Description

Long Idea: TCP International Holdings Ltd. (TCPI)

Note: This is a relatively illiquid name, and only suitable for smaller funds and PA’s.

TCPI is one of the world’s largest manufacturers of LED and compact fluorescent (CFL) light bulbs. With low-cost manufacturing facilities in China and almost 7,000 employees, TCP has been quickly growing revenues in the rapidly expanding LED bulb market, which continues to take share from other types of lightbulbs as the price/performance increases over time and regulations against incandescent bulbs take effect.

TCP sells its bulbs through major retailers, with the Home Depot representing about a quarter of sales and Walmart about a fifth of sales. The company also has a commercial and industrial (C&I) business that sells directly to larger corporate customers. A quick search on Amazon.com reveals that TCP is a big player in the space, with the number one best-selling LED bulb on Amazon, and a large number of highly positive reviews—even edging out Philips:

It’s not hard to see why, either: a 6-pack of TCP bulbs costs $22.26, or just $3.71 per bulb, compared to $7.90 for a Philips bulb.  This also explains TCP’s success in penetrating Walmart and Home Depot—they are a low cost producer of decent-enough bulbs, in a category where consumers don’t seem to care that much about brand names.

Over the past few years, CFL bulbs have declined as a percentage of TCP’s revenues as they are replaced by LED bulbs. In 2014, 55% of TCP’s sales were from CFL bulbs, which have a lower gross margin compared to LED bulbs (I estimate a 10-15% difference in gross margin, but with that difference falling as prices decline for LED bulbs). In the most recently reported quarter ended 6/30/2015, LED bulbs represented almost 55% of TCP’s sales, and continue to grow quickly (up ~32% YoY), while CFL sales decline (down 26% YoY). As the mix shifts away from CFL and towards LED, overall margins should improve, and overall sales growth should accelerate because the drag from declining CFL sales will become less pronounced as it shrinks as a percentage of the total business.

TCP had an IPO on July 1, 2014, in which the company sold 7.1mm shares for $11/share. The shares are now trading at ~$2.74. So what happened?

Basically, TCP disappointed investors early on with results that fell short of analyst estimates soon after the IPO. This is partly because of the significant decline in the CFL part of the business that was not fully offset by the growth in the LED business. These concerns drove the share price down to the ~$7 level within a couple months of the IPO. But the real carnage happened on March 2nd of 2015. To understand what happened here, first you need to know about Ellis Yan, the founder of the company and current Chairman—and the former CEO, who still owns ~65% of the company.

Essentially, Yan is a very difficult man to work for and prone to angry outbursts and tirades. Unfortunately for him, he picked the wrong person to be the General Counsel for TCP— Laura Hauser, who was not about to let Yan ride roughshod over her like he did his Chinese factory workers. As the company described in its most recent 10-K:

On February 26, 2015, Laura Hauser filed a complaint in the Court of Common Pleas of Cuyahoga County, Ohio, against the Company, its wholly-owned subsidiary Technical Consumer Products, Inc., and Ellis Yan, alleging that Mr. Yan mistreated Ms. Hauser in connection with her employment as the General Counsel and Secretary of the Company. In addition to asserting a number of tort claims against Mr. Yan, Ms. Hauser asserted a claim against the Company for respondeat superior. Ms. Hauser has not formally specified the alleged damages she is seeking for this matter. The Company believes Ms. Hauser's claim against the Company is without merit and intends to vigorously defend itself. As this litigation is in the early onset of discovery, the Company is unable to determine the probability and amount of loss, if any, related to this litigation.

On February 26, 2015, Ms. Hauser also filed a complaint with the U.S. Department of Labor-OSHA alleging that the Company committed retaliatory employment practices in violation of the whistleblower provisions of the Sarbanes-Oxley Act and the Consumer Product Safety Act (Laura Hauser v. TCP International Holdings Ltd. et al). Ms. Hauser filed an amended complaint on March 16, 2015, against the Company and Mr. Yan asserting that the parties reduced Ms. Hauser’s responsibilities and placed her on administrative leave in part due to alleged protected activities. On March 16, 2015, OSHA initiated an investigation regarding Ms. Hauser's claims. The Company believes Ms. Hauser’s claims lack merit and will fully cooperate with OSHA's investigation.

