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Tuesday, June 30, 1998
Innovex, Inc.
(Nasdaq: INVX)
Phone: 612-938-4155
Website: http://www.innovexinc.com
Price (6/29/98): $13 5/16
HOW DID IT FIND TROUBLE?
As the leading supplier of a key component used in computer disk drives, Innovex saw its stock speed from $6 to $43 in just over 16 months as all the drive makers enjoyed a blissful period. For the last year, though, Innovex's business has slowed with the industry. After a few false starts at a recovery, the company's stock has finally crashed, thanks to another wave of industry pessimism.
The backdrop for these troubles is an inventory glut created by hyper-production in the first half of '97. Asia's meltdown last fall then led to fierce price-cutting by all players, with the pain eventually making its way to all the component suppliers. At the same time, PC manufacturers have been moving to a build-to-order business model, exacerbating their suppliers' troubles as Dell (Nasdaq: DELL) and would-be copycats slash their own inventories.
Innovex's sales peaked at $42 million in the third quarter of '97 when it was producing close to 12 million lead wire assemblies per week. Results have fallen off since then, with sales of $32 million, $33 million, and $25 million in the past three quarters. Although the company has remained profitable, production fell to just 7 million units per week by the end of March when Innovex reported earnings of $0.28 per share. That was just shy of analysts' estimates, but down from $0.66 a share in the year-ago period. Revenues plunged 35% from the second quarter of '97.
The April earnings announcement brought encouraging signs of an industry recovery. Management predicted a sequential improvement in the June quarter. Alas, that was not to be. CFO Doug Keller recently told our own Jeff Fischer that April's high number of orders trailed off in May. Innovex now expects the June quarter to be flat with the March period; moreover, forward visibility hasn't improved.
With head suppliers such as Read-Rite (Nasdaq: RDRT) and Applied Magnetics (NYSE: APM) getting crushed and leading drive maker Western Digital (NYSE: WDC) now projecting a disastrous June quarter, investors who had been hoping for a turnaround in the drive industry have apparently just hit the road heading in the opposite direction.
BUSINESS DESCRIPTION
Based in Hopkins, Minnesota, Innovex is the leading supplier of lead wire assemblies used in thin film disk drives for personal computers. These fine twisted magnet wires connect the back end electronics of a disk drive with the heads that read and write information on the disk. They accounted for 87% of Innovex sales in FY97 and 78% in the March quarter.
The broad industry transition to magneto resistive (MR) heads has produced contrary trends. MR technology reduces the number of heads required to achieve the same disk drive capacity. Yet, MR lead wire assemblies have a higher selling price than those used with inductive heads.
The company's new head interconnect flex (HIF) product, manufactured by its Litchfield Precision Components unit acquired in May '96, may eventually replace lead wire assemblies. The HIF is a small flexible circuit that automates back-end hookup, creating savings for the drive manufacturer. The company believes HIF offers at least a 20% price advantage over other integrated solutions offered by competitors.
Innovex sells to virtually every manufacturer of disk drive heads, with its three largest customers being Seagate (NYSE: SEG), Read-Rite, and Yamaha. The next tier of customers includes Applied Magnetics, Quantum (Nasdaq: QNTM), and TDK. In FY97, its top five customers accounted for 28%, 25%, 15%, 9%, and 7% of sales, a degree of customer concentration that creates significant risk.
Its leading competitor is Hutchinson Technology (Nasdaq: HTCH), whose TSA product will compete against Innovex's HIF technology. Insiders own 7% of the stock, with most held by Chair/CEO Thomas Haley. For more, see the conference call synopses and related reports in the Fool Portfolio's archive and last spring's Daily Double.
FINANCIAL FACTS
Income Statement
12-month sales: $132.4 million
12-month income: $30.2 million
12-month EPS: $1.98
Profit Margin: 22.8%
Market Cap: $201.8 million
Balance Sheet
Cash: $47.7 million
Current Assets: $74 million
Current Liabilities: $7.5 million
Long-term Debt: $0.8 million
Ratios
Price-to-earnings: 6.7
Price-to-sales: 1.5
HOW COULD YOU HAVE SEEN IT COMING?
With bloodshed throughout the drive industry, investors might have feared that this cyclical downswing would eventually cut into even profitable component suppliers upstream of the price slashing at Compaq (NYSE: CPQ) or Western Digital.
With Innovex trading in April in the mid-$20s -- about where the Fool Portfolio purchased it in June '97 after the industry slowdown was first felt -- investors had essentially failed to price in the post-October turmoil, and thus the risk that the light at the end of the tunnel would keep receding.
WHERE TO FROM HERE?
Innovex remains a remarkably profitable business, with 17% net profit margins even in the difficult March quarter. Moreover, it's got a terrific balance sheet, sporting $3.09 per share cash net of debt and reasonable inventories. Even more important, it has been investing in future growth opportunities.
The $15 million used to build its Litchfield automated production facility has created capacity to make over 2 million HIFs per week, with actual production approaching 1 million per week as of the end of March.
Plans call for another $7 million to be invested to expand HIF capacity to 10 million units per week by the end of the calendar year, meaning Innovex can handle all possible demand. HIF technology is being used in Seagate's Cheetah drive, and Innovex's yield improvements have allowed it to drop prices as planned, generating increased interest.
Also, the Litchfield unit will allow Innovex to enter the semiconductor flex circuit packaging market. Management expects that high-margin industry will see 35% annual growth over the next five years. Ramp up for such offerings should begin by year end.
The current consensus estimates call for Innovex to earn $1.13 per share for FY98 ending in September and $1.51 a share for FY99.
After its recent thrashing, the stock may finally have factored in all the potential bad news (famous last words!). The earnings run-rate is $1.12 (4 x $0.28). Management aims to deliver 20% long-term growth. The stock typically trades at a discount to its growth rate. Using a multiple on trailing earnings of 16, fair value for Innovex would be around $18.
Backing out cash from the stock price, Innovex trades at just 8.4 times its currently depressed run-rate. Assuming that business simply stabilizes at the current level, it seems reasonable for the stock to regain the ground given up in the last month.
Then again, the PC industry's shift to build-to-order may take years to play out. Component suppliers may continue to find themselves caught in price wars as production capacity remains high relative to the shrinking OEM demand. Innovex's business should be able to weather this storm, but capacity utilization issues will likely continue to constrain gross margins and, thus, overall profitability until the entire industry has adjusted supplies to match the new model.
Major caveats. Still, anyone looking to play the drive industry's eventual rebound should give Innovex a serious look.
-- Louis Corrigan
(TMFSeymor@aol.com)
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