Richardson is Having an Interesting Product Cycle

This is a product-based thesis. The company, Richardson Electronics (RELL), long a “dog” stock with a lousy corporate governance structure, is having its day. It has a few new products that are finding eager audiences. These products include ultracapacitors to replace lead acid batteries in backup power systems (wind farms, telecom base stations, et al); lithium phosphate batteries to replace lead acid batteries in diesel engines; and magnitrons used to convert methane into diamonds (seriously).

“Why this? / Why now?” comes down partly to Maxwell’s demise under Tesla; partly due to ESG rethink of the use and pervasiveness of lead batteries; partly due to keen segment management by industry veteran Greg Peloquin, who returned to the company from Arrow in 2016; and partly due to the CEO’s willingness to fund odd and interesting projects.

The stock may be cheap for a number of reasons. Investors may assume growth is cyclical semi CAPEX related. The company’s long history of under-performance and poor corporate governance may lead to doubt and disbelief among otherwise knowledgeable investors. It is likely to fly under many investors radars and requires a bit of effort to understand. But the company seems to have locked up substantial supply of raw materials at reasonable prices and has a head start on competitors in what could be a large and durable niche in the uninterruptible power supply ecosystem and possibly beyond.

Introduction: Richardson Electronics (ticker: RELL), an electronics parts manufacturer and distributor, is a publicly traded family business. At the current price of $14 and with 14M diluted shares outstanding (Class A + Class B), RELL has a market valuation of ~$200M. Less ~$40M cash (no debt) yields an enterprise value of $160M. Given TTM EBITDA of ~$18M this yields an EV / EBITDA multiple of ~9x. It trades roughly in line with, if not at a slight premium, to its industry group but TTM sales growth of 30% is the highest among them and EBITDA has grown faster.

The electronics distribution business is operating in the midst of global inventory imbalances and a semiconductor CAPEX cycle. Knowledgeable but uninformed investors would wisely apply a low multiple to cyclically inflated sales for companies so exposed. However, the underlying thesis on RELL is only partially driven by current cyclical industry conditions.

This thesis is primarily driven by specific products the company offers. Broadly speaking, these products are supported by “a new age of electrification”. I realize it’s a weird thing to say 90 years after the death of Thomas Edison, but there is a shift happening on the margins resulting in changes in energy storage away from non-hydrocarbon sources and changes in generation from non-combustion sources. Wind and solar generation, hydrogen, lithium or various kinetic systems for storage, nuclear, etc.

How much of the total energy pie these alternative eventually provide isn’t known or even relevant; it is such a big pie that small changes are meaningful, especially to the component supply dynamics in the electronics industry, leading to changing demands for power management and power storage across the production chain. This is RELL’s wheelhouse.

Specifically, there are three product tailwinds of note:

1.   Ultracapacitors replacing lead acid batteries for remote backup power, et al. A lead industry website indicates that 86% of global lead production is for lead-acid batteries used in transportation, and also for zero emission and hybrid vehicles, back-up power (for example for computers and telephone systems), and energy storage in remote power applications. Global production of lead is about 12M tonnes and it is said that 90% of lead is recycled but this math doesn't seem to foot.  

How big is the lead market? I’ve seen (free) internet data that global lead sales is ~$20B and that global lead acid battery sales are ~$40B. How much of that is uninterruptible power supply? I am trying to find out, but don't think 10% is a conservative guess. A UPS system typically includes a lead acid battery as a starter. Given how we’ve "rethunk" lead in paint and gasoline it’s not a stretch that engineers would rethink its use in batteries, especially in an ESG dominated world. Ultracapacitors, which hold a charge longer than regular capacitors, offers an improved solution for UPS systems. 

These improvements are especially functional in wind turbines, which take a lot of effort to maintain. Each blade of a wind turbine has its own pitch control system so the blade no longer catches wind. Each pitch control modulator has its own backup power system. Vestas wind turbines control blade pitch hydraulically (in a fault, gravity does the work) but hydraulics are messy and prone to failure. Other manufacturers – including most GE wind turbines - use electronic systems with a lead acid battery as the backup power source.

