Sales Coming Back But Still Not Profitable
Richardson Electronics (NASDAQ:RELL) is a “cigar butt” net current asset value stock as described by Warren Buffett’s mentor Ben Graham. In other words, the company’s market cap is below its current assets minus total liabilities. In theory, even a poorly performing company can be bought and liquidated for greater than the market price. In practice, the discount can persist for a long time, especially if there are barriers to a takeover such as the CEO holding majority voting power. This has been the case with Richardson Electronics, which I first bought in 2016 and have been covering on Seeking Alpha since July 2019. The micro-cap electronic component manufacturer operates in three business units, Power and Microwave Technology, or PMT, custom video display maker Canvys, and Richardson Healthcare. The PMT business is the largest of the three units and is subject to cyclical swings. This division last peaked in 2018 and has been on a downturn through the start of the COVID-19 pandemic. Two catalysts for the next upcycle in PMT are semiconductor wafer fab equipment and 5G infrastructure. The Healthcare division is where Richardson has been attempting to establish a less cyclical revenue source by capturing share in the replacement CT scanner tube market.
Richardson recently reported is first quarter results for fiscal 2021. While sales were higher sequentially than either of the last two COVID-19-influenced quarters, they are still down from a year ago. The company noted stronger sales to semiconductor wafer fab and 5G infrastructure, and even CT tubes. However, they were still not enough to grow overall company sales. Operating costs were about the same, resulting in a typical small operating loss of $0.6 million for the quarter. The company also posted a foreign exchange loss unlike the prior year in which they reported income. Also, with lower interest rates, Richardson’s cash hoard no longer earns much interest income. The resulting net loss was $1.1 million for the quarter, or -$0.09 per share. On the comprehensive income line, Richardson had a $2.1 million foreign currency translation gain, enough to cover both the negative net income and the dividend. As a result, book value was up slightly in the quarter to $119.1 million, or $9.01 per share, and net current asset value was also little changed at $7.22/share. At $4.57/share at close on the day it reported, RELL is 37% below NCAV and about 9% higher than it was at the publication of my last article.
On the cash management side, Richardson typically has negative cash flow in the fiscal first quarter as it pays off Accounts Payable. This year was no exception. The company also had higher capex than a year ago as they spent more on CT tube development. The resulting free cash flow was -$4.1 million, which with the dividend accounted for the drop in total cash and investments to $42.5 million.
Richardson’s PMT division’s sales of $30.2 million in the quarter are $7 million below the peak reached during the last semi fab upcycle in 4Q 2018. That quarter also marked a high point for the stock, trading just under $10/share. I believe Richardson can see a similar benefit in the next year from the current semi fab cycle along with 5G buildout, but that would only mark another cyclical top and be a good exit point for the stock. In order to be a longer-term hold rather than a trade, Richardson needs its CT tube business to grow, but it has been painfully slow and unprofitable so far. In the meantime, the company should consider some common sense measures to conserve its cash, including reducing executive salary and watching its inventory levels. While I am getting impatient for Richardson Electronics to show better results, it is performing close enough to breakeven to justify holding it as part of a deep value portfolio. I will continue to consider it a sell if the price approaches net current asset value.
Two Paths To Improvement
Richardson continues to mention the coming upswing in semiconductor wafer fab and 5G equipment sales. These have been slow to arrive, although it actually is reasonable to blame the pandemic for delaying the cycle. PMT sales were 5% below 1Q 2020 but above each of the last two fiscal quarters. Sales are growing in these areas but not yet quite enough to grow the overall division. As always, CEO Ed Richardson spoke optimistically about the semi fab market on the call while acknowledging its cyclicality.
The one thing that is really encouraging and it’s up and down like a roller coaster, but the semiconductor wafer fabrication business is the largest portion of our business and it was up substantially in the first quarter. And we’re being told that next year in the semiconductor wafer fab business will be the highest in history. And if that’s true, that will have a major impact on our total sales.
Source: CEO Ed Richardson, 1Q 2021 Earnings Call
Division head Greg Peloquin was similarly optimistic on the 5G market while recognizing the delay from the pandemic.
And looking specifically at 5G and wireless sales, revenues increased double digits in the quarter. As the need continues to grow for people to work from home, the city, the country, their cabin, even their car, as they must be able to receive large amounts of data from any of those locations quickly.
The consensus in the market is that COVID-19 will still affect the 2020 forecast for 5G. Due to supply chain issues, manufacturing and design delays resulting from the pandemic has pushed some of the rollouts out. However, the infrastructure side where we play will show strong growth in 2020 and into 2021.
With growth in these two areas post-pandemic, PMT should be able to do $35 million per quarter in sales if not reach the $37.2 million that they did at the last semi fab peak in 2018. This could be good for a bump in the stock price up to at least NCAV as we saw in 2018.
Source: Seeking Alpha RELL chart page
Nevertheless, the semi fab cycle and 5G buildout will not last forever, so RELL would be considered a sell on positive market reaction to growth in these areas. Richardson needs to deliver on its goal to expand CT tube sales in its Healthcare division for the stock to be more than a trade. Unfortunately, progress to date does not inspire confidence.
