CDW Holding A Net-Net, But Capital Allocation A Question by SG, The Value Edge
CDW Holding Limited (SGX:D38) (OTCMKTS:CDWHF) is a Japanese-managed precision components specialist serving the global market focusing on the production and supply of niche precision components for mobile communication equipment, gamebox entertainment equipment, consumer and IT equipment, office equipment and electrical appliances. Being a reliable outsourcing partner with Japanese precision, CDW Holdings has grown from a private trading company in Hong Kong back in 1991 to what it is today.
Before I begin my analysis, all figures are in USD.
The company is split into 3 business divisions, namely LCD Backlight Unit, LCD Parts & Accessories and Office Automation, with the LCD Backlight Unit being their core business segment taking up two-thirds of their revenue. Within their LCD Backlight Unit, it can be further split into two segments – Backlight Units for Handsets (mainly smartphones) and Gamesets (including digital cameras and global positioning systems for automobiles). While their LCD Backlight Unit is their core business segment, the company is focused on the production of backlight units for gamesets compared to handsets.
Over the years, the company has been performing relatively well, keeping gross profit margins consistent yet increasing their net profit margins. This reflects how management has been effectively managing operating expenses through methods such as vertical integration, evident by the recent acquisition of Mt Wuxi. In FY2013, we observe the dip in revenue due to their major customer starting to wind down orders for phased out products. In terms of the LCD Parts & Accessories, we see sales declining by approximately 40%, which is the main reason for the 10% decrease in revenue. The LCD Backlight Unit remained relatively stable due to their major customer releasing new models and maintaining order volumes in 2H2013. While for the Office Automation, their smallest division recorded a 4.1% increase in sales. This is attributable to the company restructuring this division, consulting with their customers, eliminating loss making products and commencing production of higher margin and profitable ones. While gross profits have declined in FY2013, net profits remained relatively stable due to 2 one off gains – disposal of the Suzhou Plant and the USD2mn gain on the acquisition of Mt Wuxi.
(II) Balance Sheet & Cash Flows:
CDW Holding Limited (SGX:D38) (OTCMKTS:CDWHF)’s balance sheet is relatively clean with minimal debt, with cash increasing year on year. As of 1Q2014, the company’s cash position has increased to USD64mn, increasing its net cash position to USD55mn, a 2.3% premium over its market capitalization. Given how management has been quite ambiguous regarding who their major client is in their Annual Reports, the cash conversion cycle might be something that we have to pay close attention to. However, as of date, I do not think there is anything to worry about.
(III) Financial Ratios:
Gamesets being the company’s key revenue driver is heading downwards and it might not be something temporary given how the technology landscape is changing. From the images on their website, I am assuming that one of their customers would be Nintendo Co., Ltd (ADR) (OTCMKTS:NTDOY) (TYO:7974) and we all know that Nintendo isn’t the Nintendo of the past anymore. Days where every kid owned a GameBoy or what they call Nintendo 3DS now is no longer relevant today. Today, we see strong competition such as tablets and smartphones taking over the role of gamesets be it in terms of Gaming/Camera/GPS. Looking at Nintendo, not only has their projections been off lately, they have been way off. Nintendo’s prediction of 18mn 3DS handhelds fell short of actual sale of 12.24mn, reflecting the declining of such gaming products.
“We already witness the effects of changing consumer behavior in the technology space. With advances in smartphone technology and increasing consumer preference for smartphones over other handheld devices for gaming, photo-taking and global positioning capability, the demand for gamesets is on the decline…we do not think the reduced orders for gamesets is simply temporary but indicative of a larger, permanent trend,” an abstract from AR2013.
Tracking the production of Backlight Units for both Handsets and Gamesets, it is indeed true that the production of gamesets have been on the downtrend, while handsets have been slowly growing. Additionally, it is important to note how production is greatly skewed towards the production of gamesets.
(II) Economic Moat:
Looking at the consistency in gross margins, I would say that the company enjoys a relatively sizable economic moat. Furthermore, with only a 3% swing between the high and low gross margin values, it is a relatively tight range, showing how the company is able to maintain its relationships with her customers and suppliers.
Furthermore, in terms of production of gamesets, they are a key supplier in the wake of the reduction in number of suppliers, as abstracted from AR2012. While the gamesets are on a downward trend, it is still evident that the company commands a strong economic moat in withstanding competition, economic cycles and maintaining itself.
At the current market price of SGD0.143, which translates to USD0.113 the company is definitely trading at low valuation multiples. With a P/E Ratio of 4.72, EV/EBITDA of -2.12 and normalized FCF yield of 13.6% definitely does indicate that the company is undervalued. Furthermore, if we were to base our calculations of Graham’s version of net-net, the company would fulfil it as well.
CDW Holding Limited (SGX:D38) (OTCMKTS:CDWHF) is an undervalued company backed with solid financials and fundamentals. However, the company has not indicated any plans on how they plan to tide through this difficult period, especially how it is not a temporary issue. Putting myself in management shoes, I would start focusing more capital in strengthening my production of backlight units for handset, given the current growth in the smartphone industry. However, I am no expert with regards to this and perhaps it is more complicated than just strengthening their production but difficulty in supplying to companies on the scale of Samsung Electronics Co. Ltd. (LON:BC94) (KRX:0059935), Apple Inc. (NASDAQ:AAPL) and Xiaomi. Given how such key concerns not being addressed, at current prices, it does not offer a wide enough margin of safety for us to invest in it.
Disclosure: The authors have no vested interest in D38.SI