Pro-Dex: Overvalued At Current Price Unless New Revenue Streams Are Found (NASDAQ:PDEX)


Investment Thesis

Pro-Dex (PDEX) stock has had an excellent year to date. The manufacturer of multi-function surgical drivers and shavers, for use in the orthopedic, thoracic, and maxocranial facial markets, saw its share price climb to an all-time high of $32 in mid-September, and currently trades at a price of $29 – a 92% premium to 1 year ago.

On the back of 2 new product releases – a thoracic driver and a craniomaxillofacial (“CMF”) driver – Pro-Dex posted revenues of $11.1m in the quarter ended June 30th (Q4 in Pro-Dex’s fiscal year), up 59% from $7.0 the previous year and saw net income rise 47%, to $2.5m – a profit margin of 23%. In FY20, Pro-Dex grew net sales by 28% year-on-year, to $34.8m, and net income by 45%, to $6.1m (net profit margin of 17%), for EPS of $1.5 and a PE ratio of 18.75x at the time of writing.

These results – announced in late August – were the catalysts for the September stock price gains, which have been rewarding for existing shareholders – the question is whether the company has sufficient momentum to persuade new investors to open a position in Pro-Dex at a price of ~$30?

I think there are pros and cons to an investment at current price. Clearly, Pro-Dex has some sales momentum, and if the company can sustain 28% per annum revenue growth over a 5-year period then, based on my discounted cash flow analysis, there is scope for a further >100% share price upside – even using a high weighted average cost of capital (“WACC”) of 12% based on a high beta of 1.44 (figure from Google Finance) and expected market return of 9%.

After studying Pro-Dex’s recent results and sales potential in more detail however, I believe there are several reasons why a more cautious approach is worth considering.

Pro-Dex is heavily reliant on a small network of purchasers of its products – the company’s top 3 customers accounted for 92% of all sales in FY20 – whilst the release of new products at the end of the fiscal year may have painted a rosier picture of future sales demand than is actually the case, as Pro-Dex management suggested in a statement accompanying its Q420 results:

we released two new products in the second half of fiscal 2020 and while we expect to have future orders for these new products, often the launch or initial quantities are such that our customer can comfortably fill its distribution network and follow on orders may not occur for many months.

There may also be a question mark over how aggressively the company’s management are targeting business growth and share price growth. Pro-Dex’s market cap is just $112m, and 117 of its 120 staff operate from one leased headquarters in Irvine California, whilst 2 majority shareholders – Company Directors Nicholas J. Swenson and Raymond E. Cabillot – control ~38% of Pro-Dex’s common stock.

A recent aggressive share buyback programme that has seen ~125k shares repurchased for ~$1.7m in the past 12 months may hint at the fact that Pro-Dex is about to enter a period of consolidation, rather than expansion, or conversely, that management still believes the company’s shares are significantly undervalued by the market given Pro-Dex’s future prospects.

On balance, I think there is currently a lukewarm case for buying Pro-Dex shares, based on the company’s ambition and growth prospects, which I will outline in more detail in this article, as well as highlighting some strengths, weaknesses, and risks that investors ought to consider.

I would set an optimistic price target of ~$42 using a more modest DCF model (exclusively available to all Haggerston BioHealth marketplace subscribers) that assumes 10% annual revenue growth and OPEX remaining consistent at ~81% of revenues, but I also suspect that investors may find a cheaper entry point around the time Pro-Dex releases its next set of earnings, which may underwhelm the market given there won’t be the same boost to revenues from newly released products as occurred in Q320 and Q420.

As such, I am neutral on Pro-Dex stock at this time, but I think its progress is worth watching closely for signs that management is ready to embrace a more aggressive and sustained growth strategy.

Company Overview

Pro-Dex – which has been a publicly-traded company since the late-1980s – has always been a developer and seller of surgical power tools, but during the past decade, the company has made numerous forays into other businesses – from launching a consultancy service, to acquiring customised machine parts and plastic mould making businesses – the majority of which were unsuccessful and have since been abandoned.

One constant at the company has been current CEO Rick Van Kirk who has returned the company to profitability since being appointed CEO in 2015, after nearly a decade working at the company. Pro-Dex revenues were $24.1m in FY11 but had dropped to $10.8m by FY14, with the company making a $0.7m loss. Revenues have grown every year since, however, and the company returned to profitability in FY16. Today, nearly all of its revenues are derived from medical device sales, although Pro-Dex has a sideline in the manufacture and sale of rotary air motors for a variety of industries.

