Deswell Industries (DSWL)


Stock Price: $2.62
Market Cap: $42 million
Enterprise Value: $27.7 million
Thesis:
Deswell Industries is a micro-cap EMS manufacturer with an extremely poor following. The company does not hold earnings calls because they want to convey to investors that they are a long-term oriented company. Because of this, they also changed their reporting from 4x a year to 2x.

I believe the opportunity in this company lies in its improving fundamentals and business operations, and because of the margin of safety established by it trading at a severe discount to book value. I have defined in the valuation section that I believe this company to be a “quasi net-net.” Therefore, it follows that the catalyst is sheer value itself. Though buybacks are unlikely to occur in the near future, and hostile takeover attempts are blocked by the concentration of management’s held shares, the firm may consider selling the business if an acquirer offered a price equal to book value.

Business Overview:
Deswell is a manufacturer of injection-molded plastic parts and components, electronic products, and subassemblies, metallic molds, & accessory parts for OEMs and contract manufacturers. Products include plastic components for power tools, outdoor equipment, flashlights, telephones, paging machines, projectors, alarm clocks, toner cartridges, AC, ventilators, remote controls, baby products, medical products, and automobile components.

Deswell is characterized by a passive foreign investment company corporate structure. However, it generates all of its revenues from sales of product that it manufactures. It has a main facility in Dongguan, Guangdong Province, PRC.

Going forward, Deswell’s strategy is to focus on capturing the growing China market by reducing its proximity to its supplier base and customers. It also seeks to improve its manufacturing efficiency by reducing its employee base and turning to plant automation and upgrades. This will increase precision in the manufacturing process and reduce labor costs.

Customer Information:
Deswell’s sales are heavily concentrated in its five largest customers which make up over 45% of total revenues. Its largest customers are Vtech Telecommunications (slightly less than 10% of sales), Lenbrook Industries (11.5%), Loud Technologies (10.2%), an unnamed customer D (12.5%), and an unnamed customer E (11.1%).

Their largest customers are companies such as PZ ProAudio, NAD Audio, and Loud Technologies. Many of the audio brands featured in the music store Sam Ash are ones that Deswell manufactures parts for. In addition, Deswell manufactures molds for companies such as Lexmark (ink printers), Emerson (landline phones), and VTec Telecommunications (landline phones).

Some of their largest customers will stay with the company year after year, but others will come and go. By the nature of the business, they hold shorter-term contracts ranging from 6-12 months. The business is not long-term backlog oriented. At the least, they need a six-month visibility, not a couple years, since their production is based on product-to-product.

One of their largest customers in the past was Behringer. The main reasons a customer leaves is due to cost, or in the case of Behringer, taking its manufacturing in-house.

Segment Information:
Because Deswell is a holding company, the two segments are separate businesses. Some customers will use both sides, but that is not always the case.

Deswell’s factory is located in a free economic zone that is close in proximity to Hong Kong. According to the IR representative, it will likely stay there in the foreseeable future, since most of the company’s core business customers are located in that region. The company has two facilities: one for the injection molding, and the other for the assembling business. The factory space in Dongguan is 223K square. It has never had manufacturing facilities outside of China. Over time, the company’s facilities have moved further inland, from Shenzhen. What drove the decision was customers moving further inland as well, and decreasing labor costs. The end product is usually shipped elsewhere.

Jet Crown: Plastic Injection Molding (52% of total sales)
This segment has 1.07 million square feet of factory space in Dongguan. It specializes in mold design and production, requiring specialized machines. The process is highly capital intensive, and computerized. The process uses machines bought from other OEMs. Those machines use a high-power water jet that cuts through molds. Molds are stamped out of custom-designed templates. The customer owns the mold, which is housed and stored at Deswell until shipment. Two people operate each machine, and one product is produced at a time.

Within mold design, output is approximately 25-30 molds per month. The average weight of these molds is roughly 2.3 tons, and the average cost is $12,000 per set. The smallest product is the back of a cellphone, and the largest is the back of a keyboard. The segment as a whole has a relatively low scrap rate. The low scrap rate is attributable to good quality control, and the company believes that its scrap rate has been consistently at the lower end of the industry. It also helps that the products molded are not complex, and are not involved in life or death circumstances. According to the IR representative, the company added six machines in 2019 (after March 31) and scrapped two. This has been at a slightly high scrap rate than the previous year (none), but less than prior years (3 and 12 for year ended 2018 and 2017, respectively). Those machines scrapped are sold second-hand to other manufacturers.

