the operations of the Company. 

To add more color to the extent of operational improvement - at FYE 2019, the Company’s Cash Conversion Cycle was 250.1 days, in the LTM period that has been lowered to 98.4. Days Inventory Outstanding which often exceeded 200 days in the past, has been sub-100 in recent years. The Company accomplished this through scrapping obsolete inventory and improving ordering processes, but also by increasing efficiency, since new management started on-time delivery to customers has increased by ~40%. At FYE 2019, total invested capital in the business was over $30.0mm and represented over 90% of that year’s sales, in the LTM period total invested capital was less than $20.0mm and represented just 45% of LTM sales. The release of capital from the business has increased ROIC, which routinely hovered in the high single digits to low double digits historically, to 27% at FYE 2023. 

Here are some slides from the 2023 AGM which highlights both the operational improvement and the micro-cap nature of the business (no fancy banker slides here):

Lest you still think that this capital release is simply the product of COVID de-stocking and increased demand, here is NWC for some large A&D and diversified industrial competitors:

This release of capital, along with the strong earnings performance of the company, also led to a significant increase in the amount of cash in the business. At FYE 2019, TAYD had $6.1mm of cash and short-term investments, as of Q2 2024 the Company has $34.9mm of cash and short-term investments (before giving effect to the recently announced buy back).

Capital Allocation

As mentioned, the Company just announced they are in agreement to buy 459,015 shares of common stock, representing approximately 13% of all outstanding shares, at an agreed purchase price of $19.92 per share, or 88% of the average price that the shares traded at on January 8th, 2024. Even after giving effect to the buy back, the Company will still maintain $25.8mm of cash and short-term investments.

Furthermore, Tim Sopko, the CEO, has been purchasing shares in TAYD in the open market since he first came to the Company. 

While obviously not on a large nominal scale, I would note Tim Sopko was in his early 50s when he took the job and his salary was less than $250,000 annually. Amassing a stake worth close to $100,000 at cost (well over $200,000 at current market prices) in the open market nicely aligns management with shareholders.

Capital Expenditures have historically been limited (the highest amount the Company has ever spent on CapEx is $3.5mm and that was in FY 2023) and the Company completed an expansion and refurbishment of its main facility in recent years. For 1H FY 2024 CapEx was $0.5mm versus $1.4mm in the year prior.

The Company has no outstanding debt, nor has it had any in recent memory, although it does maintain a $10.0mm bank line. The lack of debt is an important de-risking element given their exposure to commercial real estate.

Valuation

Admittedly, this idea was considerably more compelling prior to the Company announcing earnings last week and the stock rallying 20% and subsequently going up non-stop; however, even with the recent advance I believe TAYD is still materially undervalued. 

Even moreso, in August 2022 the stock was trading at $9.81 when it reported its FYE 2022.

While in 2022 the operational improvements that management was focusing on had begun to come to fruition, the business was still deriving the majority of its revenue from construction and the CEO had yet to make any capital allocation decisions. Now with the larger company and continued track record, the market has rewarded the Company with multiple expansion.  Yet there is room for further expansion - the S&P SmallCap 600 Industrials Index currently trades at slightly over 20.0x trailing earnings.

For what it’s worth (understanding that many don’t care about multiples over the past decade due to the interest rate regime), over the last twenty years the business has traded between 10.0x-16.0x trailing earnings.

For modeling purposes I have only gone out two years given the changes that have been occurring in capital requirements. The 2024 assumptions are fairly baked based on the first half already being in the books, and I held margins flat to their LTM period (aggressive since they are the best in their history, conservative because 81% of backlog is high-margin A&D whereas only 59% of revenue in the historical period was A&D). The Company currently has deferred tax assets that would shield the next $7.5mm of earnings, that is not reflected here. And 2025 CapEx and NWC are just conservative assumptions.

Risks/Mitigants

Risk: This is a cyclical business experiencing peak earnings, the improvement you cite is ephemeral.

Mitigant: The longer-term traction in this business has been quite strong. Since 2011, top line revenue has grown at a 6% CAGR, and the business has demonstrated operating leverage with operating income and net income compounding at three times that rate. Furthermore, the slowdown in commercial construction has been occurring since at least summer 2022, and that has been the backdrop for the best performance in the history of the Company. Historically, this company has largely been treated as a family business, operating with 100 employees in North Tonawanda, NY; since the current management took over they’ve exemplified a growth mindset. They have significantly built out the salesforce (from scratch in 2019 they now employ 5 technical salespeople on the west coast supporting Structural sales). They have increased R&D (R&D in 2019 was $0.3mm, in the following years: $0.6mm in 2020, $1.2mm in 2021, $1.3mm in 2022 and $1.7mm in 2023). And they are now making substantive capital allocation decisions, the benefits of which will accrue to the long-term shareholders (of which the CEO is one).

Risk: The Company is currently named in a Third-Party action related to a lawsuit brought forth by the owners of 432 Park in NYC, the Company has not taken a reserve against any potential liability and this is a massive risk to the going concern value of this Company.

Mitigant: Disclosure – I am not a lawyer. However, in the past week I have spoken with both a litigator who is well versed in construction litigation (I have not retained them, simply on a friendly basis) and a CRE investor at a large asset manager. Neither of them were overly concerned with the suit. First, they both said this is not uncommon for an unprofitable real estate deal. TAYD’s particular involvement is tertiary, the condo association has sued the Sponsor over construction issues. In turn, the sponsor filed a Third-Party complaint against the construction company, the architects, the structural engineer and the mechanical engineer. Then the construction company turned around and initiated a Third-Party action against anyone who supplied them with anything, including “products and services relating to the automatic sprinkler system, structural steel, mechanical systems, electrical systems, sheet metal, component assembly, roofing, the building exterior, plumbing, concrete, curtain walls, custom machine work and elevators”. At question is TAYD’s supplying 16 viscous dampers that were than incorporated into a mass damper (for you engineering folks). TAYD’s management vigorously disputes the allegations, they delivered the dampers and they were successfully tested. This all relates to a purchase order from 2013. Discovery is going to last at least the rest of 2024. Obviously this could be a concern here, but I would also note that TAYD was named in the dispute on March 22, 2023 and Taylor first disclosed the lawsuit in their August 2023 10-K filing, and the stock rallied considerably after both dates.

Risk: This is a sub-contractor business to construction managers, it does not deserve to earn high returns on capital and thus margins will be competed away.

Mitigant: This business has a 70-year operating history. It competes with only a handful of players in the spaces it competes in. It is vertically integrated. It currently has patents that run through 2035. They have been hired by some of the largest scale construction mandates in the world. This is not some interchangeable sub-contractor that just essentially schedules the labor. And much of their recent improvements in ROIC is due to the new management’s focus on eliminating waste, in many ways they have shrunk their way into their high returns.  Management is less than five years (a very turbulent five years I may add) into their tenure and everything they have done thus far has inspired confidence.

Catalyst

Continued Cash Generation

Continued Share Repurchases

Multiple Re-Rating

Recovery in CRE