Boring Portfolio Boring Buys ZTEC
April 29, 1996

Zytec Corp. (NASDAQ: ZTEC)
7575 Market Place Dr
Eden Prairie, MN 55344

Phone: 612-941-1100
WWW site:

Closing Price, April 26, 1996: $24
Trade: Buy 200 shares


Peter Lynch often notes that the entrepreneurs who supplied the picks and shovels to miners during the California gold rush ended up making a lot more money than the miners did. So smart investors should not overlook the stocks of boring "pick and shovel" companies when constructing their portfolios.

Lynch's advice is echoed in "The Internet Report," a hot item in bookstores these days. In it, Morgan Stanley analysts Mary Meeker and Chris DePuy offer their ideas about how to invest in a medium that could play as big a role in the economy of the next century as railroads played in the last.

They suggest buying stocks of the Internet infrastructure providers -- companies like Cisco Systems, Ascend Communications, Cascade Communications, and U.S. Robotics. These firms are to the 'Net what the companies who provided the tracks and ties were to the railroad industry. The Morgan Stanley report estimates that in the next four years, the total business of these Internet infrastructure firms will grow to $43 billion: four times its present size.

Meeker and DePuy give some sound advice. At the moment, however, the stocks they list are awfully expensive. Moreover, if you have the funds available to add only one "Internet play" to your portfolio right now, how do you decide which one to choose?

The Boring Portfolio's solution to this predicament is to push the question back one step further: If Cisco, Ascend, Sun Micro et al., equip the "network of networks" that is the Internet, then who provides the stuff those companies need to make their equipment? And once you locate those companies that live further down the Internet food chain, which of their stocks offers the best value for the money?

The answer I've come up with is the last name in technology -- literally. It's Zytec Corp.

Based in Minneapolis, Zytec is a leading designer and manufacturer of custom electronic power conversion equipment for original equipment manufacturers in the computer and other electronic equipment industries. The company also provides repair services for power supply models produced by more than 200 manufacturers and dedicated repair and materials management services for a major customer. Zytec's customers include nearly every major internetworking equipment manufacturer in the world, including IBM, Cisco, Hewlett-Packard, Xerox, Digital Equipment, Cabletron, Bay Networks, Sun Microsystems, and more.

By way of example of what Zytec makes, permit me to quote from the company's latest annual report (which I commend highly to you, by the way):

"The Cisco 7010 [router] uses a Zytec-designed power supply with a continuous duty rating of 600 Watts. Four DC voltage outputs are provided, based on AC inputs ranging from 85 to 264 Volts at 47 to 63 Hz. A similar supply utilizes DC inputs ranging from 38 to 72 Volts. Other features include remote shutdown capability, over-temperature protection and fan-fail protection. The Cisco 7010 power supply fully meets recent IEC 1000 active power factor correction and EMC standards."

In a nutshell: Zytec powers the Internet.

Zytec's sales grew by 33% last year but earnings increased by only 15%, well below expectations. A shortage of essential semiconductors virtually shut down production on several key projects late in the second quarter of 1995 and pinched production in the third and fourth quarters, as well. Through a combination of makeshift product redesigns, aggressive parts sourcing, and working both their plant and people beyond capacity, Zytec coped as best it could with the flood of orders coming in the door. The cost of operating under those conditions was high, however, and net operating margins slipped to 2.3% for the year.

The company has responded by acquiring a 74,000 sq. foot manufacturing facility in Broomfield, Colo., and expanding its Redwood Falls, Minn., plant. Zytec also purchased a Hungarian facility in March, 1996, as part of that government's privatization strategy. The Hungarian plant was a going concern at the time of the purchase, and it has already begun supplying magnetic components to Zytec's Austrian subsidiary, as well as eventually supplying Zytec USA.

On April 23, Zytec reported 1Q 1996 sales of $61.1 million, up 86% from the year-ago quarter. EPS of $0.43 compared with $0.03 in 1Q 1995. Net operating margins had increased to 3.45%, as parts shortages eased somewhat and the company was able to fill its large order backlog from 1995.