Electronic Products & Assembly (48% of total sales)
There are three methods involved in the board assembly process. This is not to be confused with the assembly process for plastic molds. PTH (pin-through-mount) is the method of assembling circuit boards. The technology is several decades old and labor intensive, but still has significant market applications, especially in consumer products. According to management, despite it being an older process, it is not at the risk of obsolescence because it is only used towards certain niche products such as thicker board audios, and legacy audios. BGA is the method of mounting integrated circuit to PCB (printed circuit board). SMT is the automatic process of PCB assembly, which involves mounting components to the surface and sides of the board, rather than drilling and inserting into holes. While all three methods are similar in capital intensity, the SMT technique is the fastest and most common of all three. Over the past decade, management has invested 90% of the board assembly process in SMT.

Industry Outlook & Competitive Advantage:
EMS industry is currently experiencing excess manufacturing capacity. In China, it has moderated from where it was in previous years as a result of many smaller firms going out of business. According to the IR rep, it happened simply because they didn’t have the clean balance sheet that Deswell has. Having an excess cash position and no debt has allowed Deswell to play the waiting game, and survive over time. Or, as Buffett puts it: “Time is the friend of the wonderful company, the enemy of the mediocre. While I’m not trying to argue that Deswell is a wonderful business (which would imply its intrinsic value to trade at a premium), it does certainly have wonderful qualities. The excess cash serves its purpose as a cushion when the going gets though. And it had, for Deswell. From 2008 to 2015, the company had experienced declining sales, but because of its balance sheet, it was able to survive that tough period.

Other measures taken to counteract excess capacity in the short-term has involved retiring old machines.

While the EMS industry is considered to be commoditized, Deswell has carved out a niche. It is looking to return to moderate growth through building its brand in the audio sector. Unlike most EMS companies, Deswell does not engage in high volume consumer products (high volume companies include Flextronics and others in the Apple audio supply chain). Its focus is instead on professional quality audios, namely the transmission of audio, and therefore specializes in lower volume products. Its expertise is in audio transmission equipment, amplifiers, and mixing boards.

Though price within Deswell’s niches is not as governing as the rest of the EMS space, Deswell still needs to be low-cost. Because it is positioned at the lower end of the industry cost curve, it has the ability to walk away from a lot of business. That, and coupled with its good balance sheet, it does not have to seek higher volume and high customer growth. Instead, it grows with its existing customers, and has for the past two decades.

Overall, Deswell should benefit from the continued trend towards outsource manufacturing.

Plastic injection molding is projected to reach an overall value of $162 billion globally by 2020. The industry has been growing at a CAGR of 4.9%, due to increasing demand in end markets such as automotive, electronics, and consumer goods.

Electronics assembly is projected to reach an overall value of $1.6 trillion globally by 2020. The industry has been growing at a CAGR of 4%, also due to increasing demand in end markets such as automotive, communications, consumer electronics, industrial, and medical.
In short, Deswell’s competitive advantage is characterized by its quick response capability that comes from its uncommitted cash reserves and excess plant capacity. Those customers that have stuck with Deswell long-term continue to seek a custom designed product, which leads to greater customer loyalty.

Valuation:




Relative to Tangible Book Value, EPV offers a more conservative valuation. It rests on two somewhat pessimistic assumptions. Firstly, it assumes that projected revenues would shrink to $57 million, and profit margins would remain on the weaker end of previous years. Secondly, I used Graham’s no growth PE multiple of 7.5.

The target price range is anywhere from $3.78 (downside) to $5.18 (upside).

Financials:
Deswell has no debt, and no committed credit facilities. Therefore, all free cash flow produced is unlevered. In FY2019, the company produced $1.2 million in free cash flow (down from $3.99 million in FY2018, but up from prior years of negative FCF).