Pro-Dex has developed a patent protected torque-limiting software and sealing solution which can be adapted to customer’s needs, and the company tends to manufacture and sell its products under exclusive development and supply arrangements. This is the case with the recent launch of both its thoracic driver, which has been developed as a private label product for one of the company’s existing customers, and its CMF driver.

Pro-Dex’s product design, manufacturing, and quality systems are in compliance with FDA regulations and its manufacturing facility in Irvine, California, has a state device manufacturing license and is also certified to ISO guidelines for medical devices.

In summary, Pro-Dex has the expertise, facilities, and operational structure in place to develop bespoke surgical (or other industry) tools on behalf of its clients, which include med device giant Medtronic (MDT) surgical procedure specialist Arthrex, Brookhaven, Sandia, and Lawrence Livermore National Laboratories (according to the company website), and across other industries, Boeing and NASA. The underlying issue, however, is whether Pro-Dex can generate sufficiently large order volumes from existing and new clients to keep its staff busy and its facility at full capacity.

At the end of May 2020, Pro-Dex was selected by NASA as one of 8 manufacturers, out of more than 100 applications, to be awarded a contract to make NASA’s VITAL Covid-19 Ventilator, which received an Emergency Use Authorisation (“EUA”) in April and was awarded another in May for a version that used parts more readily available in existing supply chains.

This speaks to the versatility and capability of Pro-Dex and its business operations, but equally, the contract win does not seem to have translated into meaningful revenue generation, which highlights the issue that I believe is Pro-Dex’s main obstacle to growth. A specialist manufacturer is only as valuable as the revenues and profits it generates from the products it builds, and Pro-Dex looks a little thin in the product department, notwithstanding recent new launches.

Recent Performance

Pro-Dex revenue breakdown – FY20. Source: company FY20 10K submission.

As discussed in my intro, Pro-Dex delivered impressive Q3, Q4, and FY20 results which significantly exceeded analyst’s expectations, and led to a 60% increase in the company’s share price in the last 3 months alone. Based on the table above, however, there are one or two points of concern worth highlighting.

Despite an additional $3.1m of revenues being earned over Q3 and Q4 owing to the launch of its new thoracic driver, we can see that overall sales of medical devices in FY20 only grew by 9% year-on-year – the major difference in revenues earned between FY19 and FY20 was, in fact, a 473% growth in repair revenues, from $1.1m, to $6.3m.

Pro-Dex management says the increase was primarily down to maintenance of the orthopedic surgical handpieces it sells to its largest customer and expects to earn a similar amount of repair revenues in FY21, but as new products come online and others are discontinued, there must be a question mark over how consistent repair revenues are likely to be over the longer term, and how much of any future sales deficit can be offset by new product sales.

Additionally, Pro-Dex earned 65% of its FY20 revenues from a single customer, and 92% of all its revenues from just 3 customers. This concentration of revenues around a small pool of customers could harm the company if customers fail to renew purchase commitments, and importantly, Pro-Dex’s agreement with its largest customer expires at the end of 2021. That doesn’t necessarily mean a new contract won’t be signed, but it’s possible that, owing to pandemic headwinds or for any other reason, Pro-Dex is at risk of losing nearly two thirds of its existing income streams.

Finally, it is worth noting that Pro-Dex’s backlog of work as of FY20 stood at $7m, as opposed to $17.7m as of June 30, 2019.

Pro-Dex R&D spending on new products and expected launch dates + revenues. Source: company FY20 10-K submission.

Although Pro-Dex has new products coming online that ought to boost sales by ~$6.5m per annum going forward, as per the table above, at least $3.1m of that figure was earned in FY20 via the thoracic driver launch, hence it is unclear if the company has sufficient orders booked in 2021 to generate similar, or higher revenues than in 2020, given that its industrial and scientific, and dental product line revenues are shrinking.

These issues could become more problematic over time – Pro-Dex reported cash and cash equivalents of $22.7m in FY20, versus $5.2m of current liabilities and $12.1m total liabilities. The company’s debt is certainly manageable, provided the product and repair orders continue to flow into the business, but any lost contracts – notably to its largest customer but also to its second or third largest – could place Pro-Dex under serious financial pressure.

I believe that Pro-Dex management needs to be aggressively chasing further contract wins to make full use of its good-quality resources – either with new, or existing clients.

Strategy

Based on a review of the company website, regulatory submissions and investor resources, Pro-Dex can come across as employing a passive, “come and get us” approach to marketing its business, rather than a more proactive approach based around bringing its own products to existing and new markets rather than focusing on manufacturing private label tools for single customers.

