Sunday, 18 October 2015

Ikonics Corporation

I was running my 52 week low list this weekend and stumbled across an interesting candidate for further research.  This is not a solicitation to buy and should not be construed as a buy recommendation whatsoever.  This is just me being curious.

Ikonics Corporation caught my attention in the context of having just read Margin of Safety by Seth Klarman only because it's a tiny micro-cap company and likely won't have much (if any) institutional interest or analysts following it (which could be a good thing).  The company has 75 employees, 55% of shares are held by insiders, and only 5% of the float is held by institutions.  And best of all...

It's also very difficult to value presently.  For the six months ended 06/30/15, sales have decreased 12%, mostly due to strength in the USD vs. the Euro and other foreign currencies.

Here's a description of the company's business from the latest 10K.  What caught my attention was the second and beginning of the third paragraph:

"IKONICS Corporation’s traditional business has been the development and manufacturing of high-quality photochemical imaging systems for sale primarily to a wide range of printers and decorators of surfaces. Customers’ applications are primarily screen printing and abrasive etching. These sales have been augmented with inkjet receptive films, ancillary chemicals and related equipment to provide a full line of products and services to its customers. 

In 2006, the Company began a major effort to diversify and expand its business to industrial markets. These efforts now include the Company’s Advanced Material Solutions (AMS) business unit, formerly named Micro-Machining, which uses the Company’s proprietary process and photoresist film for the abrasive etching of composite materials, industrial ceramics, silicon wafers, and glass wafers. The customer base for AMS is primarily the aerospace and electronics industries. 

Based on its expertise in ultraviolet curable fluids and inkjet receptive substrates, the Company has also developed a patented digital texturing technology (DTX) for putting patterns and textures into steel molds for the plastic injection molding industry. The ultimate original equipment manufacturer (“OEM”) for the Company’s DTX technology is primarily the automotive industry. The Company offers a suite of products to the mold making industry. Industrial inkjet printers, which are integral to the DTX system, are manufactured and sold by a strategic partner. The Company’s business plan is to sell consumable fluids and transfer films. For most markets these sales are direct to the mold maker. The DTX technology is being expanded to prototyping where the Company’s technology offers a unique combination of high definition and large format prints." 

Here are the last five years of results by segment.  Nothing to write home about.  For simplicity of comparison, I've combined DTX and AMS because prior to 2012, they were only reported as one segment.  I also did a straight linear annualization of 2015 results (six months x 2):

DTX + AMS960,977961,331752,168749,455843,700
Sales % 12/31/201112/31/201212/31/201312/31/201412/31/2015
DTX + AMS5.73%5.55%4.30%4.05%5.11%
Op Income12/31/201112/31/201212/31/201312/31/201412/31/2015
DTX + AMS-193,466-430,584-772,671-1,048,641-993,800
Op Income %12/31/201112/31/201212/31/201312/31/201412/31/2015
DTX + AMS-6.45%-13.29%-24.50%-31.87%-47.68%
Op Income /Sales12/31/201112/31/201212/31/201312/31/201412/31/2015
DTX + AMS-20.13%-44.79%-102.73%-139.92%-117.79%

What also caught my attention was that Ikonics Corporation had some of the characteristics of being a net-net stock in the context of Graham's teachings.  As at June 30, 2015, the company had $3M+ of cash and ST investments vs. total liabilities of $1.5M ($1M if you remove the deferred tax liabilities).

The net cash is worth about $2 per share vs. $11 per share currently in the market.  It certainly doesn't appear cheap based on 2014 ttm result of $.32 per share.  Ex net of cash $2 per share, it still trades at 28x ttm, and given the poor performance thus far in 2015, eps is likely going to be much worse than 2014.

So, being curious, I did some more digging.  The following is from the June 30, 2015 10Q:

6.            Commitments

In July 2015, the Company committed to proceed with a 27,300 square-foot building expansion project. The new, 27,300 square-foot structure will contain a 20,500 square-foot production floor in addition to offices and ancillary facilities and is expected to cost $3.5 million. The building will be an addition to IKONICS 37,000 square-foot building on its Morgan Park site in western Duluth, which currently houses AMS production, warehousing, shipping and film conversion for all IKONICS business units. All AMS activities will relocate to the new facility with an expected project completion date in second quarter of 2016.

And, From the MD&A:

Capital Expenditures

Through the first six months of 2015, the Company spent $568,000 on capital expenditures. Capital expenditures during the first six months were mainly for improvements to AMS capabilities and mandatory elevator upgrades. The Company expects total capital expenditures in 2015 of approximately $950,000, excluding building expansion expenditures. Plans for capital expenditures include additional AMS and other production equipment, a new enterprise resource planning system (ERP) to replace the Company’s current system, research and development equipment and a vehicle. 

Additionally, the Company is proceeding with a building expansion to accommodate the growth of its AMS operations. The expansion cost currently is estimated to be approximately $3.5 million, although the expansion cost could vary based on unexpected factors that arise once construction begins. The Company anticipates the amounts for the building expansion will be spent over the remainder of 2015 and the first half of 2016. The Company expects to fund its capital expenditures with existing cash and investments, cash generated from operating activities and utilization of the Company’s line of credit. The amount borrowed from the line of credit is not certain and will be dependent on Company’s operating results and the timing of cash outlays for these projects.

