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My deep conviction on Pro-Dex (PDEX)

For the past couple of months, my deepest conviction long idea has been Pro-Dex (PDEX). If friends, family, or other investors asked what I was into at the moment, my first answer was, “PDEX.”

Only recently have I begun to find other stocks that I like as much as Pro-Dex… at present prices.

Anyway, here are some of my own and others’ writings on the story over the past three months:

A thesis e-mail I wrote to some friends in late July:

“Nasdaq-traded Pro-Dex is a medical and dental device maker in Irvine, CA.

“A few years ago, their biggest customer decided to take design and production of their devices in-house. Pro-Dex management responded by paying themselves higher salaries while the customer purchased one last inflated build-up of PDEX devices. This customer accounted for 40% of PDEX sales at the time.

“Pro-Dex management also completely failed to cut costs despite full awareness that they were about to lose 40% of their revenue. Losses ensued. The stock dropped significantly and has dribbled around $2 for five years.

“In 2012/2013, two activist hedge fund managers bought significant amounts of PDEX stock and took control of the board. Their proxy letter from December 2012 is well worth reading. They got rid of the old CEO and promoted an insider to lead the company.

“Together, they began to implement structural changes:

  • Most importantly, costs have been significantly reduced. This is easy to see from a simple glance at the past few years’ Statements of Operations.
  • Compensation to board members was slashed to almost nothing. (Obviously Swenson and Cabillot believe they will make their money via appreciation in their large equity stakes.)
  • Pro-Dex’s excess capital is now being invested by Swenson and Cabillot.

    PDEX headquarters

    Pro-Dex headquarters in Irvine, CA

“With these changes in place, Pro-Dex has only one task left: to increase its decimated revenues. The sales cycle in medical devices is long and involves many meetings with prospective customers as needs are communicated, engineers design, prototypes are built, prototypes are tested and re-tested, until finally (hopefully) the customer says, “Yes, this is it. Make me 1,000 of these devices, please.”

“Pro-Dex has been in a multi-year research and development phase for a significant new drive for devices, which they have said for a while now could first bear fruit on the next quarterly earnings report, due in September. [Update: Actually, that date has been pushed back to fiscal Q3 which will be reported in May 2015.] If and when PDEX shows evidence that they are getting orders for their new devices, the stock will jump.

“The downside is fairly protected here (current price $2.14 [Update: Price at close today 10/27/2014 was $2.30]) because the tangible book value of the company is approximately $2.oo/share. Provided that losses continue to decrease and/or new sales begin to occur, I view it as highly unlikely that the stock will go much lower.

“This leaves us with a near-perfect scenario for an investor: a very small probability of a large drop in price and a healthy chance of a large gain in price… I like the risk-reward ratio here.

“The investment basically comes down to this for me: how likely do I think it is that Pro-Dex will increase their sales? My answer is this: Pro-Dex’s expertise is designing and manufacturing medical and dental devices. That is what they do. They have smart engineers, they are in this world of medical devices and know what customers are looking for. Their ship has been righted (costs cut, new controllers) and they will more than likely be able once again to increase sales by giving their customers what they are looking for. I see at least a 2/3 chance of this materializing – and a 100%+ upside if it does (with several multiples of the present price quite within the realm of possibility).

“If for some reason Pro-Dex has lost their medical device mojo, maybe there is a 30% downside.

“These are the rough calculations/probabilities which feel right to me regarding Pro-Dex.

“One further note: a couple months ago the company did a rights offering, offering all shareholders the right to buy an additional (newly created) PDEX share at $1.90. The two hedge fund managers maxed out their subscription rights (they bought as many shares as they were allowed). To see such a vote of confidence by Swenson and Cabillot should encourage a prospective investor about the company’s prospects. The shares are available for not much more than that even today, still.

“A successful turnaround seems likely – and then, nice profits for shareholders.”

Post on iHub PDEX board

On September 19, I posted my thoughts regarding Q4 and the conference call.

A briefer e-mail sent October 3rd:

“PDEX story has gotten better since I introduced it to you, yet price has barely moved up. I think it is a triple at least within a year. Very confident on this one. Company announced plan very recently to buy back up to 18% of shares outstanding over next 6 mos. [12/1/2014 UPDATE: On fQ1 conference call, CEO Hurwitz made it clear that PDEX would not be using up the whole 750,000 share buyback authorization, or anything close to it. Appears they have other ideas for the cash.] Everything comes together by May probably, when they report fiscal Q3 results, which CEO is guiding to be first quarter that shows revenues from big, new customers company has been working for years to get online. CEO, who is conservative in his talk, was notably less conservative (to my ears anyway) in last conference call. Then they announced share buyback. Earlier this year they did a rights offering which I had told you about which was really just a way for the 2 activists involved to get a larger percentage of the company (they WANT the shares) and now they will be using the proceeds from the rights offering (at $1.90/share) to buy back shares in the $2’s a mere months later. What this tells you is that the activists view the company/common stock as desirable and grossly undervalued, even if they are sneakily increasing stake over shareholders who opted not to participate in the (somewhat) sophisticated rights offering. This has been my deepest conviction idea for a couple months and conviction has gotten deeper with release of earnings and conference call a couple weeks ago.”

