Spin off Dynamic:

VPG was formerly a part of Vishay Intertechnology (VSH), a messy conglomerate of passive components for the electronic and semiconductor industries. VPG's business is actually higher quality than its parent's, and generates higher margins across a whole cycle. I do not believe this is well understood, as VPG was lost in the comparative giant that is VSH.

Currently, VSH's market cap is roughly 1/10 of its parent company - at roughly $145 million, versus $1.4 billion for VSH. I believe this contributes to the relative undervaluation of VPG, and the shareholder base may undergo a transformation in the near future, as this tiny company may not be appropriate for many investment mandates.

Lastly, Vishay Precision and Vishay Intertechnology may share the same corporate name, but that's where the similarities end. These two enterprises do not share common technologies, manufacturing facilities, marketing approaches, or customer bases. Their corporate strategies are also very different. VSH wants to be a one-stop source for customers to build standard Vishay components into their products. These components tend to be quite generic in nature. In contrast, VPG's product lines are highly customized for each specific customer, requiring lengthy development and sales cycles. VPG also has a dominant presence in the foil resistors market, which generates enormous margins and cash flows with minimum reinvestment needs. There is industrial logic to separate the two businesses.

Quick Historicals and Valuation Metrics

*2009 includes standalone company costs pro forma.

The company has been profitable through an entire cycle and produced both positive adjusted earnings and free cash flows in 2009. I think this is an impressive feat as VPG's end markets are quite cyclical, which can also be seen by the huge sales drop in 2009.

Pro Forma Balance Sheet

As you can see, net cash sits at roughly $60 million. Of that long term debt balance, most of it is a legacy from VSH that is due 2102 that bears interest at LIBOR. So arguably, the economic value of this debt is below its carrying value. The equity currently trades below book and right around net tangible book.

Enterprise value roughly = $85 million.

Market cap roughly = $145 million.

Here are some metrics to chew over.

I hope that intrigues you.

I did not strictly work the metrics on net income because the firm's tax strategy is not yet set. Note though that the firm has substantial assets in Israel. I would expect overall tax rates to be less than that for a US tech company - perhaps around 30%.
 

Discussion of the Business Fundamentals

Vishay Precision's business is actually fairly boring. Passive components are the basic parts of virtually all electronic products, no matter how simple or complex they may be. VPG's products are packed into a wide variety of electronic devices such as high-end audio systems, automatic testing equipment, and scales. However, applications for VPG's components go even further than that, to include waste management, military, medical, aerospace, and energy uses. VPG's products are just as likely to show up inside of a cruise missile, in deep space, or thousands of feet down an oil well.

Foil Resistors

VPG's PhotoStress and foil resistor technologies were developed in the 1950s and 1960s by Dr. Felix Zandman, who eventually founded Vishay Intertechnology, and will serve as a consultant for VPG. Although the technologies have improved over the decades, the need to measure distribution of structural stress and to control the amount of voltage and current in a circuit remain the same. In other words, VPG is vital to the function of a wide array of electronic and industrial products.

There are many kinds of resistors, which can be made from many different materials. VPG makes resistors that are much higher spec (and more expensive) than most of the competition. The market for this technology is small -- the company estimates run rate at about $200 million per year worldwide, and VPG has about a 50% market share, which has remained very steady over time. VPG has dominated this market niche for many years.

As expected for a high spec product, VPG's resistors are used in fairly demanding applications that requires precision and stability over the life of the product. The end markets tend to be things like defense, aeronautics, medical, energy, some industrials, various kinds of scientific and industrials instrumentation.

Nevertheless, these markets are somewhat sensitive to overall capex cycles and the broader economy. Accordingly, sales fell quite a bit in 2009 and thanks to unabsorbed overhead as well as commodity cost pressures, gross margins dropped from a long term average of about 49% to 41%. Demand has rebounded strongly in early 2010, and the book to bill ratio has crept above 1 again, implying that the near future will be good. Gross margins have rebounded to about 49% as well. Even in 2009, there was absolutely no pricing pressure. ASPs were just about flat for the year.

We think this is a very good business. Customers are not very price sensitive, capex needs are low, and the firm has a dominating presence. If this were a standalone business, I'd expect operating margins to be 30%. Sales cycles are relatively short at 8-10 weeks (implying not SG&A intensive). That said, organic growth is fairly low at maybe 3-5% per year.

 In the long run, there might be disruptive technologies - for example if thin film resistors improve greatly in precision and stability. But the technology gap is large enough that VPG should be safe for a while. While we are not technology experts on resistors, we are somewhat comforted by the fact that VPG has been dominant here for decades.

Weigh Modules and Control Systems

I will abbreviate the 2^nd part of VPG's business as WMCS. Basically, they sell components and systems that senses weight. Unlike foil resistors, where the most expensive product lines cost a few dollars, WMCS systems can range from a few hundred to tens of thousands of dollars. Revenues here "normalized" are probably around 60% of VPG's total revenues, but it produces a much smaller percent of operating profits. That said, organic growth rates here are higher than foil resistors. The company says 9%, we are assuming more like 6%.

These systems are used on things like cranes, trucks & other vehicles (including some aircraft), factory production lines, and scales of all types. In general, I believe WMCS is more sensitive to heavy industry and capex cycles. It also happens to have a much greater exposure to Europe. Accordingly, the business has not picked up at all from 2009.