In a conversation following the report of first quarter earnings, Zytec's VP for Finance, John Rogers, told me that the company had gotten more knowledgeable about supplying leading-edge customers and reducing its cycle time from designing a product to getting it to market. This knowledge base, together with easing supply constraints and the expanded production facilities, should contribute to improving profit margins.

Zytec expensed all start-up costs in the first quarter associated its new Colorado facility and will do the same for some continued expenses in the current quarter.

During 1Q:96, Zytec achieved seven new product wins, from three different customers. The company expects to do $25 million in business at the new Colorado plant, beginning in the current quarter, and altogether the company now has total capacity to reach $300 million in annual sales (as compared with last year's $170.5 million).

Zytec has a distinctive "Minnesotan" culture about it. The company's management is modest and low key. Make no mistake, though: they know what they are doing. Zytec won a Malcolm Baldridge National Quality Award in 1991, and it consistently wins contracts from some of the most demanding and quality conscious customers in the world.

As of the end of 1995, cash flow per share stood at $0.81. Long-term debt of $5.6 million was 8.4% of total assets; total debt/asset ratio stood at 0.68. As Zytec expands, an additional equity offering is likely.

Corporate Performance 1995  1994   1993  1992  1991
Revenues ($Mil)      170.5  128.1  90.6  89.6  79.4
Net Profit ($Mil)      3.9    3.4   2.7  -3.3   0.6
EPS                    0.84   0.72  0.73 -1.09  0.18
Net Profit Margin (%)  2.3    2.6   2.9  -3.7   0.7

(source: Morningstar)


Since it went public in 1993, ZTEC shares slumbered around the $10 mark until the company reported its strong 4Q earnings in late February of this year, whereupon the stock rose sharply to the $15 level. Then on March 19, Zytec issued a press release saying it expected earnings for the 1Q ending March "to be approximately 40 to 45 cents per share," compared with current analysts' estimates of $0.25. In response, the stock gapped up to hit $20 and rose steadily to close at $30 1/8 on April 23, as traders anticipated an earnings surprise in the company's report of quarterly results.

That report brought no such surprise, as the Minnesotans did exactly what they said they would, posting EPS of $0.43 -- well north of the $0.25 that would have pleased Wall Street barely a month ago, and merely 1333% better than the three cents per share the company made in the year-ago quarter, but no surprise.

To make matters worse (from the stand-point of momentum traders), the company cautioned that the huge spikes in sales and earnings were not sustainable, and that analysts should expect revenues to be relatively flat sequentially for the remainder of 1996, although earnings might rise a bit as margins improved.

The result of this apparently anti-climactic report was that ZTEC shares sold off, ending last week at $24, down 20% from their recent peak. At that price, the stock is trading at less than 14-times the $1.75/share that two analysts who follow the company have just projected for the year. (Note: sequentially flat earnings for the year would yield 4 X $0.43 = $1.72).

That $1.75 estimate is more than double last year's $0.84. Although that kind of growth is surely unsustainable, the networking infrastructure industry is forecasted to grow by 40% annually between now and the turn of the century. So even if we assign a multiple of half that size to ZTEC, that works out to a current (as in "today") fair value of $35 for the stock -- and solid appreciation potential from there. Given that the stock was trading at $30 a week ago, these estimates feel eminently plausible to me.

Note also that with a market capitalization of $118 million, Zytec is valued at less than 0.7 times 1995 sales. Zytec's peer, Computer Products, Inc., sports a price/sales ratio of approximately 2.0.

Investor's Business Daily rates ZTEC 77 on EPS growth, 98 on Relative Strength, and A on accumulation/distribution.

Heartland Advisors, based in Milwaukee, controls 10.6% of ZTEC stock. Stein Roe & Farnham holds another 5.8%. Zytec's CEO, Ronald Schmidt, owns 10.8% of the firm's approximately 4.91 million shares. Other insiders control another 28.1%. The float (as listed in IBD) is only 2.3 million shares.


Bear in mind that although the story behind Zytec is boring, the recent stock movement has been anything but. The share value has tripled since December. Yet the stock still represents excellent value, as I see it. Given the relative stability of the rest of the Borefolio, it can handle a little bit of spice in the mix.

--Greg Markus (MF Boring)