Frank Voisin is the author of the popular value focused website Frankly Speaking, found at http://www.FrankVoisin.com
Digital Power Corporation (AMEX:DPW) manufactures high-grade customized power systems used by the medical, military, telecom and industrial markets. These power systems facilitate power conversion, distribution, inversion and provide uninterrupted power. In March, the company was trading for around $13 million but as of the time of writing (mid May) the company is now down to just $9 million. Moreover, the company has $1.78 million in cash and $0.48 in securities and no debt, resulting in an enterprise value of just $6.74 million. Over the last four years, it has earned on average $0.51 million and generated free cash flow of $0.46 million.
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There are a few things I like about the company. For one, unlike many companies of this size DPW does not rely on any single customer; of its approximately 200 customers, none account for more than 10% of revenues. This should provide it with more stable revenues. Another thing I like is that the company outsources all of its manufacturing to contract manufacturers which allows it to focus on high value design work while maintaining flexibility in its cost structure, which should help it to maintain profitability during weak sales cycles.
Unfortunately, there are many things to worry about here, the biggest of which is the company’s relationship with Telkoor Telecom of Israel, which owns 43.09% of DPW, making it the company’s largest shareholder. This on its own would not lead to much of a concern, but as you dig into the company’s filings, you see more and more connections that lead one to wonder how separate the two companies are.
First, the Chairman of the Board of DPW, Ben-Zion Diamant, also the CEO of Telkoor! Given the nature of the relationship between the two companies (discussed below), this creates a scenario fraught with conflicts of interest.
Second, DPW and Telkoor have what DPW calls a “strategic alliance” for providing military power products. This means that DPW purchases products manufactured by Telkoor for sale in the military segment. In 2011, DPW purchased $2.6 million worth of these products, which is significant for the company. DPW says these sales are made at prices no less favourable than if DPW were an independent third party, but unfortunately fails to provide any details that would allow one to confirm this. Given the relationship between the parties, the company should, in the interests of transparency, provided greater details.
Third, In 2010, DPW purchased $0.48 million worth of intellectual property from Telkoor:
On August 25, 2010, we and our wholly-owned subsidiary, DPL, entered into an agreement with TPS, a wholly-owned subsidiary of our largest shareholder, Telkoor, of which Mr. Diamant is the Chief Executive Officer. Pursuant to such agreement, (1) TPS sold, assigned and conveyed to DPL all of its rights, title and interest in and to the intellectual property associated with the Compact Peripheral Component Interface 600 W AC/DC power supply series (the “Assets”) and (2) DPL granted to TPS an irrevocable license to sell the Assets in Israel on an exclusive basis. In consideration for the purchase of the Assets, DPL has paid TPS $480,000. The consideration for the license provided to TPS to sell the Assets in Israel is a royalty fee of 15% of TPS’s direct production costs of sales, due on a quarterly basis.
Though this amount does not appear significant, keep in mind that this is near the company’s four-year average earnings and free cash flow. There is no evidence provided to suggest either way whether this was a fair price or how it was arrived at. As a shareholder, I would want to know these things.
Fourth and perhaps most concerning is that DPW purchased 1.14 million shares of Telkoor, representing 8.8% of the company. According to the DPW, these shares were purchased at NIS 3 which is oddly 21% higher than Telkoor’s closing price on the transaction date, June 16, 2011 (source). No explanation is given for the premium. Here’s the company’s rationale for the transaction from its press release:
This transaction was made by Digital Power’s wholly-owned subsidiary, Digital Power Limited. As a result of the transaction, an existing manufacturing agreement between Digital Power and Telkoor will be updated and extended. In addition, subject to the approval of its board of directors, Telkoor intends to consider the appointment of Amos Kohn, President and CEO of Digital Power, to its board of directors, and intends to consider a policy for the payment of dividends to shareholders.
Commenting on the transaction, Amos Kohn, President and CEO of Digital Power Corporation said, ”We are pleased to report this acquisition of Telkoor’s shares. This transaction will tighten our existing business relationship and strengthen the synergy between the two companies. It also will secure Digital Power’s access to technologies and products that are developed by Telkoor. This transaction is the first step in Digital Power’s strategic collaboration plan as a leading provider of power solutions for our markets.”
So in order to extend the manufacturing agreement between the parties, which gives DPW prices that are no less favourable than an arm’s length party, DPW had to buy 8.8% of Telkoor. Oh, and Telkoor agrees to consider DPW’s President for its own board, and to consider paying a dividend.
Does this strike you as a satisfactory reason for the purchase (let alone the apparent premium)? Me neither. Overall, I don’t like what I see. There is no way to separate the two companies to determine whether the dealings between them are fair and there are too many questionable arrangements to ignore.
What do you think of DPW?