The defense industry, which accounted for 84% of revenue in 2019, has a positive outlook. Allocations to naval vessels, the core area of the company’s operations, however, have yet to increase, according to the 2020 National Defense Authorization Act. The company also does not have a key customer outside the defense industry, which raises concerns about continued profitability.
Even though the company has attractive prospects, waiting for a better opportunity to invest in the stock is the right decision. The stock should be closely monitored by investors to identify an attractive entry point.
Industry outlook and business strategy
TechPrecision primarily serves two industries: defense and renewable energy. In the defense sector, the company derives its revenue from the U.S. Navy by selling warships and submarine components to the department's contractors. It is also involved in the supply of guns and weapon-handling equipment. Its revenue from the alternative energy industry, which makes up 16% of total revenue, is generated by selling parts for nuclear reactors, wind turbines and solar panels.
The Navy's 2019 budget was $194.1 billion, a 7% increase from 2018. Of this, $24.2 billion was allocated to shipbuilding and conversion, which is an increase from $22 billion in 2018 and $21.2 billion in 2017. Congress has approved another $24 billion budget for naval vessels for fiscal 2020. The department projects it will need 306 ships by 2023, up from 299 in 2019. Consequently, it is likely to maintain the shipbuilding budget allocations over the next four years. This inevitably means TechPrecision will receive a higher number of orders in the future.
Currently, Electric Boat and Huntington Ingalls are the major defense contractors working with TechPrecision. The two entities are working together to deliver the Virginia and Colombia classes of submarines. TechPrecision has ongoing contracts with both companies that are expected to yield $12 million in revenue over the next two years. On the fourth-quarter earnings call in June, CEO Alex Shen reported that contractors were seeking more parts suppliers to enhance manufacturing capacity. In addition, last April, Electric Boat Chief Financial Officer Jason Aiken said the company's capital expenditures had increased by 75% from the prior-year quarter due to increasing demand in the defense sector.
The global renewable energy industry is also forecasted to grow steadily. According to a 2019 report by Zion Market Research, the solar industry will grow at a compounded annual rate of 11.2% between 2019 and 2025. Further, the World Nuclear Organization estimates the installed nuclear capacity will increase by 25% globally between 2019 and 2040. Moreover, wind power is set to grow by 300 gigawatts over the next five years. In 2018, windfarm installations increased by 51.3 gigawatts.
Because of its small size, TechPrecision cannot compete effectively with large companies in the industry. As a result, it concentrates on a niche group of customers. According to its annual report, the company generated 70% of revenue from three customers in 2019 and 58% from two customers in 2018. This indicates it is dependent on a few large customers, which is the major risk facing it at present.
TechPrecision has not reported significant sales growth over the last several years. More importantly, its revenue does not have a clear trend. For fiscal 2019, the company reported negative revenue growth. In 2016 and 2019, the poor performance was attributed to lower sales in the defense segment.
Despite the sales decline, TechPrecision reported improved gross margins in 2016 and 2019. Two factors contributed to this outcome. First, the company produced higher-margin products in these two years relative to other periods. Second, it had a higher rate of overhead absorption on the back of an increase in the utilization of fabrication and machining plants. In 2015, on the other hand, the low gross margin was the result of a high proportion of low-margin products in the company’s sales mix.
Source: Data from Eikon.
TechPrecision’s efficiency in managing selling, general and administrative costs improved consistently over the last five years. As a percentage of sales, the expenses were highest in 2015 (25%) and the lowest in 2018 and 2019.Â
An important indicator of the economic trend in the machines and equipment industry is the quality and strength of the backlog. As illustrated in the graph below, backlog affects TechPrecision’s revenues as well. InÂ 2019, the company reported a $12 million backlog compared to $14 million in 2018 and $15.8 million in 2017. Consequently, the company is likely to record lower revenueÂ in 2020.
Source: Data from Eikon.
TechPrecision trades at a price-earnings ratio of around 40, which is an indication of the optimism of investors. The consensus forward price-earnings ratio, according to Morningstar, is 5.96. Analysts expect the company’s earnings to benefit from the positive outlook in the defense industry. The significant disparity between the trailing and forward earnings multiples is a result of analysts being bullish on the company's prospects.
Shares, however, appear to be overvalued from an enterprise value perspective as well. According to Refinitiv Eikon data, the enterprise value-Ebitda ratio is 17. Its earnings before interest, taxes, depreciation and amortization for 2019 were $2.64 million. With an enterprise value of $44.39 million, the equity value comes to just over $42 million. With 29.25 million shares outstanding, the amount translates to $1.44 per share, 6 cents lower than the current share price of $1.50. TechPrecision is slightly overvalued based on these figures.
TechPrecision is overvalued from a relative valuation standpoint as well. The industrial machinery and equipment sector is trading at a price-earnings ratio of 29.16, which is below the company's price-earnings ratio of 40. The high concentration on a few customers and the relatively smaller scale of TechPrecision warrants a price-earnings ratio lower than that of its peers. As such, shares seem overvalued at present.
Risks and challenges
TechPrecision derives over 50% of its revenue from two or three customers. Hence, one of the major risks facing the company is a failure to generate sales from key customers. If it loses a major client, the company must find new customers quickly or suffer heavy operating losses. The magnitude of this risk is significant since the company has a high turnover rate.
The company also lacks diversification from an industry standpoint. For instance, 98% of TechPrecision’s revenue in 2019 was from the defense and alternative energy industries. Thus, poor performance in one of the sectors can severely affect the company’s operations. A cut in defense spending, for example, is a real threat to its operations.
Another prominent risk facing TechPrecision is related to the availability and cost of raw materials. The products made by the company require some critical raw materials such as steel, nickel and aluminum. Consequently, tariffs on these materials, such as those imposed by the U.S. government in March 2018, can increase production costs, leading to a loss in business and margin compression.
Moreover, some of the company’s products, such as nuclear reactors, are subject to environmental and safety regulations. If TechPrecision does not meet the requirements, it could face legal fines and even lose key permits. The company’s sensitive business operations also put its reputation at risk.
Low production costs and expertise in technology-intensive sectors such as defense and energy protect TechPrecision from competition. However, the company faces serious threats from low customer diversification.
Although the defense industry is expected to grow in the future as the U.S. government invests in modernizing the military, the budget for the Navy, the main source of the company’s revenue, has yet to be increased. The backlog also indicates TechPrecision's sales are likely to be lower in 2020 compared to 2019. Consequently, the company’s outlook for the next year is negative. These prospects could be improved by an increase in Navy spending or by gaining another major customer.
Moreover, the significant disparity between the trailing and forward price-earnings ratios is a clear indication the majority of analysts covering TechPrecision are positive about its ability to grow revenue and earnings over the next year. From a valuation perspective, however, the stock is expensive. As such, investors need to wait for a better discount before investing in TechPrecision.
Disclosure: I do not own any stocks mentioned in this article.
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