This article is part of our Rising Star Portfolios series.
Investment ideas come from many places: watchlists, newsletter recommendations, even discussion boards. Today's idea comes from the latter. Fellow Fool nonzerosum suggested some three weeks ago that my Messed-Up Expectations (MUE) portfolio invest in Nam Tai Electronics
After digging further into the company, I agree.
Why it's appealing
If you like gadgets, then you probably like Nam Tai, or at least have used its products. It's a Chinese maker of components used in putting together cell phones, notebook computers, digital cameras, and other electronic gadgets. While it doesn't sell directly to consumers, it is affected by the success of those that do.
As you might imagine, it was hit pretty hard by the last recession, with revenue dropping 20% and 34% in 2008 and 2009, respectively, while net income fell 56% and 95% for those two years. Even in the depth of the recession, however, it managed to eke out a profit, something that its two major competitors, Jabil Circuit
Instead, management at Nam Tai has been paying off debt -- it currently has none -- and cutting costs. That's paid off handsomely in 2010 as the company grew revenue and net income again in each of the last three quarters, ending the year up handsomely over 2009.
Management expects to see 2010's growth continue through this year, at least. Add in a new manufacturing plant in Wuxi, China, that should turn profitable by the end of the year, and the company is looking at even better profitability in 2012.
What could hurt
The biggest concern is a significant slowdown of the world economic recovery, which could be exacerbated by oil remaining at its currently high level for an extended period of time. The latest issue of The Economist suggests that a 10% increase in the price of oil cuts a quarter of a percentage point off global growth. The editors say that the world's economy is currently growing at about 4.5%, so a sustained move to above $150 per barrel would put a serious crimp in the recovery.
However, even during the depths of the last recession, Nam Tai managed to stay profitable, smartly building cash, reducing debt, and cutting costs. If another recession occurs, the company is still in a strong financial position to weather it.
Another significant concern is its location. Being in China opens several potential risks. For instance, management wishes to expand production capacity and start building on land in Guangming that the company has owned the use rights to since 2005. The local government has yet to release the land to the company and, until it does, nothing can be started, potentially hurting production capacity next year. However, assuming the local government lets this project move forward, that would be paid out of cash, with no need for debt.
Other risks in China include higher inflation, higher labor costs -- salaries have increased 100% over the past year -- and higher income taxes, with another 3 percentage points of increase expected in the latter over the next two years.
What I'm doing
At last night's closing price of $7.53 per share, the market is expecting 4.2% growth in free cash flow to equity (FCFE) per year for the next five years, 2.1% for the five years after that, and then no more growth at all (discounting at my 15% hurdle rate). Given the smart moves being made by management and its improving sales and profitability, I believe that's a bit of an MUE.
Only one Wall Street analyst follows the company, and his growth estimate for earnings is 12.5% over the next five years. Note, he's been behind the curve in estimating quarterly earnings for the past three quarters as sales turned around (but he is catching up). Assume the company can grow FCFE at that rate for five years, 6.2% for the following five, then reach a terminal rate of 2.5%, and shares would be priced at more than $12, some 60% higher than currently.
In short, Nam Tai is seeing improved sales and profitability, is reaping the benefits of cost cutting, and is investing in its own growth. I think the market is underestimating what is possible over the next couple of years for this company. The risk of a major pullback in the world economy is real, however, as are the problems of operating in China listed above. Therefore, I'll be purchasing about $350 worth of shares tomorrow for the MUE portfolio, a 2% position, and will likely keep it at that level until the risk of a worldwide economic slowdown recedes somewhat.
Fool analyst Jim Mueller doesn't have a position in any company mentioned. He works for the Motley Fool Stock Advisor newsletter service. Nam Tai Electronics is a Global Gains pick. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy is never messed up.