Recent updates

On October 22, Pro-Dex released a proxy containing a fair amount of commentary by CEO Hal Hurwitz. I actually thought his statements were less confident than those made on the conference call. In the proxy, he seemed to be managing expectations.

On October 24, Whopper Investments noted that a share buyback had begun.

 

Disclosure: PDEX is $2.30 at the time of this writing and I am long.

Nat Hunt

18 Comments

  1. Hi Nat,
    Have you had a look at the recent acquisition? It seems like they bought it on the cheap, however full details are not available to us. Although the business is quite different from the medical device area, they share the precision component. It would make sense if they can sell some fixed assets and thereby increase the utilization of manufacturing capacity. Another thing I noticed recently is that Pro-Dex started hiring again. 3 months ago the company hired a new talent manager.

    https://www.linkedin.com/profile/view?id=7537199&authType=NAME_SEARCH&authToken=U-bF&locale=en_US&srchid=562758191417471497598&srchindex=2&srchtotal=28&trk=vsrp_people_res_name&trkInfo=VSRPsearchId%3A562758191417471497598%2CVSRPtargetId%3A7537199%2CVSRPcmpt%3Aprimary.

    Since then 2 vacancies appeared on monster.com.

    http://jobview.monster.com/Manufacturing-Engineer-Job-Fullerton-CA-US-142242835.aspx?WT.mc_n=Indeed_US&from=indeed. http://jobview.monster.com/Mechanical-Engineer-Designer-Job-Fullerton-CA-US-142180762.aspx?WT.mc_n=Indeed_US&from=indeed.

    It looks like the company is making good steps.

    The one thing I didn’t liked about last earnings call is that the company was a bit vague on the timeline of the development projects. Where they were very specific on the previous call (end of Q2’15 or early Q3’15) Hurwitz now stated that they believed the manufacturing revenues would commence in fiscal ’15. He then mentioned “like previously stated”, which is not entirely true as he was very specific before. Also there are 2 major development projects, and when he talks about the timeline he treats it as 1 project. I am looking to contact the company somewhere in the coming weeks to get some clarification (if possible).

    What’s your view on the acquisition and other recent developments?
    PDEX is my nr1 position.

    • My view of the acquisition is that I’m not quite sure it’s an acquisition. They acquired the company’s debt, not its equity if I read correctly. And, I think they bought about $1.5M of principal, unpaid interest, etc. for $1.2M cash. That company is in default, so it may be a Pro-Dex sub. soon.

      Hopefully it is a heads-I-win, tails-I-win situation for PDEX: if the company is able to right its ship and pay its debts, PDEX makes a tidy return. If the company can’t pay its debts, I would guess PDEX still views the assets, customers, etc. as worth more than $1.2M.

      Now, if the company (Riverside?) was having trouble paying ~8% interest, how much more trouble it must be likely to have paying this 18% default rate? Without knowing the business specifics, it seems more likely it will fall into Pro-Dex’s hands.

      The 8-K was a bit complex, for me at least, so I had to read it a couple times to begin to get a picture of what Pro-Dex is doing here.

      PDEX is my second biggest position, 14% of my portfolio, as documented here: http://nathunt.com/2014/11/portfolio-nov-2014/

      In terms of the language used on the CC; I didn’t really pick up on that, so I haven’t given it any thought until now. I just remember having the impression that things were still on the same time-track.

      Regarding the jobs: I don’t have any insight on that.

      What do you mean when you say PDEX and Riverside share the “precision component”?

  2. Earnings released today. No operational update and no more conference calls. That’s very disappointing.

    • I am not surprised they canned the calls — with Hurwitz gone, maybe that was more his thing, or a legacy of the past Pro-Dex. I am not reading into it. I don’t think Swenson cares about the short-term price of the stock, so I don’t think he would stop the conference call for a reason like that.

      • It’s not that I’m upset there are no more conference calls. Just the way they handled it. They could have had a CC this time and announced there would be none going further or issues a press release in advance explaining their decision. They also had no management commentary and instead buried what looks like good news in their 10Q. Many novice investors will overreact without reading through the whole report.

        • This is not a short-term investment for me, so I don’t care about short-term price moves. In fact, it is more beneficial for the price to be low if they continue to buy back shares.

