Pro-Dex Should Have Another Good Year

Pro-Dex (PDEX) appreciated 93% in 2016 and I think they’ll have another good year in 2017 (though not as good as 2016). In February 2016, Nate Tobik published a PDEX write-up of mine in his Oddball Stocks Newsletter. While the stock has advanced faster than expected, the thesis hasn’t really changed so I’ve copied the entire write-up below. There are a few notable updates from the past ten months:

1. Their new #1 customer (referred to as project #1 in my write-up) signed a $24 million purchase order to be split between 2017 and 2018. Quite significant for a company that did $13.4 million in sales in 2015. This will be the catalyst for quarterly sales to ramp from the current run-rate of ~$5.3M up to $7M+ in 3Q17 (which ends March 31, 2017).
2. Their acquisitions haven’t gone as smooth as they hoped so they stopped M&A for the time being. With that being said, each segment is trending in the right direction. In the most recent quarter, the three small segments (ESD, Fineline Molds, OMS) made money for the first time. These had previously been dragging company results down. Margins in the core Pro-Dex business have also been trending up as they continue to work through some manufacturing inefficiencies discussed below.
3. Their production facility is only at 40-50% capacity so there’s a long runway for growth before major capex expansion is needed.
4. There are a couple potential new projects in various stages. As you can see below in my write-up, management is pretty tight-lipped on how large the projects they’re working on could be. This means estimating future revenue requires a lot of educated guessing. Suffice to say, there should be one or two new product launches in 2017 and I expect them each to be worth a couple million per year in revenue.
5. They’ve continued to repurchase shares.

In summary, even though the stock has appreciated faster than expected, the business has continued to grow and the future looks even better than I predicted ten months ago. I expect 2018 revenue to be in the ball park of $33 million. Here is my original write-up from February 2016:

Pro-Dex manufactures devices for medical OEMs. Previous management did not do a great job running the company and two activist investors, Nick Swenson and Ray Cabillot, won a proxy fight in early 2013. The turnaround has taken a couple years, but with five new projects in the pipeline, 2017 revenue should nearly double from 2015 levels. The company is tiny ($10 million market cap) with average daily trading volume that ranges from $15k-$30k.

Business overview

Pro-Dex (PDEX, $2.32) is a contract manufacturer that produces devices mainly used in the medical industry. Medical OEMs that don’t want to produce their own devices (or don’t have the capability) will hire Pro-Dex to do it for them. Sometimes Pro-Dex is strictly a third party manufacturer, but often they’re more involved with design and they even own the intellectual property in some cases.

The sales cycle for medical devices can be quite long. As an example, one of their largest projects ever was launched in the 4th quarter of fiscal 2015 (FY ends June 30). Pro-Dex originally started courting this customer in mid-2011 which led to an option agreement in December 2012 and a manufacturing agreement in early 2013. It took another two years for revenues to start flowing.

Because of the long sales cycle and lumpy results, Pro-Dex has started to branch out via some small acquisitions and investments. As a manufacturer with underutilized capacity, it makes sense to acquire other small manufacturers and gradually fold them into their own plant to increase utilization. Below are the acquisitions and investments they’ve made:

1. They launched an Engineering Services Division (ESD) in 2015 where they consult with companies that are seeking to hire contract engineers. This is still very small, but in the first quarter of 2016 ESD had $109k in sales, $68k in gross profit and -$24k in operating income.
2. Huber Precision was purchased for $209,000 on December 1, 2014. Huber manufactures parts for the oil and electronics industry and has “a good run-rate, a good positive cash flow and a good customer list which is our primary interest” (4Q14 conference call).
3. Fineline Molds was purchased for $757,000 on February 1, 2015. Fineline manufactures plastic injection molds and had 2015 revenue of $257,000. In the 8 months of results since purchase, Fineline has $520k revenue, $70k gross profit and -$61k operating income, in addition to possessing $962k in assets, no liabilities and a $502k backlog.