WMCS is very different fundamentally from foil resistors. Customers are much more price sensitive, and sales cycles are much longer. VPG has to work closely with customer design teams and solutions tend to be more customized and deeply embedded in the final product. While this may be a good thing in the long run, as it stands today, sales cycles can be 1-2 years per product. Although once a design is won, it sticks for the product's entire life cycle of 8-10 years.

The market is extremely fragmented. VPG estimates that it has about a 1% market share and wants to use this segment as the primary vehicle for growth. Almost all of VSH's past acquisitions have been focused on this segment. The overall strategy has been to "move up the value chain", so far primarily through acquisitions. VPG went from making very simple strain gage sensors to making load cells, to making control systems. More sophisticated products generally yield higher margins but this has not shown up very well in historical financials.

This strategy may make sense on paper but has not been executed well. Almost all of the past 5 yrs of restructuring costs have been focused here. And the giant impairment in 2008 was due to bad acquisitions in this segment. The company has acknowledged to us that in their zeal of acquiring strategic technologies/products to fill their product lineup/capabilities, they have overpaid, especially in light of the economic downturn. They claim to have all the vital technology pieces in place today, which means they will no longer pay big "strategic" premiums in the future. But obviously, this may or may not be true. I did not get the impression that the CFO was particularly penitent about these deals.

In the "good" years of 2008 and 2007, WMCS made gross margins in the mid to high 20s. Today, thanks to unabsorbed overhead, gross margins are more like 22%. Price competition has been muted and ASPS have been just about flat (thankfully).

As the segment continues to move up the value chain, the company believes that it will achieve gross margins of about 30%. Because WMCS is quite SG&A intensive thanks to the long sales cycle, this implies a standalone operating margin in the high single digits. Today, we believe the standalone operating margin is zero or even negative.

In general, we do not believe this is a good business, though it has some potential. It's certainly possible that the company has done relatively poorly in the past because of the long sales cycles (which makes it to get a foot in the door) as it is a relative newcomer. This implies as the business grows and matures and its market position becomes more secure, the operating margin will naturally increase. This is probably the best scenario for this business.

However, with the information we have today, we assume that WMCS will be a mediocre business for some time and struggle to gain scale. We model long run gross margins in the high-ish 20's and implied standalone operating margins in the mid single digits. As a point of comparison, Metler-Toledo (MTD) is probably the best of breed in this business. It has gross margins near 50% and operating margins of between 12-15%. It will be a miracle if WMCS will approach that.

Changes Following Spin Off

I will just very briefly mention that the management team will now be incentivized with VPG shares and options as opposed to VSH. This obviously much more closely aligns their incentives. In general, options and RSUs of existing directors and officers will be converted from VSH to VPG. This is relatively unusual and is a good sign. However, overall equity exposure by this group is small.

Following the spin off, the Zandman family entities will exercise control via the class B shares. There are 12.3M common shares and 1M class B shares, with class B shares accorded 10 votes. So Zandman et al will have nearly 50% of the vote.

Operationally, the biggest thing is that VPG will ramp up the R&D budget by 40%. Currently R&;D is merely 4% of sales. So this change, if it leads to no benefits, will lead to a 1.6% drop in operating margins. However, we view this as a positive development, as the R&D budget looks very small today. This implies that we have had an underinvestment in the enterprise by legacy VSH management.

VPG has made many restructurings in the past several years. However, we think these expenses will be going away in the near future. There have been no significant acquisitions for three years, and the recession necessitated some big cuts. We think the company is fairly lean today and should benefit from positive operating leverage should the economy rebound.

The company has been acquisitive in the past. However, management has stated that they will lie low for about 1 year following independence to allow investors to get more comfortable with the story. This is a good thing has they do not have a good track record with acquisitions.

Lastly, we'll just mention that there is a very small hidden asset in the form of a valuation allowance on tax assets. The $7 million allowance is worth about 50 cents per share and it seems likely that it will be reversed as the company is structurally profitable.

Near Term Outlook and Risk - Reward

Our investment horizon is one to two years. The company's acquisitive nature is the biggest risk, in our opinion. For out thesis to work out in a major way (there is no escaping this), we would have to see a decent world economic upturn.

2010 has witnessed a strong rebound in both revenues and profitability for foil resistors, with gross margins at near 50% yet again. If this holds, coupled with perhaps a very small rebound in WMCS late 2010, we could see EBITDA of $25 million, higher than trough 2009 levels but well shy of its potential. Implied EPS is $0.74, compared to over $2 in some historical years.

If this is the case, company is trading for 3.4x EV/EBITDA, and 8.8x EV/ net income. I'll let you run your own numbers, but even in this semi-depressed scenario, we can see the stock in the high teens.

Our ballpark estimate of long term earnings power is perhaps $35M EBITDA, which translates into $1.26 per share. If the firm trades for 7x EV / long run EBITDA, we have $23 per share. If it trades for 15x EV/Core earnings, we have $23 per share as well. Even if we assume the firm wastes the entire cash balance on acquisitions, the stock is worth $18 per share.

In a blue sky scenario, the company could reach $50M of EBITDA, which is just above a previous peak and the company will benefit from a little bit from acquisitions made since then. I will not work through the valuation scenarios, but suffice it to say the result will be a multibagger.

We think the risks are quite bearable. Several scenarios would result in material permanent capital impairment.

1)      double dip recession or Europe blows up

2)      Wastes massive amount of money on acquisition

3)      Some technological innovation disrupts the foil resistor market

We think these are all acceptable risks. The super clean BS and very high quality resistor foil business gives us comfort.