          • Don’t get me wrong. I’m not worrying about it. If it had tumbled today I would have bought more. I just don’t like what they did from an ethical standpoint.

          • Nat – Have they ever quantified how much revenue these two projects they are working on should bring in?

            Thanks,

            Gregg

  3. Buried in their 10Q is the following, so everything is still on track as far as I can tell:

    Business Strategy and Future Plans

    Our business today is almost entirely driven by sales of our medical products and related repair services to our largest customer (accounting for 59% of our fiscal 2015 year-to-date revenue), and we continue to focus a significant percentage of our time and resources on providing outstanding products and service to our valued principal customer.

    Simultaneously, we are working to build top-line sales through active proposals of new medical device products with new and existing customers, and anticipate completing two on-going engineering projects during fiscal 2015 which will allow us to realize previously deferred revenue recorded on these projects as well as potential new product sales later in fiscal 2015. Additionally, we are seeking additional revenue streams by offering our engineering, manufacturing and quality systems services to other customers in diverse industries, through our Engineering Services Division (“ESD”). As previously announced, we opened headquarters for ESD in Troy, Michigan and have assembled a talented team of recruiters and sales people both in our Irvine and Troy locations to generate top-line growth.

    This fiscal year we acquired two businesses, Huber Precision, which manufactures machined parts for the auto and electronics industries, and Fineline Molds, which manufactures plastic injection molds for companies in a wide variety of industries. We believe these acquisitions will allow us to diversify our product offerings and increase the utilization of our machine and assembly departments.

    In addition, during the second quarter of this fiscal year we invested $1.2 million in notes receivable secured by real property and business assets of a company located in Ramsey, Minnesota. The options under consideration relating to this investment include a complete sale or liquidation to satisfy the claims of the notes, a refinancing or restructuring.

    In summary, our current objectives are focused primarily on maintaining our relationship with our current largest customer, expanding our business with new product launches and services related to our areas of expertise, and successfully integrating recent acquisitions that will further diversify our product portfolio while increasing our manufacturing efficiency. However, there can be no assurance that we will be successful in any of these objectives.

    • Not really. But they referred to it as the two largest design projects in PDEXs history. In terms of costs or potential revenue? I don’t know.

      • Thanks. Since the development and testing phases for the projects seem to be pretty much at an end I don’t think they need to spend much more for completion. We should start to see some revenue recognition in Q3 & Q4.

  4. I’ve read a lot of 10q’s and k’s and here’s where I stand. Please let me know if you think I’m missing something:
    At today’s price you get 8.8m in book value (1.9m cash, 2.5m receivables, 1.2m Riverside Notes, 1m inventory, .5m in deferred rev, some tax assets and no LTD); modest sales growth; $7.6m backlog (which has been growing the past 3 or 4 quarters). The biggest risk being Large Customer Risk but this relationshipis growing and mgmt is pursuing other deals.
    I hate this word but you get the future for “free” which includes: 1) the 2 new/large devices that are in progress 2) Huber Percision & Fineline Molds 3) a growing backlog 4) Enginering Services 5) the in-house battery division in development 6) the possible take under of Riverside 7) share repurchase plan 8) any growth in equity investments 9) anything else mgmt can create plus a low tax bill.

    Thoughts?

    • I think that’s a good summary, Billy.

      Basically, what happened over the past few months (it seems to me) is the investment did become more complex (with the acquisitions, new businesses (engineering services)). I look at this like I am allowing Swenson to manage my money for me.

      Thanks for the comment; it will be interesting to see (maybe soon?) how this Riverside situation plays out.

    • Also, I can’t remember if I have mentioned this here, but you reminded me of it: PDEX’s equity investments have performed quite well since being established ~18 months ago.

  5. Have you had a chance to read this Riverside agreement. My first impression was they gave 1) some more time, until July and 2) a 200k revolver and received a) a higher principal owed and b) incentivized Robertson to possibly liquidate [im unsure on that point]

    • Yes, I read it. I keyed in on the language (extensive) about who gets what in a sale of Riverside. It seems that PDEX’s goal may be for Riverside to be sold (the incentivizing you mention) rather than to integrate the company into its own business.

      Now — is the higher principal just a reflection of the new loan from Pro-Dex, or is it a true concession? I was a little unclear on this although assumed it was the latter.

  6. Q3 earnings out today and looking good. Backlog up from $7.6M to $9.7. Sales up over $1M+ from last Q. They received a $500K order to ship in FY2016 and received another $500K for a product development agreement with another customer. The two big projects appear to still be on target to start generating some revenue in Q4 and ramping up into next year. They even liquidated most of their investment portfolio so they can build up inventory!

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