Summary
- PCTI designs and manufactures antenna components used in IoT products, as well as radio frequency testing equipment.
- The company's revenues and gross margins are volatile because of the mix of these two segments, high margin cyclical RF testing equipment and less cyclical but lower-margin antenna components.
- Below gross profits, the company loses most of its profitability in R&D expenses. I think these expenses are a cost to do business rather than a durable moat builder.
- A priori promising cash flows, much higher than net income, are caused by stock-based compensation and underestimated acquisition CAPEX.
- Based on accrual profitability, cash profitability or even R&D self-financing capacity, the company trades at excessive multiples.
PCTEL ( PCTI ) is a designer and manufacturer of antenna components used in electronic products, as well as radio frequency testing equipment.
The company has not been able to grow revenues since the introduction of Wi-Fi and mobile internet after 2007. Although PCTI sustains a high level of R&D expenditure, it is difficult to see that as profits and not as a cost of doing business, given the company's inability to grow revenues in the past decade.
Although PCTI is doing better on a cash basis and pays $4 million in dividends, I believe its stock price is not justified on an operating income basis, R&D basis, or even a cash flow basis.
Note: Unless otherwise stated, all information has been obtained from PCTI's filings with the SEC .
Business description
Antenna components
One of PCTI's business segments is antenna and communications components. These allow all kinds of devices to communicate with their networks, either cellular, WiFi, LoRA, GPS, or others. The company specializes in relatively bigger components, such as those used in cars, machines, or outdoor settings, not the smaller ones used in laptops or cell phones.
This segment is not super interesting regarding the competitive landscape where it operates. It is a design-win business that requires investment in product development, putting the bargaining advantage on the customer. Products are relatively commoditized, with several companies providing them. This can be seen in PCTI's gross margins for this segment, around 30%.
RF testers
The company's second segment is radio frequency signal testers, used in mobile network deployment. Telecom operators use these products to test the strength of network signals at different locations.
This segment sells a complete product and enjoys a competitive advantage. That can be appreciated in gross margins that have ranged around 65% for more than a decade.
Small cycles in revenues and gross margin
Probably because mobile networks and home WiFi routers were introduced in the late 2000s, the company's revenues more than doubled by around 2012 from the previous decade's average. But since then, the company has been cycling, albeit in a tight range between $80 million and $100 million in revenues.
Gross margins have also ranged between 38% and 48%. In my opinion, gross margin cycles are not caused by operating leverage but rather by the mix between two segments, the higher margin RF testing equipment vs the lower margin antenna components.
SG&A and R&D eat the profits
Like many companies, PCTI's problem is below gross margins at the operating expenses level.
The company's SG&A level has relatively accompanied the movements in gross profits, indicating a variable structure that can protect profitability.
However, R&D expenses are much more fixed. In my opinion, R&D expenses are a necessary cost of business and not a moat builder for PCTI, at least in the antenna segment. High and fixed R&D is common among design-win business model companies. These should be considered selling costs because the company is developing new technology for a specific client contract. That is, in my opinion, why the company cannot lower its R&D expenses when revenues or gross profits are lower, to keep profitability intact.
Low average profitability
The effect of relatively cyclic revenues and variable margins, coupled with a fixed R&D structure, is low operating profitability on average. When the company's gross profits fall, it has to sustain losses because it cannot curtail its R&D expenses.
Strong balance sheet
The company's balance sheet is truly strong. PCTI has $27 million in cash and securities as of 3Q22 and no debts. We will see in the next section that the company's cash inflows differ from profitability significantly.
Valuation
Cash versus accruals
The chart below shows the difference between FCF and net income for PCTI. It has averaged $7.6 million in the past 12 years. A priori, this indicates PCTI is much more profitable on a cash basis than on an accrual basis, and the difference is consistent over time. In fact, PCTI has paid a $4 million dividend (second chart below) for four years already.
Two factors explain that difference.
First, the company pays almost $4 million in stock-based compensation. Not only managers receive stock, but other employees as well, given that the highest-paid officers receive $700 thousand in total compensation a year. Stock-based compensation has to be removed from FCF because it reduces the share of the business that every investor is entitled to.
The second factor is that CAPEX has been below depreciation and amortization for a long time. CAPEX averaged $1.6 million less than D&A per year for the past 12 years. This, in turn, is explained by the amortization of intangibles from acquisitions (second chart below). Acquisitions are not considered CAPEX, and therefore overestimate FCF.
Because most of the FCF surplus over net income can be explained by stock-based compensation, and acquisitions that are not included in CAPEX nor discounted from FCF, I believe FCF is not a great representation of PCTI's operational profitability.
Multiples
When FCF is adjusted by removing stock-based compensation and the effect of acquisitions, it does not present a picture that is too different from the one presented at the operating level.
A market cap of $87 million for a company that has generated an average of $0.5 million in operating profits for the past 12 years seems excessive. The average multiple to net income (when it is positive) is just massive.
Further, if R&D capacity is considered (pre-tax income + R&D expenses or the capacity of the company to self-finance R&D expenses), PCTI is in a better position. This measure has averaged $11 million in the past 12 years, implying a multiple of 8x. Using a 3-year average of $15 million yields a multiple of 6x.
Although these multiples seem low, the reader should be aware that they are multiples on the capacity to finance an expense and not a multiple on profitability. As we saw, PCTI has to spend on R&D, even when it cannot use self-generated funds, because it is a requirement to do business. Further, the massive R&D expenses of the past decade have not provided the company with the ability to grow revenues and eventually profitability. Therefore, these multiples are high as well.
Conclusion
One of PCTI's segments operates in a design-win sector where profitable competition is difficult. The other seems to enjoy higher margins but is more affected by the cyclicality of investment in cellular networks. The result is a company that has not been able to grow revenues for most of the past decade and has relatively volatile (albeit high) gross margins depending on the product mix of its sales.
At the level below gross margins, PCTI uses most of that profitability in R&D expenses. These are fixed and, in my opinion, a requirement to do business, particularly in the design-win antenna component segment, rather than a moat builder.
Therefore the company has not generated a positive average operating income for most of the past decade either. When initially more promising cash inflows are analyzed, they are caused by stock-based compensation and acquisitions not considered part of CAPEX. Finally, even the multiple on self-financed R&D capacity is not low enough to justify the purchase, more so considering that R&D has not generated an increase in profitability in the last 12 years.
For these reasons, I do not believe PCTI is an opportunity at these prices.
For further details see:
PCTEL Trades At Excessive Multiples Of Several Profitability Measures