The problem is that lead acid batteries require replacement every 3-5 years and degrade in extreme temperatures. There are opportunities to do better. Wind turbine owners are electing to swap out lead acid batteries for ultracapacitors, which last more than 10 years and operate consistently in wider temperature bands. An ultracapacitor need only store enough power to pitch a blade, which takes less than 30-seconds. Here's a short video from 2018 with a former regional sales manager at Maxwell (he's now at Licap). 

In May I attended the American Clean Power conference and talked to competitors, customers, OEM’s and installers all of whom affirmed this evolution. In the US based aftermarket wind turbine business alone, this is estimated to be a $300M opportunity (30,000 installed GE wind turbines x $10,000 / turbine). 

The opportunity to sell U/C’s into the wind farm world fell into RELL’s lap when Tesla acquired Maxwell for its dry capacitor business and shut down everything else. RELL (and many others) formerly sourced U/C’s from Maxwell. Forced to go elsewhere, it now has an exclusive supply agreement with Korean-based LS-Mtron for distributing U/C’s into the US “green energy” space. RELL is supposedly buying every U/C LS Mtron makes and at a significantly lower price than from its prior supplier. 

RELL US assembles the U/Cs into a form factor identical to the lead acid battery system and has a patent on this design. Former Maxwell folks have split into two separate companies (LICAP and UCAP, which acquired the old Maxwell business). They, along with Skeleton in Europe, are pursuing this market, all from behind RELL.

I think this market alone is enough to support continued growth and earnings from a low base. But taking a step back from wind turbines, when one considers how often a lead acid battery is integrated into a backup power system (at telecom base stations, to start a generator, etc) and that ultracapacitors last longer and need less maintenance than a lead acid battery, and that lead acid batteries are considered “dirty” in an ESG world, it isn’t a hard stretch to believe the ultracapacitor opportunity could be quite a bit larger than simply backup pitch control systems for GE wind turbines.

2.       Diesel electric engines replaced with lithium phosphorous engines. RELL has a supply distribution agreement with Chinese based Amolgreen to supply lithium phosphate batteries to Progress Rail – a division of Caterpillar – for integrating into rail cars. The sales value per car is in the six figures. RELL is one of the few US manufacturers with the capability to assemble these cells in the US, meeting “Made in America” purchasing requirements. The company believes that in-roads with CAT could bear fruit on additional machinery and implements.  

3.       RELL builds specially designed magnetrons that used to create synthetic diamonds from methane and for tire recycling. The specialty magnetron is an engineered solution where RELL has called out significant growth as per the 3Q22 earnings call (4/7/22): “For instance, on the magnetrons, in the normal year on the YJ1600, we build 800 a year. And we went from building 800 last year, we have orders for over 5,000 right now.”

In addition to these secular tailwinds, and as previously mentioned, there is concurrently a semiconductor CAPEX cycle, which is driven by both supply / demand dynamics (ie resolving “chipageddon”) and the effort to produce chips and components domestically. Chip making is a highly cyclical and high capital intensity business and development CAPEX will ebb and flow. The key is that I think most investors believe whatever is happening at the company today is mostly tied to the semi CAPEX cycle and missing the greater product related “secular” event.

History. RELL was founded by the father of current CEO Ed Richardson, who has worked there (according to his self-reported business biography) since 1961. Mr. Richardson owns 2.1M Class B shares, which convert 1:1 to common shares but has 10x voting rights. This situation gives him ~60% of the vote, a corporate governance red flag and therefore should be noted right off the bat.

Started in the 1940’s as an electronics overstock seller and distributor, the company moved into manufacturing through the 1981 purchase of National Electronics in La Fox IL – still the national headquarters - and it went public in 1983. Skip ahead to 2010: Over-levered, losing money and suffering from the transition from analog to digital TV, the company sold its core RFPD electronics distribution business – it’s largest segment - to Arrow Electronics for $210M, leaving behind a smaller company with two business lines: The “Electron Device Group”, focused on capacitors, vacuum tubes, and high voltage power supplies and an integrated display business (ie “Canvys”) focused on the healthcare space. (Expecting parents possibly saw the first glimpse of their issue on a Canvys display integrated into an ultrasound machine.)

In 2014, three years after the sale of Richardson RFPD to Arrow, the company rehired that segment’s leader, Greg Peloquin, who had been part of the sale, and put him back in charge of the EDG division, an effort akin to “getting the band back together.” The primary driver of this investment thesis is substantial growth and opportunity in this segment, now renamed “Power and Microwave Technologies” (PMT), and notably in ultracapacitors and magnitrons.

