RFIL - RF Industries Must Decouple SG&A Before Becoming An Opportunity

2023-03-17 09:48:23 ET

Summary

• RFIL manufactures and designs cables and connectors used in the telecommunication and radio frequency industries.
• The company's industry has undesirable high-rivalry characteristics that have led the company to relatively volatile profitability.
• RFIL's new management has been successful in incrementing the company's revenues and gross profits and incrementing the recurrent portion of the business.
• However, the gross profit is eaten by the company's increased SG&A.
• I tend to believe that the SG&A problem is not easy to solve, and that is entrenched in the industry's competitive dynamics.

RF Industries ( RFIL ) is a designer and manufacturer of cables used in telecommunication applications.

In previous articles from March and September 2022 , I recommended a hold rating on the stock because it was competing in a difficult industry and had trouble managing its costs. The multiple on earnings asked then was too high for a company of those characteristics. The stock price has fallen 39% and 27% since, respectively.

In this review, the company struggles with the same problem: it can grow revenues and gross profits, but all of the improvement is eaten by SG&A expenses. The company's management has called for a cost reduction program, but that only reveals how difficult it is to operate RFIL profitably.

In my opinion, until the company can separate gross profits from SG&A expense increases, RFIL is not an opportunity.

Note: Unless otherwise stated, all information has been obtained from RFIL's filings with the SEC .

Recap

A difficult industry: The RF connector and cable industry is not easy. Suppliers require facilities and a capable workforce, but the utilization of those resources moves cyclically with the CAPEX cycles of the telecommunication carriers. Standardized and relatively undifferentiated products, purchased on bid format on a project basis, further promote profitability-destroying competition.

Participating in such an industry, RFIL's revenues and profits have also been relatively low and very volatile. Further, the company has difficulty de-pegging its SG&A expenses from its gross profits because most of its business is nonrecurrent.

The new strategy: Long-time followers of RFIL commented in other articles that the company's new CEO (in office since 2018) has implemented a strategy that has increased revenues, particularly in the more recurrent, distributor-based segment called RF assembly (compared to the more project-based Custom assembly segment).

Indeed, those claims are all verifiable. Despite a setback during the pandemic, the company's revenues have grown since 2018. Gross margins have kept relatively stable (they are normally volatile because of product mix changes).

At the segment level, the RF connector segment represented 24% of sales in FY17 , 33% in FY20 , and 36% in FY22 (under the Segment Information heading).

A not-so-great balance sheet : Previously, RFIL enjoyed the safety of an unleveraged balance sheet and $15 million in cash reserves. The company entered into the acquisition of Microlab in March 2022, financing it with cash and $12 million in a term loan. Although the company still has $3.7 million in cash and the term loan pays a fixed 3.8%, the situation is not as secure as before.

Recent data

The top line keeps growing, but no profits : The company's strategy seems to be paying off at the top line, with revenues and gross profits consistently up. The RF assembly (more recurrent) segment proves itself as a damper of volatility, for example, during 1Q23 reaching 50% of revenues, mostly because of a fall in Custom assembly.

But all of that improvement is eaten by SG&A expenses. In the chart below, gross profits minus SG&A have not moved from their long-term average.

Is it endemic? : I believe that SG&A expenses accompanying gross profits are a chronic condition of the market RFIL operates in, at least in the Custom assembly, non-recurrent, project-based segment.

One piece of evidence (besides that the company has not improved this aspect despite growing gross profits) is the cost reduction plan commented on by management on its 1Q23 earnings call . According to management, the plan could save up to $2 million starting in FY24. Further, management mentioned that the plan required searching costs to be reduced 'line by line'. Although the plan is commendable, it would only represent a 10% reduction from current TTM SG&A expenses, showing how difficult it is to control them.

The context has turned sour : RFIL's revenues depend on telecom carriers and smaller operators investing in capital deployments. Part of the bullish thesis on RFIL is that it can benefit from the industry transition towards 5G and DAS technologies.

Unfortunately, the recent increase in interest rates implies a setback for that thesis because higher rates reduce the profitability of investment projects. Companies reduce their investments to protect cash flows and reduce leverage.

Conclusions

RFIL trades at 40% less than when I wrote about it one year ago. It currently has a market cap of $42 million.

However, the company's operational history does not give me the confidence to believe in the net income potential.

The biggest hurdle ahead is to separate gross profits from SG&A expenses. Otherwise, the increase in business does not represent an increase in profitability and only partially improves the company's value.

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