Medical device contract manufacturers have two big positives inherent to their business: high switching costs and they’re recession resistant. It’s a lot of work for an OEM to either switch to a different manufacturer or to bring the manufacturing in house. This is one reason the sales cycle is so long—an OEM has to be very thorough in choosing the correct partner because they know they’re stuck with them for a long time. In addition, the medical field is notorious for being one of the most resilient industries when it comes to economic cycles. People get sick and need medical care no matter what the economy is doing.

Industry overview

Contract manufacturing in the medical industry is highly competitive. There are a handful of large companies, but most of the industry is made up of several thousand small companies similar to Pro-Dex. These companies also compete with their own customers. If a customer can in-source the manufacturing for cheaper than what they pay Pro-Dex to do it, they will.

Fortunately, the above is not too common. Most small and medium-sized OEMs don’t have the capital to in-source production. Even large OEMs often prefer to outsource because it can be cheaper and can accelerate time-to-market. Manufacturing is also capital intensive and not the core competency of these medical OEMs; they make their money through product development and marketing, not manufacturing. As the medical device industry becomes more competitive and price-sensitive (thanks to things like the Affordable Care Act), manufacturing efficiency becomes more important to these OEMs. The flip side is the federal government’s focus on decreasing the healthcare budget may trickle down to decreased margins for contract manufacturers.

One of my first concerns when looking at this industry was “why isn’t all this manufacturing sent overseas for cheaper labor?” While I won’t deny this is a concern, much of my worry subsided after more research. Many OEMs see increased risks associated with hiring an overseas manufacturer. When an OEM hires a company like Pro-Dex to produce their highly complex medical device, it is more like a long-term partnership than it is a traditional client/supplier relationship. OEMs see a lot of value in being close to their manufacturer—both so communication is easier (similar time zone) and so they can visit and audit the facilities on a regular basis. Engineering issues are not uncommon in the production of these devices, so being “down the street” from each other results in quicker fixes and thus quicker time-to-market. The OEMs that do outsource overseas are often doing so to have better access to those local markets, not cheaper labor.

A minor tailwind inherent in the industry is the ever-aging population of the United States. As people get older they need more medical care and thus the demand for medical devices will slowly increase over time.

Background

A brief background on how Pro-Dex got to where they are today is important to the story. In Q2 2010, Pro-Dex received notification from their #1 customer that they were bringing the manufacturing in-house. This customer accounted for 30.9% of revenue in FY 2009 ($6.5M out of $21.1M total). It ultimately took this client until early 2012 to transition the manufacturing to their own facilities. In the mean time, they increased purchases from Pro-Dex to build up their own inventory. In FY 2011, this client purchased $12.3 million from Pro-Dex (which accounted for 45.3% of total revenue).  What did the board and executives do? Reward themselves handsomely of course. Management compensation shot up in 2010 and 2011 thanks to temporarily improved results. After the customer left, the company promptly went back to losing money hand over first in 2012 and 2013.

In mid-2012, two activist investors, Nick Swenson of Groveland Capital and Ray Cabillot of Farnam Street Capital, started a proxy fight that they eventually won in 2013. They immediately fired the previous CEO, cut excessive R&D, slashed director and executive pay, and replaced the entire board. The board now consists of Swenson and Cabillot, Will Farrell (former Medtronic exec), David Hovda (CEO of a private medical device company), and Richard Van Kirk (current CEO). The directors earn $200/meeting (audit chair makes $23k/year) and that’s it. Safe to say they’re running this company for long-term share price appreciation and that’s it.

New management

Swenson owns 21.6% of shares, Cabillot owns 12.8%, and each of them was purchasing shares around current prices on the open market in the fall of 2015. Together they own 34.4% and are clearly the ones running the show. I don’t know much about either investor but they’ve clearly had a large positive impact since coming onboard. Swenson was involved in another company I owned a while ago called Air T, Inc (AIRT) and I was happy with what he accomplished there.

