A deep value play

Overview

Sigmatron International (SGMA) is a tiny $19m company. It is an EMS company that is being priced as if it was going bankrupt. SGMA has been beaten down lately due to interest rates rising, wiping profits and also due to a significant loss on the WAGZ investment that pointed to bad capital allocation from management. For the ones that dont know about WAGZ, it is a pet tech company the company acquired for around $23m issuing stock and debt to fund them. WAGZ did not even have $500k in revenue but somehow management found it attractive? That is the worst capital allocation and value destructive transaction I have seen in a while. Long story short, 2 years later they defaulted on their debt and the creditors told them that the default could be waived IF they sold WAGZ. So they sold WAGZ for $1 to the owner and gave 81% ownership and now they only own 19% of WAGZ. They are no longer required to fund WAGZ operations. As a result, they are 100% focused on the core business, EMS.  

Debt

One of the main reasons the stock is trading for so low is due to its rising debt and interest rates. Since 2021, debt has increased from $42m in FY 2021 to a high of $102m in Q3 2023. With this increase in debt comes an increase in interest rates. Now interest rates go for SOFR+Applicable Margin. The TCW Term Loan has an Applicable Margin of 7.5% and the JPM Revolving Facility has an Applicable Margin of 2.5% currently (depends on revolver availability). This is a concerning amount, however, they have been paying down debt principal in FY24. One of the covenants for the TCW loan requires them to pay $250,000 per quarter towards the principal amount and also has to pay 50% of excess cash flow at year end. So its $1m decrease in principal + the 50% of excess cash flow per year. And yes, they generate positive cash flow. However, to my surprise, they have been paying down the JPM which has no requirements on payments and has a lower interest rate. As of Q2 FY 24 ending Oct 31, the company has repaid 13% of debt principal from Q4. I expect the trend to continue as they keep selling off inventory, generating cash to deleverage. Management is focused on reducing inventory for FY24 and inventory will start picking up as backlog builds up for FY25. Another tailwind is the FED announced rate cuts coming in FY24. In my assumptions I still have the SOFR at 5.32% to be conservative. If the FED cuts rates, interest rates (SOFR on debt) will decrease resulting in an increase in profits. I believe debt will decrease the coming quarters at a fast pace and interest will decrease showing the true earnings power of the business.

Competition

The EMS industry is very competitive in nature. The main differentiator I believe it to be scale, as economies of scale and operating leverage are crucial in this industry to provide lower cost solutions to customers and increase profits. Before 2022, the company earned gross margins of 8.5%-9% and operating margins of less than 1.7%. As revenues increased in 2022, gross margins shot up to the 12% range and operating margins shot up to the 6% range, having a real effect on operating profits, making them the highest it’s ever been. After 2022, margins have cooled down but still remain higher than pre 2022 and I believe it will stay that way because they reached economies of scale. As long as they maintain revenues above 2021, assuming SG&A is fixed and COGS will hover around 88%-90%, they will be generating substantial operating income well above pre 2022 levels, and factoring in interest expense decreasing, net margins will also increase. As a reference, KTCC, the closest competitor in market cap ($44.7m), has gross margins FY23 of 8.1% vs 12% for SGMA and operating margins of 2% vs 6% for SGMA. Another thing is that KTCC never reached that economies of scale. Despite tremendous revenue growth comparable with SGMA’s, margins stayed relatively flat. I believe there is no significant difference in services offered between SGMA and KTCC, there is a qualititative factor that separates both of them besides the margins. Return on Invested Capital for SGMA after reaching economies of scale and operating leverage was reached, was 11% vs 3.8% for KTCC. It is also a more efficient collector of accounts receivables as DSO is a around 40 days and KTCC is above 80 days. However, SGMA also has its negatives as any other company in the world. SGMA ‘s inventory days and turnover are not good compared to KTCC. It is a liability for SGMA as the cash generation cycle doubles in time compared to KTCC minus the DSO. SGMA’s inventory turnover averages 2.5x while KTCC averages 3.5x. Days Inventory Outstanding SGMA averages 155 days while KTCC averages 100 days. In general, SGMA is a superior company to KTCC as SGMA yields a higher margin and reached economies of scale and operating leverage, it also trades at half the value of KTCC.

Expansion

Covid initiated a surge in demand in the EMS industry which caused an increase in capital expenditures among the players to expand facilities to be able to meet the demand. While good, they also got the bad, which was supply chain issues due to component shortages. SGMA has a manufacturing footprint in China, Vietnam, Mexico, US, and a procurement office in Taiwan. They expanded every facility investing in equipment to serve the high demand, the investments were very successful. However, due to the high demand there were component shortages that impacted the company’s ability to ship products and that is still going on today and is one of the main issues with the lower revenue growth the past quarters and decrease in operating income as they have had to absorb all the overhead with lower volumes. That problem with the supply chain is subsiding slowly but it is still expected to impact the industry going forward to FY25. 

The China-US trade war has caused customers in the EMS industry to shift manufacturing outside of China into Vietnam, Mexico, and US. Although the company barely commented on this issue because they dont do earnings call, all the competitors are seeing a shift to manufacturing to the US which benefits the industry as it will get more customers and also higher margins. I believe SGMA to be prepared for an increase in demand for US manufacturing as the previous investments in the US facilities blossom. An alternative option to China that customers have is also shifting to Vietnam manufacturing, they commented on this matter on the newsletter in their website, “Certain customers also benefit from VN as an alternative option amid continuing Section 301 Tariffs on Chinese exports by the U.S.”. 

Industry Tailwinds

With rate cuts and consumer confidence gaining traction, a lot of markets the EMS companies serve are seeing tailwinds that will increase demand for EMS.

For example, the auto industry will likely increase production and increase demand for EMS. Now, SGMA is prepared to handle that demand as they expande the Mexico facility and equipments to assemble the PCB more efficiently and cleaner as auto customers are demanding cleaner and more customized PCB. Other companies in the EMS are seeing the same trend. Jabil, one of the biggest players in the EMS industry is seeing an increase in auto projects related to EV specifically. Kimball Electronics (KE) is seeing the same trend. Another market the company is seeing that is improving and getting a lot of demand from is renewables, and KE is seeing that too. As the component shortage eases, it will get easier for EMS companies, especially SGMA to ship out products.

Outlook

SGMA announced Q3 being soft as customers reduce their inventories going into year end and expect demand to pick back up in Q4. They also said they won new business and programs  that will kick in Q1 FY25, and as the supply chain issues eases, I expect margins to gradually increase or stay flat. I do not see them falling further. I also expect debt principal payment at FY24 to total $22.76m, which reduces the debt outstanding from $92m in FY23 to $69.2M in FY24 and interest expense to total around $9.53m, net income of $3.41m. This would mean that the company would trade at 5.68x FY24 earnings (This does not factor in the 50% of excess cf paid towards the TCW loan). 

The company is not being valued properly. Interest rates are masking their true earnings power,  investors are discounting the company due to WAGZ, which created a debt burden for them but are correcting it as 100% of their focus is towards the EMS. They are trading at a 50% discount to its closest competitor that trades at 10.3x earnings. SGMA also trades at 28% of its tangible book value.  Higher ROIC than competitors will differentiate SGMA and outperform in the long term.