A homegrown third business line called “Healthcare” launched in 2016, manufacturing replacement tubes (“Alta 750”) for CT-scanners and MRI machines. This business has struggled due to OEM’s willingness to match replacement prices in order to protect long term service customers. This segment has been a drag on earnings and possibly as an acknowledgement of its poor market position, incentive compensation for the Canvys and PMT business leaders excludes performance at the Healthcare segment (ie 50% segment results, 50% corporate OpInc excluding Healthcare).

Status quo in Healthcare is not sustainable. Either of the two alternatives - success in pending product launches for Siemens machines or outright closure of the segment – would both be beneficial to earnings. I don’t anticipate any success here; any would be meaningful upside to what is already attractive.

Financials. The company’s fiscal year ends in May and it already preannounced FY22 sales of $225M, up 27% y/y, accelerating from 13% sales growth in FY21. Margins have expanded since 2H21 from the lower single digits to higher single digits. Backlog at year end was $200M, up 87% y/y, but this should be taken with a grain of salt, since the company has only recently started quantifying backlog. (Management says it was previously immaterial).

Management has indicated that backlog is driven primarily by volume, not price and not supply chain backup. The concurrent growth in sales AND backlog speaks to this trend. If these opportunities for ultracapacitors and magnitrons are as real as they seem to be and they are delivering on them as they seem to be, this will be worth substantially more.

FCF. It’s understandable for a company in the distribution space to use its working capital to fund growth by re-investing profits into inventory and receivables - that’s what distributors do – but RELL’s FCF conversion is lumpier than larger, well known and arguably better managed distributors. This probably speaks to the opportunity for better w/c management. Given the corporate governance structure, the CEO would need to find their own motivation to change. In the meantime, he’s buying as much inventory as he can b/c he thinks the market could be big

Valuation. The company is likely to do $20M in EBITDA this year, so the stock is trading at less than 8x FY22 results. Growth is largely driven by discrete products in the company’s portfolio and primarily tied to a secular “age of electrification”. If these trends continue and the company can indeed deliver, there’s an argument for this re-rate higher against higher forecasts. Given the importance of a few products on this thesis, and given the company’s long history of under-performance, I expect this asset will require a more than the usual monitoring.

Risks. There’s a tendency for investors to try to encapsulate risks as if they aren’t infinite. On the flip side, it’s not hard to worry unendingly about everything. Here are a few rational concerns at the top of my risk list:

As a family business, it is possibly not run to optimize for efficient manufacturing. A database search for “six sigma” or “lean manufacturing” within RELL documents showed zero hits.

Ultracapacitors don’t work / manufacturing is shoddy. This is kind of a new market and variuances out to be expected. Maybe turbines are the test bed, particularly b/c the maintenance is so onerous. But what if they don’t hold up? Also, RELL says its sole sourcing from a S Korean manufacturer that is new to the market and therefore reliant on a single supplier for a large market.

Limited history of value realization. For the many years the company has been around, results have been mixed. Over the last 20 years, you’d have seen growth in Tangible BVPS (see graph) only for the first 10, culminating in the RFPD sale. And the company has come across my radar over the over the years generally viewed as a “value trap” ie cheap without a catalyst. I think the poor corporate governance, the long history of under-performance, and the belief that growth here is all driven by a cyclical semiconductor CAPEX cycle phenomenon leads to the mispricing. However, underlying secular trends notably effecting the PMT group offer potential for a sustainable shift in earnings power that is not yet reflected in the price.

 

Corporate governance risk. For better or worse, the CEO does not make decisions 100% optimized for capital allocation and shareholder returns. The reality is, most CEO’s - and most people too - operate for the sake of ego gratification first and foremost and it’s the rare leader that puts the customer or shareholder first. My impression is that the RELL CEO cares deeply about customer and employee satisfaction but that has not translated into durable shareholder returns.

Changing tides on ESG. I don’t see anyone “standing up for lead” the way they do with coal or gas, especially given we’ve removed it from other products over the years due to its extreme toxicity, but anything is possible.

These risks can be ameliorated through portfolio management ie keeping the position size reasonable until pending deeper due diligence over time.

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