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March 16, 2006 |
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Since fiscal 2000 Deswell’s revenues have more than doubled, shareholders’ equity has increased by an average of 10.5% a year, and the company has paid out more than $40 million in dividends (total return from dividends alone since 2000 is 42.9%, or 8.5% annually!). This type of impressive performance is reserved for the most elite companies in the world…
Ordinarily the most opportune time to invest for the long-term is when a company is going through tough times and its share price is falling. However, in Deswell’s case bottom feeders should proceed with extreme caution. Quite frankly, with the crash in stock price being mirrored by a collapse in business fundamentals, it is becoming painfully clear that the good times at Deswell have come to an end. Fundamentally Speaking Deswell’s trailing dividend yield is currently 7.3% (compared to 7% in 2000), the company trades at 1.24 times tangible book (compared to 1.74 in 2000), and its price to earnings multiple is 11.5 (8.6 in 2000). These basic indicators are flashing buy compared to when we originally selected DSWL, but a deeper look at the company’s performance yields three concerns. First and foremost, DSWL’s 7% dividend yield represents the trailing yield. A recent dividend cut combined with weakening business conditions suggests that 7% will not be returned to shareholders in the form of dividends in the upcoming year.
Second, the seven year slump in gross margins at Deswell is ominous, and can not be explained away by rising material costs (resin), Yuan appreciation, and rising labor costs. Rather, the consistent squeeze on margins tells us that the competition is catching up. The squeeze has been so tight that gross margins today are threatening to dip below net margins produced less than a decade ago.
Lastly, the company’s impressive financial performance is less impressive when observing the company’s increasing share tally. Dilution is not necessarily a grave concern for DSWL shareholders, but it is a concern.
These items of interest do not suggest that Deswell has completely lost its competitive advantage of operating efficiently in China. Only that the dividend yield going forward is likely to be closer to 4% than 7%, that the impressive streak of 40+% net margins produced in the late 1990s is not about to be duplicated, and that dilution should be monitored closely in order to put potential returns into context. On the positive side of things, the company has shown an ability to reduce costs quickly in response to negative changes in business conditions, and management has aggressively added to the company’s state-of-the-art injection molding facilities without acquiring any notable amount of debt. As for the company’s balance sheet, no major revisions have ever been made and - with the exception of rising inventories (compared to flat sales) - every major line screams financial strength and stability.
Conclusion and Investment Opinion Although still heavily reliant on a few customers, Deswell has expanded its customer base and decreased exposure to any single customer in recent years (Digidesign, Inc. and Epson Precision (H.K.) Limited combined for 37% and 33% of Deswell’s sales in the last two year respectively). Deswell currently generates 40% of sales from the United States, and this figure has steadily increased every year since the 2001 US recession. Geographical and customer trends are important to the investor because they are leading indicators of Deswell’s financial performance. Most notably, with the threat of another US recession on the rise (as US housing prices fall) Deswell’s US sales could take a hit. As for currency, commodity, and the competition, these are areas of interest that the average investor can draw few conclusions on. China will allow its currency to appreciate on its own terms, but the US is growing increasingly anxious, and predicting when, and if, commodity prices will decline and alleviate some of the margin pressures at Deswell is impossible to do. As for the competition, Deswell says that they are “not aware of any empirical data defining the manufacturing industry in China” (20-F). What information is available and updated regularly (i.e. Plastics News) is primarily news or anecdotally driven. In short, Deswell was “diamond in the rough” in 2000, and may well be an undervalued gem at, or below book tangible book value ($7.21) today. It would likely take a severe and sustained economic downturn for DSWL’s assets to stop producing positive returns. Nevertheless, the risks going forward are so numerous the potential rewards are not notable enough to make Deswell an attractive buy at $9 a share. Rather, and despite an impressive financial history, the Deswell machine is acting broken, and there may not be a quick fix. Ultimately what may be required for Deswell to thrive again is the destruction of competitive forces that have amassed in China. During any destruction and/or consolidation phase Deswell’s balance sheet could be negatively impacted, and the declining returns on assets and equity already being witnessed could actually turn negative for a period of time. In other words, the most opportune time to invest in Deswell is not necessarily when its share price is falling, but when the investor can conclude with a large degree of confidence that financial returns will soon stop falling. Deswell remains on our Watch List with a reevaluation target of $7.21 a share. Disclosure: No at or associated with FallStreet.com has any investment position in Deswell Industries.
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