After a couple years of development and testing, Richardson released the ALTA 750D tube in 2018. This tube is marketed as a replacement tube for a Toshiba (OTCPK:TOSBF)/Canon (NYSE:CAJ) CT scanner. As shown in the 2018 price guide on this page, a replacement tube from the OEM could cost $180,000, while a new aftermarket tube such as Richardson’s was quoted at $95,000. As I discussed in earlier articles, many customers had scanners that used both this tube as well a newer version, which Richardson calls the ALTA 750G. These customers wanted to be able to purchase both types of tube from Richardson. I’m not sure what prevented Richardson from recognizing this earlier and having the 750G available, but it is now in beta testing and expected to launch in the first half of calendar 2021. (This is a delay from the last half of 2020 that the company had discussed in prior quarters.) Richardson may be progressing down the learning curve as they also currently have two other tubes in development for launch later in 2021, according to the latest conference call.
The pandemic was an impediment to Richardson’s marketing efforts and hospitals’ interest in changing CT tube suppliers, but the company noted that they had higher ALTA 750D sales in 1Q 2021 than any other quarter except for 3Q 2020. While that sounds promising, Richardson Healthcare’s total sales this quarter were $1.8 million. That would be a maximum of 18 tubes at $100,000 each even if they had zero sales of other products. Richardson believes they can manufacture 1,000 tubes per year with their current facilities, so the current run rate of <72 per year is far below potential. Richardson Healthcare’s gross profit in the quarter of only $0.1 million also indicates that they need much higher sales to cover manufacturing and development costs and reach the 40% gross margin goal that division head Wendy Diddell has quoted in the past.
Below, I model a typical recent quarter with $30 million in PMT sales and $10 million sales in Canvys plus Healthcare. The slightly negative EPS is in line with actual results, ignoring some minor impacts from interest and taxes. You can see that, at peak PMT sales of $35 million per quarter, the company would be profitable enough to justify a share price well above book value if only those conditions could be expected to persist. Unfortunately, the cyclicality in PMT prevents this. I then show results assuming mid-cycle PMT sales, but with sales of 200, 500, and 1,000 CT tubes per year at a gross margin of 40%. At 200 tubes per year and earning $0.43 per quarter EPS, RELL would be well above book value at a P/E of only 10.
Ed Richardson noted on this quarter’s conference call that he expects the CT tube business to be breakeven in three years, so it would take them even longer to reach their production capacity. This tells me that the stock can be a speculative play on greater PMT sales like it was in 2018, but remains far from delivering its goals on CT tube sales.
How To Buy Some Time
Richardson is relying on its cash hoard to carry it through until CT tube sales are a significant profit driver. The company should be taking other measures to conserve cash to preserve it for shareholders. For example, the proxy statement shows Ed Richardson earned a salary of $795,690 in fiscal 2020. This is high for a CEO of a company the size of RELL. The fact that this salary comprised 70% of Ed’s total compensation is also out of line with most CEOs who have a much higher percentage of performance-based payout. Even cutting this in half would add $0.03 to EPS, which is a large chunk of the shortfall to breakeven in recent years. Ed also earns $445,000 per year in dividends on his 2 million RELL.B shares. While the pay policy is brought up frequently in earnings calls, most recently by Seeking Alpha contributor Harry Sauers, I unfortunately expect no change as long as Ed remains a controlling shareholder.
Inventory has also been a large consumer of cash, including a $1.6 million build in the last quarter. Days of inventory have been growing considerably over the last two years.
Ed’s response to me on the conference call was that this is mainly pre-build for anticipated 5G and semi fab sales growth:
As you may know, when we sold RFPD to Arrow, that business was $370 million in sales. And Greg ran it and went to Arrow for three years and has come back to help us build the business again. It’s doing quite well and increasing the business 15%, 20% a year. And it takes additional inventory to do that, particularly products like for 5G, a lot of them are on allocation and then we try to buy in well in advance, so that we have inventory to service that business. So some of the inventory is there and some of it has to do with the increased semiconductor wafer fab business.
If sales recover to their 4Q 2018 rate, the current inventory level would represent 185 days coverage, better than today, but not back down to where it was in 2018. This pre-build can be understandable to avoid stock-outs, but carries the risk of inventory becoming obsolete if not sold. Actual inventory write-offs have been fairly steady at 0.4% of inventory per quarter except for the last two fiscal fourth quarters when it spiked closer to 1%. Avoiding these incremental write-offs could save Richardson around $300,000 per year, and getting back to 2018 levels would generate $10 million of cash flow if the inventory is not rebuilt.
With all these criticisms, it may seem strange to maintain a Bullish rating on Richardson Electronics. Given its debt-free balance sheet and ability to come close to breaking even, I still consider the downside to be limited at 63% of NCAV. The potential upside from the semi fab cycle and 5G buildout is credible enough, given how the company and stock performed in 2018. RELL is a speculative buy based on a short-term improvement in PMT sales.
Richardson is betting the long-term future of the company on CT tube sales, and that is a much riskier bet, given the experience so far. I would like to see much more improvement in this area before considering RELL as a long-term hold. More careful inventory management and CEO pay aligned with performance would also be needed for the company’s long-term health.
Disclosure: I am/we are long RELL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.