2023-07-11 10:49:43 ET
Summary
- As of March 2023, Espey Manufacturing & Electronics had a total backlog of $82.1 million compared to $76.2 million a year earlier.
- In my view, this will enable the company to book FY23 revenues and net income of over $36 million and $3.5 million, respectively.
- I think that Espey should be valued at above 9x EV/EBITDA, which translates into $20.65 per share.
Introduction
I like to write about undercovered microcap stocks on SA, and today I'm taking a look at Espey Manufacturing & Electronics Corp (ESP). It's a power electronics design and manufacturing company focused on the military vehicles market, which I think has a strong balance sheet and decent history of profitability. In addition, the company has a $0.10 per share quarterly dividend and I think it's starting to look cheap as it's trading at just above 6x EV/EBITDA as of the time of writing. Let's review.
Overview of the business and financials
Espey was founded in 1928 and specializes in the design and manufacturing of power supplies, power converters, filters, power transformers, magnetic components, power distribution equipment, UPS systems, antennas, and high-power radar systems. Its products are designed for military and severe environment applications and are used in military vehicles, radars, and locomotives among others. Espey has a design, manufacturing, and testing facility in the city of Saratoga Springs with an area of over 150,000 square feet. It employs about 150 people, around 35% of which are represented by the International Brotherhood of Electrical Workers. There is no seasonality, and the business is vertically integrated as the company produces individual components, populates printed circuit boards, fabricates metalwork, paints, wires, qualifies, and fully tests items in-house.
Espey barely spends anything on research and development (R&D expenses in FY22 were just $32,362) as its business primarily is driven by customer product needs and custom product development with some customer funding. The company is on the eligible list of contractors with the US Department of Defense, and it seems that it has carved out a nice niche for itself as the business has a history of stable financial performance, with annual revenues typically ranging between $27 million to $37 million over the past decade. In addition, Espey's operating income has been positive in 9 of the past 10 fiscal years.
Turning our attention to the latest available financial results, we can see that the company seems to be benefitting from increased global defense spending due to the war in Ukraine as net sales for the first nine months of FY23 rose by 15.3% to $27.2 million. Thanks to economies of scale, the operating income margin improved to 12.17% from just 5% a year earlier. In addition, the company booked interest income of $0.13 million in Q3 FY23 alone as it invested decided to invest most of its cash reserves into investment securities.
The investment securities stood at $13.9 million as of March 2023 and they included certificates of deposit, municipal bonds, and US treasury bills. With interest rates around the world rising rapidly, I expect that Espey's annualized interest income could surpass $0.6 million soon.
Looking at the balance sheet, I think that Espey is in a solid position. The company has an asset-light business model and cash, and cash equivalents were $4.58 million as of March 2023. There were no debts at the end of Q3 FY23. Overall, Espey had $18.5 million in cash and investment securities, which account for 41.7% of its market capitalization as of the time of writing.
Looking at what to expect for the future, I think that FY23 revenues and net income are likely to top $36 million and $3.5 million, respectively, thanks to the strong backlog. As of March 2023, Espey had a total backlog of $82.1 million compared to $76.2 million a year earlier. The company expected that a minimum of $8.7 million worth of orders would be filled in Q4 FY23 (see page 16 here ) and the FY23 results should be released around September 20. In my view, the strong Q4 FY23 financial results could lead to an increase in the quarterly dividend to at least $0.20 per share soon. The company had a quarterly dividend of $0.25 per share between 2012 and 2020.
Turning our attention to the valuation, Espey has an enterprise value of $25.8 million (if we treat the investment securities as cash) as of the time of writing and is trading at an LTM EV/EBITDA ratio of 6.2x. Considering that Espey has a stable business with a history of profitability and that FY23 financial results are likely to be strong, I think that it should be trading at above 9x EV/EBITDA. This translates into $20.65 per share or an upside potential of 26.2%.
Looking at the risks for the bull case, I think the major one is an economic slowdown in the USA as this could result in lower defense spending and potentially lead to a weaker backlog for Espey. The US economy has shown resilience over the past few years, but many experts still expect inflationary pressures, rising interest rates, and geopolitical uncertainties to lead to a mild recession in late 2023 or early 2024. In addition, investors should keep in mind that this is a thinly traded stock, with a daily trading volume rarely exceeding 5,000 shares. There could be significant share price volatility, and it could be challenging to exit a large position.
Investor takeaway
Espey should have a strong finish to FY23 thanks to its strong backlog and I expect revenues and net income to surpass $36 million and $3.5 million, respectively. This paves the way for an increase of the quarterly dividend, and I think it's also a positive development that the company has invested much of its cash balance into deposits as annualized interest income could soon surpass $0.6 million. In my view, Espey looks cheap at the moment as it's valued at just 6.2x EV/EBITDA on a TTM basis. That being said, this is a thinly traded stock and there could be significant share price volatility ahead which is why I'm putting a speculative buy rating on Espey.
For further details see:
Espey Manufacturing: Strong Backlog, Valued At Just Over 6X EV/EBITDA