When it comes to electronic and electrical power supply components, Espey Mfg. & Electronics (NYSE:ESP) stands out as a vertically integrated powerhouse. From transformers and radar equipment to power supplies for the Navy, Espey is a trusted supplier with a massive pre-funded backlog. Their products are essential for Navy vessels operating in harsh and wet conditions, as well as for the rail, military aircraft, and off-road industrial vehicle markets.
Espey’s reputation for rugged and reliable design extends to commercial applications, such as keeping trains running smoothly on high-vibration routes. They also provide power converters and transformers to major military aircraft platforms supplied by industry giants like Raytheon, Lockheed Martin, Boeing, Northrop Grumman, and General Dynamics. With an impressive track record and a wide range of customers, Espey has positioned itself as a key player in critical industries.
So, what makes Espey a compelling investment opportunity? Let’s explore the catalysts driving their growth and the potential risks investors should consider.
Investment Thesis: Safeguarding National Defense and Beyond
Espey’s close relationship with the Navy highlights the trusted role they play in ensuring mission-critical electrical power supply. From destroyer and submarine platforms to the Navy’s future DDG-X destroyer, Espey’s products are vital for radar systems, weapon operations, and more. The Navy’s recent commitment to Espey, combined with their vertical integration and proven track record, make them highly likely candidates for future Navy contracts.
Espey’s expertise extends beyond defense, with a strong presence in the commercial rail market. Their power systems enable reliable long-haul rail travel in high-vibration environments, proving essential for customer satisfaction and cost-effective maintenance. The trust and reliance built over the years lock in customers and create high switching costs, which further solidifies Espey’s market position.
While military-driven cyclicality can pose challenges, Espey has successfully diversified its customer base and secured non-Navy contracts. This strategic move has resulted in a three-year streak of winning new orders, averaging $40 million annually. Their ability to secure platform designs outside the Navy and rail markets opens up new growth opportunities and reduces dependence on military budgets.
Catalysts: High Backlog, Strong Leadership, and Dividend Potential
Under the leadership of CEO David O’Neil, Espey has experienced remarkable growth. O’Neil’s compensation structure aligns with the company’s success, focusing on sales and backlog increases, as well as operating earnings. With the current all-time high backlog and promising operating income growth, O’Neil’s leadership indicates a favorable outlook for shareholders.
The funded portion of Espey’s $83.6 million backlog stands at $83.5 million, and they expect to fulfill a minimum of $39.5 million this fiscal year alone. These numbers exclude additional build-to-print or short lead time sales, offering potential for even more revenue growth. Espey’s ability to attract substantial new orders is crucial for their long-term growth, and they have demonstrated their capability to do so.
Investors should also consider Espey’s dividend history and potential for future increases. Prior to the pandemic, Espey consistently paid a quarterly dividend of $0.25, sometimes supplemented by a special dividend of $1.25. The reinstatement of the regular quarterly dividend and its subsequent increase to $0.15 per share reflects the company’s financial strength. As Espey continues to grow and generate strong cash flow, further dividend increases could positively impact the share price and yield.
Why This Opportunity Exists: Margin Expansion and Market Misunderstandings
Although Espey’s revenue growth, backlog, and new orders have been impressive, their gross margin has suffered due to inflation impacting fixed-price contracts. Management has targeted the reduction of fixed-price contracts to improve margins, which have already shown signs of recovery. Despite this positive trend, the stock price has yet to reflect the company’s true earnings power.
Another factor contributing to market misunderstandings is the lumpiness of Espey’s revenue growth. They book revenue based on contract milestones and shipments, resulting in fluctuating revenue figures. While revenue growth may be uneven, Espey’s funded backlog provides visibility and stability for the coming years, with potential for margin expansion as fixed-cost contracts run off.
Risks: Platform Transition, Military Funding, and Working Capital
- Espey’s position as a supplier for legacy Navy platforms like Aegis DDG-51 and Zumwalt DDG-1000 Destroyers presents a risk as the Navy transitions to its next-generation DDG-X destroyer. However, given Espey’s history, recent capital commitments, vertical integration, and the critical nature of their products, it is likely that Espey will continue to be the Navy’s chosen transformer supplier.
- A decrease in military funding due to budget cuts could pose a risk to Espey’s growth. However, the current geopolitical landscape, marked by escalating conflicts and the need for technological upgrades, suggests a reduced likelihood of significant budget reductions.
- Espey’s growth potential may lead to lumpy cash conversion and increased working capital requirements, particularly in the early stages of new customer relationships. While this may impact cash flow in the short term, it is a positive sign for long-term business growth. Espey’s robust balance sheet provides a cushion to manage working capital needs effectively.
Valuation: Tangible Book Value and Forward Free Cash Flow Yield
Espey’s balance sheet is a testament to their financial strength, with $14.7 million in cash and short-term securities and no debt. Additionally, the company owns a valuable property in Saratoga Springs, NY, estimated to be worth around $8.4 million. Adjusting for this property value, Espey’s tangible book value stands at $39.4 million, translating to a favorable price-to-tangible book value ratio.
Another approach to valuation involves looking at Espey’s funded backlog, which is projected to generate $40 million in revenue over the next two years. Historically, Espey converted an average of 13% of revenue into free cash flow. If this trend continues, the company could generate approximately $5.2 million in free cash flow each year, resulting in an attractive forward free cash flow yield over the two-year period.
Actionable Conclusion: A Hidden Gem With Untapped Potential
Espey’s strong growth trajectory, demonstrated by their exceptional year for new orders, coupled with their massive pre-funded backlog, sets the stage for significant shareholder value. While the stock may have been undervalued and misunderstood in the short term, Espey’s attractive valuation, promising future, and competent management make it a compelling investment opportunity.
Investors should consider the long-term potential of this hidden gem, as Espey continues to deliver on its promises and unlock untapped opportunities within critical industries.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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