Frank Voisin writes about value investing topics at http://www.frankvoisin.com
Pro-Dex, Inc. (NASDAQ: PDEX) designs and manufactures a range of power and control products including powered surgical devices, multi-axis motion controls, and custom motors. The company’s products are sold under the Micro Motors, Astromec and Oregon Micro Systems brand names. Approximately three quarters of revenues are derived from the medical and dental industries.
PDEX trades for about $7.4 million, yet has $3.6 million in net cash and generated $3.2 million in operating income in the last twelve months. Furthermore, the company has generated an average of $1.4 million in free cash flow over the last five years, which amounts to a 37% free cash flow yield on an ex-cash basis. Quite impressive, so let’s take a closer look.
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Let’s start with historical returns.
The company’s historical returns have been relatively lackluster, but not the difference in the last two years between the company’s CROIC (which is based on cash flows) and its income statement (and thus accrual based) returns. This is due to non-cash impairments. This doesn’t worry me. Although I am not impressed with the company’s historical performance, I do like the improvement over the last few years, especially on a cash basis. If this is sustainable, then PDEX would certainly be too cheap at these prices.
Here we see that the company has enjoyed growth in revenues for several years, and that margins have recently rebounded closer to long-term averages. The operating and net margins are affected by impairment charges, that should be complete now. Let’s look at the more important figures: cash flows.
Over the last five years, the company has had strong cash flows from operations, accompanied by strong free cash flows (except for 2008). Recall that this is in relation to a market cap that is just $3.8 million net of cash. In this context, to earn free cash flow of more than $1 million in a year is great, and to do so consistently for five years is truly exceptional.
Here we see the company’s cash balance growing and debt declining. The company is now operating with its highest net cash balance.
Part of the free cash flow has been generated by consistent improvements in the company’s cash conversion cycle, particularly inventory management that has allowed the company to free up more than $1 million.
So with strong (recent) performance, lots of cash and great free cash flows, should we be buying PDEX? No. The company’s performance is almost certainly going to degrade and quite substantially, all in the next year.
PDEX generates 40-45% of its revenues from a single customer, and a further 15-20% from the next largest customer. Unlike other companies with highly concentrated revenues, this is not just a theoretical risk in PDEX’s case, as the following note from its 10-K reveals:
[I]n December 2009 our largest customer (the “Customer”) informed us that it was in the process of developing, and planned to eventually manufacture, its own surgical devices which are functionally comparable to the products the Company currently provides to the Customer. …
On June 21, 2011, the Customer indicated that it planned to purchase all of the products it currently has on order with us for Products A and B but did not plan to place any new orders with us for these products. The Customer currently has orders of (i) $793,000 for Product A scheduled for delivery through September 2011 and (ii) $4,169,000 for Product B scheduled for delivery through April 2012.
In addition, the Customer indicated that it plans to limit repair requests from us to those Products A and B that are covered by our product warranty, thus most likely nearly eliminating repair revenue (for out-of-warranty products) for us.
Based on the foregoing, it is probable that revenue otherwise attributable to this Customer will begin to decline during the first half of fiscal year 2012 and could decline to zero or a negligible amount by the end of fiscal year 2012.
This is a good example of what can happen when a company is overly reliant on a small number of customers. The loss of this customer is sure to deal a significant blow to PDEX’s results next year, when 40-45% of revenues disappear.
There is a possible bright side. The loss of this customer will allow the company to free up a significant amount of inventory (assume 40 – 45% of the current $3.7 million, or say $1.55 million). Also, some portion of its Accounts Receivable will be received and not replaced as its largest customer pays the company, freeing up perhaps 40 – 45% of the Accounts Receivable (say $1.3 million). There are a few important assumptions here (e.g. the company does not break out the percentage of A/R attributable to this customer), but in this simple scenario, we could see $2.85 million of cash freed up. This is relative to a market cap net of cash of $3.8 million.
The net difference would be $1 million. For $1 million, a purchaser would be getting assets currently carried at $1.7 million and the operations would be thrown in for free. The question is whether the company can manage to break-even after losing 40 – 45% of its revenues. This will depend largely on management, and its willingness to make the necessary cuts to accommodate a much smaller customer base.
One more thing worth noting is that despite the loss of this customer, the company currently has the largest backlog in its history, at $14.3 million. This is up nearly a third in the last year.
What do you think of PDEX?
Author Disclosure: No position.