2023-10-23 09:24:32 ET
Summary
- Record-setting funded backlog, burgeoning new orders, and margin expansion point to an overwhelmingly undervalued stock.
- Espey’s balance sheet provides a cushion for inflation or economic slowdown. But geopolitical risk could be a boon to business.
- The stock’s 4% dividend yield pays for patience and could increase.
- Short-term investors have sold off shares, leaving long-term investors a fantastic opportunity.
Company Overview
Espey Mfg. & Electronics ( ESP ) is a vertically integrated designer, manufacturer, and tester of electronics and electrical power supply components. The items they produce include transformers, radar equipment, battery chargers, and power supplies for the Navy, one of their largest customers. The company has become a trusted supplier for Navy vessels that must maintain their electrical power supply in harsh and very wet conditions.
Another large market for Espey is rail. The company’s power converters keep trains moving forward reliably in high vibration and temperature settings.
Espey also supplies power converters, transformers, and other power supply products to military aircraft platform suppliers like Raytheon ( RTX ), Lockheed Martin ( LMT ), Boeing ( BA ), Northrop Grumman ( NOC ), and General Dynamics ( GD ).
On its commercial side, Espey also produces converters and power supplies for hybrid-electric off-road industrial vehicles in the mining market.
The company also provides build-to-print contract manufacturing for customers with pre-designed components.
Procurement is a major pain point with so many parts going into these complex machines. Espey’s vertical integration gives them an advantage in the RFP process for new platform designs because they can take care of product design, manufacturing, and testing of transformers and power components in a single vendor, easing customer’s procurement process.
Investment Thesis
The phrase ‘mission-critical’ gets thrown around a lot, but I think it’s applicable here. For instance, the Navy’s destroyer and submarine platforms must keep their electrical power supply going to operate their radars, weapon systems, and operations functioning while inevitably getting wet. Water and electricity don’t get along, and failure is not an option when it comes to national defense. Espey has been a trusted and relied-on supplier for the Navy for decades.
The same experience with ruggedization and design reliability transfers to the commercial rail market, where uptime is crucial to customer experience and maintenance costs. Espey’s rail power systems keep long-haul rail travel running on high-vibration routes, and electric power and braking create extreme temperatures for its systems.
The trust Espey has built over the years with its customers creates high switching costs in the form of the risk that a new, untested supplier cannot deliver. In addition, most of the company’s products are designed into regulatorily approved Navy vessels, aircraft, and electric rail cars. Once Espey’s products are designed, customized, and tested on-site, Espey’s products are used exclusively for the life of each new platform the company wins.
The company’s website proclaims it is the sole distribution source for transformers for several important Naval Submarine and Surface Combatant applications. Earlier this year, the Navy awarded Espey $7.4 million for facility enhancements and expansion of high-power testing, demonstrating the importance of their partnership.
Catalysts
CEO David O’Neil has been with the company since 2000, serving as Treasurer and CFO. On January 1, 2022, he was appointed President and CEO. His bonus compensation shines some light on the company’s evolution since then. Two of his three bonus components are paid on 1) increases in sales plus backlog and 2) increases in operating earnings. The third is discretionary, but his total bonus cannot exceed his $275,000 annual base salary. Since his appointment, albeit less than two years ago, Espey’s backlog is at an all-time high, and operating income has advanced noticeably.
The company’s annual report (June FY) notes that the funded portion of its $83.6 million backlog is $83.5 million. Espey expects a minimum of $39.5 million of its backlog to be filled this fiscal year. That number doesn’t count additional higher margin build-to-print or short lead time sales in the interim.
Espey’s long-term growth story will depend on its ability to attract new orders. Many of the military and industrial platforms they produce are planned ahead by a few years but can be cyclical based on the budgetary flexibility of the military and industrial customers. In response, Espey opened itself up to bidding contracts outside the Navy. In doing so, it has put together a three-year string of new orders of about $40 million annually—a feat it hasn’t accomplished before. In addition to growing the top line, winning new customer platform designs outside the Navy and rail markets could help diversify the company’s normal military-driven cyclicality.
From 2012 through December of COVID stricken 2020, Espey paid a $0.25 quarterly dividend, often supplemented by a $1.25 special dividend. The regular quarterly dividend was reinstated in the March quarter this year to $0.10 and raised to $0.15 at fiscal year-end. Shares advanced ~25% upon news of the reinstatement but have returned to their ~$15 share price at the time of this writing (4% dividend yield).
Further dividend increases could help the share price or, at least, its yield. Given Espey’s visible prospects for the next few years, cash flow profile, and dividend history (all but two board members remain from its dividend-paying regime), I think there is a strong case for further dividend increases.