Most of Ms. Hauser’s complaint alleges that Yan was a huge jerk; verbally abusive and unprofessional, but probably not that uncommon for self-made, hard driving entrepreneurs in hyper-competitive emerging markets. The really damaging part of her complaint, though, was that TCP had engaged in unsafe practices—putting the “UL” certification on bulbs which had not actually passed UL inspection. This was a very serious allegation, since the bulbs could be potentially unsafe and cause a fire, which could have led to Walmart and Home Depot pulling the bulbs from their shelves and severely damaging TCP’s finances and reputation. Ultimately, despite an in-depth review of the problem at the big retailers, it turned out to be a non-issue (the bulbs were verified to be UL compliant), and retailers continue to happily sell TCP’s products. The company finally settled with Hauser for the (admittedly extortionate) price of $3.9mm, as detailed in their 7/28/2015 8-K:

On July 28, 2015, TCP International Holdings Ltd. (the "Company") and Ms. Laura Hauser entered into an agreement to settle all disputes between them, including the outstanding litigation brought by Ms. Hauser against the Company and its former Chief Executive Officer, Ellis Yan, through private mediation. As part of the settlement, Ms. Hauser will receive $3.9 million in cash, which is expected to be paid in the third quarter of 2015. The settlement will result in the dismissal of the case filed in Cuyahoga County, Ohio on February 26, 2015, by Ms. Hauser against the Company, its wholly-owned subsidiary Technical Consumer Products, Inc., and Ellis Yan.

Interestingly, the company’s share price has never fully recovered since plummeting in the wake of the scandal. And yet, the net effect of all of this is actually quite positive for the company and its prospects: Mr. Yan was forced to resign as the CEO, and the replacement CEO who was announced on 7/2/2015, K.R. den Daas, is extremely reputable. He worked at Philips—the class act of the lighting industry—for over 30 years, and most recently ran Philip’s North American lighting business, and will likely have significantly more credibility with investors and large customers than Ellis Yan. From the press release announcing his appointment:

“I am delighted to join TCP as CEO,” said Mr. den Daas. “Having spent my entire career in the lighting industry, I have watched TCP become a significant player in the global lighting market. I look forward to leveraging the products and manufacturing platform the TCP team has developed to take advantage of the enormous lighting market opportunity in front of us.”

Mr. den Daas has significant experience in the lighting industry serving in various capacities at Royal Philips between 1977 and 2010. This includes most recently being Chairman of Philips Lighting North America and Chief Executive Officer, Business Unit Professional Luminaires, North America for Philips. During his tenure with Philips Lighting, Mr. den Daas was responsible for manufacturing, R&D, distribution, commercial and all other business functions of Philips Lighting in the United States, Canada and Mexico. Under his leadership, Philips became the largest lighting company in North America.

The new CEO has publicly stated that the company’s gross margin target is 25%. In the most recent quarter, the gross margin was 23.1% (up from 22.7% in the year ago quarter), and the previously mentioned shift to higher margin LED sales makes the target margin look plausible.

So how cheap is TCPI? If you believe management’s margin targets, and assume some moderate revenue growth (say, ~5% higher than the trailing 12-month revenues), TCPI looks to be trading for an extremely undemanding P/E of ~3.1x. If you assume lower revenues (say, down 10% compared to trailing 12-month revenues— despite the fact that total sales have grown at a CAGR of 14.5% since 2011), you end up at around ~10x earnings—not super exciting, to be sure, but not so terrible either. Note that these numbers exclude one-time charges (such as the legal settlement in the most recent quarter) and apply a normalized tax rate to the adjusted earnings:

So what are the risks? First of all, TCP is still effectively controlled by Ellis Yan, who is a relatively sketchy character and probably not the person you would most want as the chairman of the board. That being said, he is aligned with shareholders through his ownership stake, and is no longer in control of day-to-day decision making at the company (at least, that would appear to be the case; one can never be sure what is happening behind the scenes).

Another major risk is that the LED space is getting increasingly competitive. A Goldman Sachs research report from Q1-2015 claims that average selling prices for LED bulbs are declining by over 20% per year:

On the other hand, TCP is already positioned at the very low end in terms of pricing, as can be seen on Amazon.com, so as long as they can preserve their cost advantage, they should be able to maintain their gross margins. In the meantime, LED unit volumes are skyrocketing, driven by the more attractive price points and the phase-in of regulations against incandescent bulbs in most major Western markets. The same Goldman Sachs report shows LED market penetration of just 8% in 2015, and this is projected to hit 50% in the next 7 years:

So what is TCPI worth? Clearly, the business does not have much of a competitive moat. Still, it is operating in a space where there is significant secular growth over the next 10 years, and it is among the lower-cost producers. With a tangible book value of ~$2.92/share, and normalized earnings power of $0.40 - $0.50/share, it earns a respectable mid-teens return on tangible equity. All this suggests that it merits at least a 10x P/E, which would suggest a share price of $4 to $5—or at least ~45% upside from the current price. Even in a pretty bearish scenario, the company should earn at least $0.25/share, which at a 10x P/E would imply less than 10% downside from the current price. It is relatively small (~$78mm market cap, but a float of just ~$27mm because of Yan’s large stake) and under-followed, and the events of the past year explain why the opportunity exists.

Catalyst

Investors realize that there is nothing fundamentally broken about the business.

The company earns something close to its normalized EPS (conservatively estimated at $0.40 - $0.50/share) and re-rates to a reasonable multiple.