2023-08-02 11:58:52 ET
Summary
- Pro-Dex is a contract manufacturer focused on medical products, and it has quadrupled its revenues since FY14.
- The company recently opened a new factory and I expect revenue growth to accelerate over the coming months.
- I think Pro-Dex should be trading at above 20x P/E, which translates into $26.50 per share.
- However, I’m concerned about the reliance on just a few customers and my rating on the stock is a speculative buy.
Investment thesis
I've mentioned in several of my recent articles on SA that I've been searching for small-cap companies with growing revenues for my personal portfolio. Among the stocks that look undervalued to me based on fundamentals at the moment is Pro-Dex ( PDEX ), a contract manufacturer focused on medical products whose revenues have more than quadrupled since FY14 to more than $40 million. The company has a TTM net income of $4.7 million and its results should get a boost in FY24 thanks to a new factory in California. My rating on the stock is speculative buy due to the reliance on a handful of customers. Let's review.
Overview of the business and financials
Pro-Dex was founded in 1975 and is a California-based contract manufacturer involved in the manufacturing of "autoclavable, battery-powered and electric, multi-function surgical drivers and shavers used primarily in the orthopedic, thoracic, and maxocranial facial ("CMF") markets" (see page 6 here ). Many of the major clients of Pro-Dex usually place orders for specific products developed under development or supply agreements.
The company also has its own line of rotary air motors which it sells to customers in several industries, and it also has a patented adaptive torque-limiting software focused on the CMF and thoracic markets named TorqueDrive.
Looking at the financial performance of the company for the past decade, we can see that revenues have been growing at a rapid pace over the past several years, and they have almost quintupled since FY14 to $48.1 million on a TTM basis. This is equal to a compound annual growth rate ("CAGR") of 18.6% since FY14 which I consider compelling.
In addition, I expect revenue growth to accelerate over the coming months as thanks to a new production facility. In 2020, Pro-Dex bought a 25,000 square foot industrial building in the city of Tustin, about four miles away from its Irvine HQ. The build-out of the facility was completed in the fall of 2021 and Pro-Dex revealed in the press release for the Q3 FY23 results that all assembly and repairs operations were transferred to the new location in Q4 FY23. The Q4 FY23 results should be released in early September.
Looking at the Q3 FY23 financial results, net sales soared by 41.2% year on year to $13.1 million and the key driver behind this was a $3.2 million improvement in repair revenue thanks to a recent repair program that includes the upgrade of a handpiece that Pro-Dex sells to its largest client to its most current generation. Sales of medical device products, in turn, booked modest growth of 7.1% year on year to $6.99 million.
The increase in medical device sales can be traced again to the company's largest client as revenues generated by it rose by $0.63 million during the period. This client is included in the orthopedic category. Recurring revenue from distributors of CMF drivers soared by $0.79 million thanks to momentum built by the launch of a new driver in Q3 FY22. However, this increase was offset by a slump in sales in the thoracic segment as Pro-Dex's sole client for its thoracic driver filled the near-term requirements of its distribution network.
Turning our attention to the income statement, the gross profit margin inched down to 29.1% in Q3 FY23 from 30.8% a year earlier but the operating income more than doubled to $2.07 million as selling, general and administrative expenses as well as research and development costs barely changed.
Looking at the balance sheet, I think that the situation is solid as cash and cash and equivalents and short-term investments rose to $3.24 million in March 2023 while net debt came in at just $9.12 million. As you can see, Pro-Dex has a relatively asset-light business model, and accounts receivable, and inventories accounted for over half of $46.98 million in total assets as of the end of Q3 FY23.
Pro-Dex has low CAPEX requirements and purchases of equipment and improvements came in at just $0.82 million for the first nine months of FY23. Net cash provided by operating activities, in turn, was $4.84 million for the period and besides paying off debts, the company also used $1.55 million for share buybacks.
Looking at the valuation, Pro-Dex has an enterprise value of $72.9 million as of the time of writing and is trading at a P/E ratio of 13.6x on a TTM basis. Considering revenues have been growing by double-digit percentages over the past several years and that profitability has been improving thanks to economies of scale, I think that Pro-Dex should be valued at above 20x P/E. This translates into around $26.50 per share or an upside potential of 47.2%.
Turning our attention to the downside risks, I think that the major one here is customer concentration. You see, the largest client of Pro-Dex accounted for 65.9% of net sales in Q3 FY23, with another client responsible for another 15.7%.
I'm concerned that decreased orders or the loss of any of these two clients could lead to a significant decline in revenues as well as profitability. This has already happened several times in the past, most notably in FY12 when sales to a major client slumped to $6.71 million from $12.29 million a year earlier (see page 4 here ). Also, investors should keep in mind that this is a microcap stock whose shares have low liquidity, with a daily trading volume that is seldom above 5,000 shares. This means that it could be difficult to close even a small position without causing significant share price volatility.
Investor takeaway
Pro-Dex has been growing its business rapidly over the past years, and I'm optimistic that the new facility in California will enable it to expand over the coming months as well as improve its margins thanks to economies of scale. At a P/E ratio of 13.6x, it looks cheap for a growth stock, but I'm concerned about the significant reliance on just a few customers. Considering the loss of any of them could be detrimental to the business, my rating on the stock is a speculative buy. I think risk-averse investors should avoid Pro-Dex.
For further details see:
Pro-Dex: Growing Rapidly But Relying Only On A Few Customers