HTCH posts fiscal year 2014 results this afternoon. They recently issued guidance and refinancing news, which included bond conversions at $3 to $3.75, with the stock currently trading at $3.62. So, while we are unlikely to be shocked by unexpected news, I am submitting this post before the report to maximize the likelihood of being roundly embarrassed by subsequent information.
Generally, recent results have been improving, though not as quickly as I might have hoped. Last quarter they announced a potentially significant new product that utilizes their technology for optical lens stabilization in smartphone cameras. I will leave analysis of that aside. It serves as a sort of free option on forward valuations, and could amount to a large new revenue base.
While it is disappointing to swallow the up to 50% dilution coming from their refinancing arrangements, I think the problem is that they have the core business, which is recovering, but is scraping the limits of available working capital until positive cash flows can pull it higher. And, they have this new, but unproven, revenue base, which is basically like a tech. startup venture. Because of the point where they are in their core business' recovery, they can't leverage it for financing the new venture. And, the new venture can't attract mature pricing on its own. So, they have had to finance with bonds that have elements of early phase financing, including convertibility at relatively generous share prices.
Here is a post I did on HTCH about 5 quarters ago. Operating results have been somewhat disappointing since then, mostly in terms of revenue. Here is the forecast of a model based on gross margins. At the time, this forecast was based on quarterly production of 130 million units with gross margins approaching 19% at the end of 2014.
In the September quarter, they produced 117 million units with 12-13% gross margins. They have guided a slight increase in production for the December quarter. In the June 2013 quarter that preceded the post with the graph, they had produced 99 million units with quarterly gross margins around 2% and TTM gross margins around 6%.
So, there has been significant improvement. Disappointment has come mostly from revenue levels. Margins should still approach expectations at any given level of revenue, and management continues to stand by their guidance for higher market share on new dual stage suspension programs, even though the programs have taken longer to ramp than expected.
The model shown in the graph would predict a current share price of about $8. It may be the case that the model overstates the current valuation because it is largely based on gross margins. In the past, gross margins probably mostly captured changing revenues, but recent margin gains have come from cost cutting. At gross margins I expect to see over the next 2-3 years, this model would predict a share price of $10-$20. Maybe the contraction in the asset base that has coincided with the recent gross margin improvements would argue that this target range should be reduced.
On the other hand, market valuations for HTCH before the post 2007 decline in market share ranged in the 1x to 2x range for both Price-to-Sales and Price-to-Book. These valuation ranges would also predict a share price in the $10-$20 range in the coming few years. And, with the recent refinancing, even the stagnant market share projections with no projected OIS revenue point to annual Free Cash Flow of around 40 cents per share. Projections more in line with guidance (my scenario 3) point to Free Cash Flow growing to more than $1 per share, even without OIS. Keep in mind that there is a tremendous asset base here, much of which had been written off, and that depreciation levels are much higher than sustainable capital expenditures. Plus, there are off-balance-sheet tax assets worth more than $5 per share, even with the recent dilution.
Here are projections of revenues and gross margins. They have around a 22% market share currently. This is down from around 60% before 2007. The bottom scenario here projects a stable 22% market share, which would be well below guidance and would also represent a decline from recent trends. The top scenario forecasts a 1% market share gain per quarter for the next 3 years, topping out at 34%. This would correspond to growth of about 5 million additional units per quarter.
The final three graphs demonstrate the effect of the refinancing on the three scenarios going forward. There were two main parts to the move:
1) A conversion of $15 million in debt exchanged for 5 million shares.
2) A planned exchange of approx. $37.5 of bonds with new bonds that include a conversion option at $3.75 per share.
Pre-conversion outcomes reflect forecasts before the refinancing. The middle bars reflect just the first step. The right, purple bars, reflect the balance sheet in the case where the second set of bonds are also converted to shares.
I have been slightly unfair in the graphs here, as the retired bonds were also convertible at a higher strike price, and I have not accounted for that previous potential dilution, as it would have only affected the best future outcomes.
These moves were probably necessary in order to secure working capital in the very near term in all potential scenarios regarding both suspensions and OIS.
In some ways, the dilution may not have been as bad as it seems because, by converting debt expense into profit, the refinancing brings Hutchinson into a more profitable position. This has the effect of creating a little more of a safety net for the worst case scenarios. But, it also has the effect of recapturing the tax assets more quickly. We can see that at play in these last two graphs, where book value increases substantially from scenario 1 to scenario 3, but book value that includes the tax assets grows more slowly. Since tax assets are currently larger than the enterprise value of the firm and represent an asset that provides no compounding returns to the firm during the time they are not utilized, the conversion provides a bit of a free lunch that partly mitigates against the dilutive effects on current shareholders.
While the delays on the hoped for returns on this position are aggravating, I continue to believe that the worst outcomes are diminishing in probability while the most likely outcomes provide valuations several times the current market value.