Richard Van Kirk was named CEO in January 2015 so there’s not much to go on here. He joined the company in 2006 as VP of Manufacturing and was promoted to COO and now CEO. He owns 68,942 shares (mostly options that should vest) that are currently worth $160k. His salary is $205k and both his short-term and long-term incentives are completely based on reaching threshold cash flow levels and then growing cash flow year-over-year.

Catalysts

The major catalysts over the next 1-2 years will be new projects that the market is not accounting for. In total, there are five projects that have either just recently launched or will be launching over the next few quarters. The first full year that all these projects will be live is 2017 which is why my valuation is based on 2017 numbers. Each project is described below.

Project #1 (surgical handpiece for orthopedic surgery) launched in Q3 2015. They sold $400k of product in that quarter and $1.1M in Q1 2016 “to build inventory.” Don’t know many details here.

Project #2 (surgical screwdriver) launched in June (Q4 2015). The development contract was entered into in FY 2012 and completed in Q4 2015, allowing them to record $336,000 in non-recurring engineering service revenue. They also manufacture a different surgical screwdriver, but this is a newer model. Importantly, this new model is not cannibalizing previous sales. As a side note, all of these projects are difficult to estimate future revenue for. This uncertainty is probably a major reason the stock is so cheap right now. Looking at past projects they’ve done can give a ballpark to help estimate these new projects. For this one, I use $500,000 annual revenue for the bear case, $1 million for the base case, and $1.5 million for the bull case.

Project #3 (contract manufacturing job) launched in Q2 2016. The development contract was entered into in FY 2013 and completed in Q2 2016 (will be in next quarterly release this month). From the 2015 shareholder letter: “Purchase orders already in-house for this product will make this valuable customer our largest in terms of annual revenue.” So this is soon to be their largest customer, what’s that worth? Pro-Dex sold $6.6 million to their current largest customer in FY 2015, but that customer already decreased 2016 orders by $1.6 million (meaning they’ll buy $5 million in 2016). Their #2 customer in 2015 accounted for $1.2 million in sales. IF this contract manufacturing job is for their #2 customer AND Pro-Dex is accounting for the $1.6 million decrease in orders by their #1 customer, then this contract manufacturing job should be worth a minimum of $3.8 million per year. Note the conservativeness of this estimate though. If this contract manufacturing job is for a smaller current customer (or not a current customer at all) the contract would have to be bigger to leapfrog them into the spot of largest customer. If management was not accounting for the $1.6 million decrease by their current largest customer (maybe they were referencing 2015 numbers), this project will also be larger than I estimated.

In addition, the former CEO, Hal Hurwitz, posted on his LinkedIn page under things he accomplished at Pro-Dex: “Negotiating new development and supply contracts. Result: Led the winning effort for the largest competitively bid contract in Company history.” Based on the time line of events, I am confident he is referencing this contract manufacturing job. The largest single project I can find in their past was around $3 million per year which lines up well to my estimates above.

Project  #4 is “coming online by the end of [calendar year 2015].” The development contract was for $500,000 and was entered into in Q4 2015. $500k is the largest development fee I can find in their history, though I’m unsure how much the development fee eventually correlates to annual revenue. If I go solely off past development fees and resulting annual sales, I’d estimate this project to be worth at least $4-5 million. That seems aggressive though so I use $2-3 million in my valuation.

Project #5 is “expected by the end of [fiscal year 2016].” This project was just announced and no other details have been released. I put $1 million for 2017 revenue which would be a fairly small project.

Supporting the above claims is the company’s growing backlog. It has now increased sequentially five consecutive quarters and currently sits at $14.2 million. Another potential catalyst is a buyout from a larger medical device company. Mergers and acquisitions have greatly increased in this space over the past couple years. A contract manufacturer having strong relationships with an OEM is very attractive to potential acquirers. After healthcare reform and an excise tax increase on medical device sales, companies are finding they can consolidate manufacturing to increase margins and get back some of that lost income. Just in 2014 there were 48 medical device manufacturers acquired.