The company has a current ratio of 4.5, and a quick ratio of 3.66. Working capital turnover is 1.22x, increasing since 2014. Inventory turnover is 4.32x, increasing since 2017. Receivables turnover is 4.23x, increasing since 2017. Payables turnover is 9x, and increase from the two prior years, but decrease from 2017 and prior.

DIO has been on a decreasing trend since 2016. DSO has been on a decreasing trend since 2017. DPO has overall been on an increasing trend, with the exception of FY2019. Overall, the CCC has been on a decreasing trend since 2018. Prior to that, it was increasing for the past decade.

Working capital management has improved in the most recent years. This is signaling a turnaround in the business. In addition, there has not been any inventory or DSO bloat, which is a good sign.

On the income statement, non-operating income has played a key role, keeping the company’s bottom line going. Dividend income from marketable securities, interest income from bank deposits, and rental income has provided a steady, reliable source. Unrealized gains from marketable securities are provided a steady, plentiful source, but are not as sustainable.

Manufacturing facilities and warehouses that were idle have been leased to third parties for rental income. Income earned has been growing each year: $839K (2017), $1,111K (2018), and $1,455K (FY2019).

Capital allocation-
In 2013 and 2014, the company had carried out an extensive buyback program. While it is certainly possible that it will happen again the future, at present, paying out a dividend takes precedence over a buyback.

There are several reasons against not initiating a buyback at the present. Management does not want to bring the cash position too far down, due to competitive advantage and cultural reasons. Additionally, the share count is relatively small and compressing the float further will make it harder for investors to buy shares.

During the 8-year period in which sales were declining, paying a meaningful dividend to shareholders encouraged patience, and created a long-term shareholder base. In FY2019, dividends were funded solely by net cash provided by financing activities.

Improvements in Business Operations-
Revenues stabilizing
  1. 2014: $40.9 mil
  2. 2015: $38.1 mil
  3. 2016: $44.6 mil
  4. 2017: $44.5 mil
  5. 2018: $60.7 mil
Improved gross margin
  1. 2014: 8.9%
  2. 2015: 11.1%
  3. 2016: 10.8%
  4. 2017: 16.7%
  5. 2018: 16%
Recovering and improving net income
  1. 2014: -$7.4 mil
  2. 2015: -$2.8 mil
  3. 2016: -$4.9 mil
  4. 2017: $1.4 mil
  5. 2018: $6.2 mil
Maintaining strong balance sheet
  1. Liquid securities: ($15.5 mil in cash + $18.9 mil in marketable)
  2. No debt

Proxy:
There is a heavy concentration of share ownership in senior management. The Chairman of Board, Richard Pui Han Lau, owns 51.7% of outstanding common shares. Total members of senior management and Board own 61.6% of common shares. For the most part, this is as an ant-takeover measure. The company is not looking to sell, as the Chairman has been buying up shares. In terms of valuation, the Chairman is a firm believer that the company is worth at least book value. At the very least, it should be valued at its assets, because of its improving fundamental situation.

Risk Factors:
1.     Because the minimum wage is set by the regional Chinese government, Deswell is dependent on external factors for labor costs. Its only two facilities are both in the same region, and will experience concurrent labor cost increases should the minimum wage be increased.
2.     Deswell does not have long-term contracts to obtain plastic resins. In FY2019, the cost of resin was 21% of COGS. In FY2020 thus far, resin is responsible for 40% of gross margin product. The resin is purchased in bulk and its cost is difficult, if not impossible, to pass off to the customer. From an inventory standpoint, pricing is unpredictable. To be better stewards of shareholder capital, Deswell utilizes short-term contracts rather than long-term contracts. They have never had to hedge for materials, as the costs of hedging is rather expensive.
3.     If there are any shortages in electronic components, this could cause a short-term setback or delay in production.
4.     Thus far, the trade war has had a little bit of an impact, despite there being crossover with Deswell’s customer base. The real risk lies in the portion shipped to the US, which is positioned at immaterial at this point for the injection molded plastic products (5%), and significant for electronic products (30%). As a percentage of total revenues, sales to the US make up 19%. As a ramification, there are present negotiations in progress for the possible future relocation of facilities to Vietnam.

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