One could argue that military escalation or US involvement in the Ukraine/Russia fight could increase demand for Espey’s products. More recently, the Israel/Hamas battle has also escalated the geopolitical landscape. This situation could be more beneficial to Espey, considering Gaza is located on a coast.
Why this opportunity exists
The business has grown notably over the last few years, but inflation took a bite out of its fixed-price contracts, and gross margin suffered. Management has largely run off fixed-price contracts, and margins have recovered, unlike the stock price.
At the same time that revenue, backlog, and new orders are on the rise, gross margins over the last couple of years have obfuscated the company's true earnings power. Gross margins have recovered, but there are still fixed-cost contracts yet to run off. That should add a margin expansion element to the story, considering the company’s operating leverage and growth prospects.
The market thought the third and fourth quarters stunk. Shares advanced in February when Espey reinstated its dividend. But the market frowned on the stock when it announced fiscal third quarter new orders that must not have met expectations, and the fourth quarter saw marginal improvement year-over-year, regardless of eye-popping annual levels and backlog. Keep in mind that Espey books its revenue based on the output method methodology based chiefly on contract milestones and shipments to a lesser extent. So, revenue growth will be lumpy.
Risks
- In around ten years, the Navy will transition away from legacy Aegis DDG-51 and Zumwalt DDG-1000 Destroyer platforms. These are two major platforms that Espey supplies for the Navy. As it stands, the Navy will be transitioning to its next-generation DDG-X destroyer platform . The design and schematics of the DDG-X are still in the works. There is a risk that the Navy will choose another transformer supplier for the new platform. Given Espey’s history with the Navy, the Navy’s recent capital commitment to Espey, Espey’s vertical integration, and the monumental risk associated with failure, I think there is a high likelihood that the Navy will go with Espey for the new platform.
- The federal budget could decrease military funding. Today’s escalating international wartime landscape and the potential for US involvement reduce this risk. Especially in the Navy, which is due for a technological upgrade regardless.
- There is some operating leverage built into the company’s gross margin. If new orders fall off, there will be margin contraction. Given the funded backlog, this risk might lurk for a few years but should be monitored. As long as the funded backlog stays elevated, margin expansion is more likely in the coming years.
- Many of Espey’s long lead time products can mean lumpy cash conversion. Therefore, the business model can be working capital intensive. If the company continues to grow new orders and win new platforms, the new business could soak up working capital in the early stages of new relationships, and cash flow might not reflect earnings. However, this will be a boon to business in the long run. In the meantime, Espey’s balance sheet provides a fluffy cushion for working capital. More on that next…
Valuation
There are a few ways to look at the value of this company. But first, I should point out that its balance sheet is in pristine order. It contains $14.7 million in cash, short-term securities (CDs, Munis, and T-bills), and no debt. So, let’s start there.
The company owns a 151,000-square-foot facility in Saratoga Springs, NY that houses its headquarters and production. Industrial properties in the Saratoga Springs and Albany area are listed for sale at an average of ~$56 per square foot. This would imply a value of around $8.4 million for Espey's property.
The company has no goodwill or intangibles. Suppose we replace the $8.4 million with the $4.8 million book value of its land and buildings. In that case, we get a tangible book value of $39.4 million, which implies a price-to-tangible book value of just over one based on its $40.8 million market cap at the time of this writing.
Alternatively, we can see that Espey’s funded backlog can provide $40 million in revenue for two straight years. Over the last ten years, the company has converted 13% of its revenue into free cash flow on average (significantly higher under O’Neil’s oversight). If that tradition holds, Espey could see roughly $5.2 million in free cash flow in each of the next two years. That excludes short-term orders in the interim. At its current market cap, you’d be getting a 12.7% forward free cash flow yield over that time.
Actionable Conclusion
Management doesn’t put on earnings calls or issue investor presentations. But if you read through the last 10-K , you’ll notice that they had a fantastic year for new orders from a historical perspective, and they expect next year to be even better. This is a high-visibility company with a huge, funded backlog.
You’ll also notice a steep incline in Contract Liabilities or cash received in excess of revenue recognized. This is likely payment received for engineering design work for new customer platforms. Those new platforms could very well lead to more orders in the future.
I think you have the combination of a stock that is beaten down by short-sighted market expectations, an attractive valuation, a bright future, and a management team that is very competent and incentivized to act in the shareholder's best interests.
For further details see:
Espey Mfg. & Electronics: Massive Pre-Funded Backlog And A Balance Sheet You Won't Believe