IEC: Capable Management but Shareholder Friendly?

February 10, 2012 | Comments (2)

The initial question I start with, but in this case, nothing jumped out screaming value.
On a side note, IEC is ranked number 3 in the 2011 Forbes Best Small Companies list and the companies that show up on this list are usually growth orientated which is why I can’t conclude as easily whether it is cheap or not.


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Jae Jun

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Verdict

  • Management: B+
  • Growth: B-
  • Moat: C
  • Risk: C
  • Valuation: B+
  • Overall: B-

Business Description from the 10-K

IEC Electronics (IEC) is a provider of electronic manufacturing services (EMS) to technology companies. The Company specializes in the custom manufacture of circuit cards, system level assemblies, a range of custom cable and wire harness assemblies, and precision sheet metal.

Their business segments consists of Military and Aerospace, Industrial & Communications, Medical and other.

Why is it Cheap? / Is it Cheap?

The initial question I start with, but in this case, nothing jumped out screaming value.

On a side note, IEC is ranked number 3 in the 2011 Forbes Best Small Companies list and the companies that show up  on this list are usually growth orientated which is why I can’t conclude as easily whether it is cheap or not.

    Management Check

    The best place to get information about management is to read the Proxy. The code for the Proxy document is “DEF 14A”. You can then automatically track the SEC filings and use the method described in the tutorial for detecting changes in SEC documents.

    Here are some points regarding management and their decisions.

    • Insider ownership is high at 16.59%
    • CEO is also chairman of the board
    • Huge increase in salaries for insiders in 2011 vs 2010. CEO compensation increased 75%. Although performance targets were met, most of these numbers were possible only through acquisitions instead of actual organic business growth.
    • Management does not buy back shares or buy their own stock even at low prices.

    Another piece of interesting information is the debt acquired to finance acquisitions. The interest rate on these loans is between 2.5 to 4%. With such low interest rates, using debt instead of using their cash on hand is a no brainer. Nice move by management.

    Growth Plans

    The murky aspect of any analysis. Always filled with what if’s.

    As a smaller company in a highly fragmented industry, acquiring companies to grow is a must and IEC has shown that it will acquire. As mentioned above, they have gone about it smartly the past couple of years.

    IEC also has some additional potential because they do business in several segments. Revenue is diversified and if IEC locks down additional contracts for each segment, that should help drive further business.

    Another aspect that is advantageous for IEC is that none of the their competitors are “giant” corporations, but on the flip side, it will be equally difficult for IEC to become a giant. At some point it will plateau.

      Strategic Advantage/Moat

      Companies like IEC could claim all sorts of strategic advantages, but in reality there is none.

      By none, I mean none of the claims are durable. A competitor could easily do the same thing. Here are some strategic advantages the company claims. You judge for yourself.

      • Company strategy is to focus on creating manufacturing partnerships with new and old OEM’s. This allows IEC to have a broader product line without a need to buy out every company.
      • Another way of looking at it, IEC depends on having really good relations with customers. Help the customers save money, and then make it difficult for the customer to switch to another company because the service is so good. If a customer is saving money and happy with IEC, why would they want to change?
      • By having multiple manufacturing partnerships, rather than just supplying a certain part of a product, IEC can provide parts for the entire supply chain and build the entire product for the customer.
      • It would be better to be the low cost provider in this industry, but IEC is not.

      Competitor Discussion

      There are plenty of companies, both private and public, that provide the same type of service.

      With a lack of durable strategic advantages as explained in the previous section, it’s expected that plenty of competitors exist.

      The one thing I can see that sets IEC apart from their competitors is their military and aerospace business segment. Due to regulations, the government is not allowed to purchase from suppliers outside the USA.

      Risks

      Always protect the downside. Apply risk protection methods first and the upside will take care of itself.

      Refer to the risks associated with the company.

      Inventory Risk

      • Does not hold too much inventory (could be an advantage actually).
      • Has to purchase raw materials up front or receive them from customers. Uses turnkey services which could be a problem is the supplier does not have the required parts. Also it means IEC has to purchase small quantities regularly which is more expensive than buying in bulk.
      • Obtained 53% of materials from two suppliers. If a relationship broke down with any one of the two, it would cause big delays and losses.

      Concentrated Customers

      • Concentrated customers. In 2011, Sigma represented 16% of revenue, GE represented 10% of revenue and the top 5 customers make up 45% of revenue.
      • 56% of revenue come from military and aerospace. Any reductions in military and aerospace budget will affect IEC.
      • Customers do not commit to long term production schedules. They could cancel, delay or change orders any time.
      • Solvency will be an issue if they lose just one major account.

      Valuation

      IEC’s business has turned around since 2005. Margins have dramatically increased compared to early 2000′s and the company is  cheap on a P/S basis. P/B and P/Tangible Book is on the average side.

        ROE has been excellent, but the use of debt has been helping. ROE since 2005 has been 23% average. Compare with CROIC which is 17% during same period. Still high but the number has dropped to 8.3% in 2011.

        Long term debt has increased due to the acquisitions, but with such low interest rates, it shouldn’t be a problem.

          Inventory turn has decreased from 2010 to 2011. This only confirms that the top line growth was from acquisitions.

            Share dilution seems to be an issue. Increases by about 5% annually.

            Has an extraordinarily high accrual buildup. Accounting isn’t very good. Red flag.

                    Using a couple of quick stock valuation tools to check out what the market is expecting from the current stock price;

                    • Reverse DCF shows the market is expecting about 5.5% growth with a 12% discount rate.
                    • A reverse Graham valuation with EPS of $0.68 so the expected growth to be 1%.

                    Possible Catalysts

                    Some potential business developments that could help IEC.

                    • Government defense budget is not cut
                    • USA gets involved in another war (hope not)
                    • Acquisitions proves to do well
                    • Partners with several additional suppliers to stabilize its distribution channel
                    • Diversifies customer base without losing sales

                    Other Pieces of Info of Interest

                    • Was created through a merger in 1990
                    • Founded in 1966
                    • Acquisitions in each of the past 3 years
                    • 33% higher backlog in 2011 vs 2010
                    • Acknowledges that employees are biggest assets
                    • Good relations with employees. No work stoppages, no unions. Only 1 review on glassdoor.com but it’s a good one.
                    • Certain “covenants in IEC’s credit agreement with Manufacturers and Traders Trust Company restrict the Company from paying cash dividends.”

                    Conclusion

                    Management looks capable but I have to question their shareholder friendliness. The company will never pay a dividend, salary spikes are enormous and there will be consistent share dilution without any buybacks or open market purchases.

                    It feels like the management team is more content with their corporate lives and benefits vs rewarding shareholders.

                    Growth is limited and will mainly come from acquisitions. Business has no moat with plenty of risks to consider.

                    Ultimately, the company is a little too much on the risky side, even though valuation based on earnings is low.

                    Other Links

                    http://seekingalpha.com/article/316036-iec-electronics-lining-shareholders-pockets-or-management-s

                    Disclosure

                    None

                    • eric

                      Nice review. However I get some different numbers using the sheets:

                      “Reverse DCF shows the market is expecting about 5.5% growth with a 12% discount rate.”
                      When I use -7% I get a value of $5.07. 5.5% with 12% DCF gives me $9,61

                      “A reverse Graham valuation with EPS of $0.68 so the expected growth to be 1%.”
                      using these figures I get $5.94

                      Am I doing something wrong here?

                    • http://www.oldschoolvalue.com Jae Jun

                      It’s probably the difference in the FCF and EPS value I used. Can’t remember the exact number at the moment.

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