And, From the Outlook:

Future Outlook

IKONICS has spent on average approximately 4% of its sales dollars for the past few years in research and development and has made capital expenditures related to its DTX and AMS programs. The Company plans to maintain its efforts in this area to expedite internal product development as well as to form technological alliances with outside experts to commercialize new product opportunities.

The Company continues to make progress on its AMS business initiative. The Company has entered into agreements with major aerospace companies and smaller programs to determine the feasibility of using its unique technologies in the production of military and commercial aircraft. Progress is being made on a number of these in-house feasibility projects, and the Company believes that several of these could lead to ongoing business. In anticipation of this business, the Company is expanding its AMS capacity and patent applications.

The Company is also continuing to make progress on its DTX business initiatives. In addition to its growing inkjet technology business, the Company offers a range of products for creating texture surfaces and has introduced a fluid for use in prototyping. The Company is currently working on production improvements to enhance its customer offerings. The Company has been awarded European, Japanese and United States patents on its DTX technologies. The Company has modified its DTX technology to enter the market for prototyping and 3D printing.

Domestically, both the Domestic and IKONICS Imaging units remain profitable in mature markets and require aggressive strategies to grow market share. Although there will be challenges, the Company believes these businesses will continue to grow and prosper. In addition to its traditional emphasis on domestic markets, the Company will continue efforts to grow its business internationally by attempting to develop new markets and expanding market share where it has already established a presence. However, the strong U.S. dollar made this more challenging in the first half of 2015, and the Company anticipates continued strength of the U.S. dollar in the near term.

In addition to the $3.5 million building expansion to accommodate the AMS division and the implementation of the a new ERP system, other future activities undertaken to expand the Company’s business may include acquisitions, building improvements, equipment additions, new product development and marketing opportunities.

Here are my takeaways after reading this:

  1. The net cash that I originally thought the company had is as good as gone, given that expansion is going to cost $3.5M
  2. If I exclude DTX and AMS, the company's results don't look all that bad.  I get 2015 operating income of about $3M (EBIT), on an EV of 19M, so a pretax cap rate of about 16 2/3 %. 
  3. I think there's something to the company's guidance on making progress on the AMS initiative.  Although they haven't come out and said anything outright, reading between the lines, why else would they endeavour to spend $3.5M (16% of their market cap) on expanding AMS production facilities if they didn't have something more than "feasibility projects" which could lead to ongoing business. 
This is where the complexity in valuing the company's future possible FCF's comes in.  Thus far, since 2011, the company has had operating losses of close to $3.5M on DTX + AMS combined. Why should anything change now?

The best I can do is try to make a conservative educated guess as to what the AMS initative might generate in terms of ROI on the $3.5M spent.

If ROI is expected to be 10%, maybe AMS incremental cash flow ends up being $350K, not considering any of the other segments.  I'm going to ignore tax for the moment as the company likely has loss carryforwards for the foreseable future.  If I discount $350K at 12% with zero growth, I get $2.9M for the segment in perpetuity.  If I discount $350K at 15% with zero growth, I get $2.3M for the segment.

The other segments, exluding DTX + AMS, threw off operating income of $4M in 2014 and look like they will throw off $3M in operating income in 2015.  The company doesn't seperately disclose R&D by segment, so let's be really conservative and assume that 100% of R&D spending thus far throughout 2015 should be allocated to the Domestic, Export and Imaging segments.  This gets us $3M - $640K = $2.36M in annualized operating income.  In order to estimate free cash flow, I have to add back depreciation and amortization, add/subtract change in working capital, and deduct capx.

Again, I'm going to be really conservative, tax operating income at 30%, not add back any depreciation, and ignore 100% of the change in working capital of +$273K.  I note from the 10Q that capx of $568K was mainly attributable to AMS, so I'm not going to deduct 100% of capx in determining a valuation for the remaining segments.  This gets me after tax free cash flow of $1.6M.  If I discount the remaining free cash flows at 12%, I get $13.76M for the remaining segments, and if I discount at 15%, I get $11M for the remaining segments.

Adding the two together, I get a range of potential values between $13.3M and $16.6M, vs. current market cap of $22M (I'm going to use market cap as opposed to EV because in my analysis above, the excess cash is gone).  Not great.

What happens if ROI on AMS ends up being 15%, not 10%?  PV of incremental cash flows becomes $525M, and my PV at G = 0%, Re = 12% becomes $18M, and at G = 0%, Re = 15% becomes $14.5M.

I can't really project much better or more precisely than this, but suffice it to say, the above becomes a barometer for potential valuation scenarios should price continue to fall.  If price gets down to $7 per share from $11 currently, market cap drops to $14M, and potential margin of safety at G = 0%, Re = 12% becomes 1 - $14M / $18M = 22%.

If growth enters into the AMS picture, the results could be far better, but for the moment, this is just guesswork as to a range of possible outcomes.  One to watch for now.

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