Risks

The biggest risk in my eyes is customer concentration. In FY 2015, the largest customer accounted for 49% of sales while the second largest was 9%. This concentration will moderate as the new projects ramp up (and the #1 customer decreases 2016 purchases by $1.6 million as previously described), but high levels of concentration will remain. Even in my 2017 pro forma numbers below, the biggest customer is still around 20% of sales. Customer concentration is a little safer in a company that has high switching costs, but there’s always the possibility of an OEM in-sourcing the manufacturing like their previous #1 customer did. The only good thing here is how long it takes an OEM to transition to their own manufacturing (over two years last time). If this happened again, I’m confident new management would put more effort into replacing the lost revenue than old management did.

Another negative of this business is Pro-Dex has no say over the end user demand of what they produce. If an OEM experiences decreased demand, they can increase marketing, hire more salespeople, do market studies to find out what’s changed, etc. Pro-Dex sales are completely dependent on how successful their OEM customers are at selling the products.

Valuation

Valuing Pro-Dex requires a lot of educated guessing. Management isn’t very forthright about guidance or future projections (they don’t even do conference calls), so a lot of my numbers are based on looking at past project sizes and margins and estimating how the new projects will unfold. While I wish it were more precise, I’m confident the potential positive outcomes far outweigh the negative ones. As a reminder, in the catalysts section above I justified my future revenue numbers for each new project. The numbers for their three small segments (ESD, Fineline Molds and OMS) are estimated from recent sales which I think is a gross simplification. ESD was launched in 2015 and Fineline Molds was purchased in 2015; I fully expect these to grow by 2017. The line “Other revenue” is 2015 sales minus the #1 customer minus $1 million for the surgical handpiece (I wanted to break those out separately). Altogether, I’m assuming zero growth anywhere in the company besides the five new projects. In my bear and base case, I also assume the current #1 customer continues to decrease orders in 2017 which is far from a guarantee.

Pro-Dex won’t be paying taxes anytime soon thanks to $9.5 million in off-balance sheet net operating losses. Operating expenses are simply SG&A + R&D (which I have increased 35% from TTM). Therefore, valuation is almost entirely dependent on total revenue and gross margin, which I haven’t discussed.

In the past, gross margins were in the low-to-mid 30s. On the Q2 2014 conference call, then-CEO Hal Hurwitz stated long-term normalized gross margins should get back to the mid-30s. Currently, gross margins are depressed as they work through some inefficiencies with manufacturing of their new projects. It’s also important to remember their manufacturing facilities are underutilized (more precise capacity numbers will be in their next 10-Q) so future revenue should have higher margins. Management has repeatedly stated under-absorbed manufacturing costs as one of the main causes of decreased margins. I’ve tried to be conservative in the above valuation with respect to gross margin—using 28%, 30% and 32%—but it could grow higher than that. To give you an idea of the potential, slapping a 35% gross margin on the base case would value the shares at $8.37; on the bull case it boosts the price to $11.14. It probably goes without saying that a 12x multiple on a company that achieves this growth is a conservative assumption as well.

Finally, remember in 2014 that there were 48 medical device manufacturers acquired. Of the seven that released numbers, the median sell price was 1.8x EV/sales and 8.2x EV/EBITDA. Using my 2017 base case, these EV/sales and EV/EBITDA averages would value Pro-Dex around $9.50/share and $3.50/share, respectively.

Do I think things will go perfectly? Of course not, but between the five projects they’re ramping up and margins that are currently depressed, there’s multiple ways we can win. As a reminder, their fiscal year ends June 30 so the above 2017 estimates are actually closer to 1.5 years away. If the base case is even close to the actual results, the IRR on this investment is going to be well over 50% by fiscal yearend 2017.