My sentiments are echoed by a Pro-Dex investor presentation which lists “Bringing innovations to market vs. the innovations disproportionately benefiting our customers alone”, and “Entry into disposable and single use markets” as 2 of its “Investment Highlights”, but arguably the company has not quite executed at this level yet, and alas, the presentation does not seem to have been updated since 2017!

In fairness, the same presentation highlights the fact that the company has shipped more than “40,000 handpieces to the largest orthopedic distributors in the world” and has a >60% share of the CMF market – whilst also noting that CMF is the smallest market in the orthopedic space.

Addressable market size and product strength are two areas where I actually think Pro-Dex is highly competitive – the company’s key contract with its largest customer (which Pro-Dex does not name but I would guess it to be Medtronic) has lasted for many years and was extended in 2018 until 2021, whilst the development of its private-label thoracic driver on behalf of another client suggests Pro-Dex’s products are robust and reliable – despite the escalating repair bills.

The global orthopedics device market is estimated to be a $47.7bn industry by 2026, so theoretically at least, Pro-Dex has a huge addressable market and a proven ability to deliver complex and powerful devices to custom specifications. Against this, Pro-Dex products do seem to have long development cycles – work began on the thoracic and CMF drivers in 2019 – but overall R&D costs of $2.3m in FY20 supporting $6.5m of long-term annual revenues streams seems efficient to me.

Another opportunity Pro-Dex is pursuing is an investment into medical device startup Monogram Orthopaedics Inc, which develops surgical robotic solutions, and like Pro-Dex, uses sophisticated algorithmic technologies such as cloud based robotic navigation. Pro-Dex invested $800k into Monogram in 2017 via a convertible note, receiving in exchange exclusive rights to manufacture and supply products to Monogram. This appears to be another project that has stalled, however – although Pro-Dex received its investment back in full plus interest in 2020, the company had previously impaired it owing to Monogram’s failure to commercialise its products. Discussions remain ongoing around development of a custom orthopedic shaver, however.

In many ways, this is a typical example of the pros and cons of Pro-Dex as a company (based on my research), and as an investment opportunity. The company seems to identify and pursue promising opportunities that don’t quite seem to get off the ground, whilst steady growth is underpinned by its existing relationships making surgical tools for its loyal client base.

Again, the question investors must consider is which is the more likely of two scenarios: either that a Pro-Dex new business opportunity eventually succeeds, opening up lucrative and large new markets that the company is able to service with its high level of expertise and geographically convenient location, or, it keeps hitting brick walls before losing a key medical device contract, placing the entire operation in jeopardy.

Clearly, the market has decided that the former scenario is more likely, hence the share price gains, but I am not quite so convinced, personally.

Conclusion

This article may come across as somewhat critical of Pro-Dex and its future growth prospects, and this is because it is not obvious, to me at least, how Pro-Dex will sustain its recent sales momentum. Even the company’s CEO Van Kirk noted concerning Q420 revenues that the outperformance – based on 2 new product launches – should be considered a one-off.

The timing of these product releases led to a record quarter. While we do not expect every quarter to have two launches and meet such record levels, we still plan to build our business year over year.

The problem is that Pro-Dex’s new product launches are bespoke tools designed for a single customer, who by Pro-Dex’s own reckoning, are unlikely to increase order sizes drastically based on supply and demand. As older product lines are discontinued, does the company have sufficient sales momentum to continue to grow?

That’s a hard question to answer but based on Pro-Dex’s recent performance – growing revenues every year since 2014 and achieving profit margins >15% – there is a persuasive case to give the company the benefit of the doubt. The enterprising management team led by Van Kirk will hope to secure further contract wins in FY21 either within the medical device sector or via other avenues – the recent NASA contract win is a good example – but the deals must be revenue generating over the long term. Van Kirk collected a salary of >$800k in 2020, including a bonus of $280k, which suggests that much rests on the CEO’s shoulders, and that Van Kirk is heavily incentivised to deliver more growth.

Even with an annual growth rate of 10% however, if all else remains equal (OPEX, CAPEX, depreciation and working capital) and we reduce beta to 1.2 and expected market return to 8%, I estimate Pro-Dex’s free cash flow to be in the region of $10 – $11m by 2025 (CAGR = ~8%), which gives me a firm value of $154m and a FVP of $42 – not a significant enough premium for me to recommend an investment into the company given the risks I have highlighted.

As I said in my intro, if Q121 results reflect a decline in revenues, the company’s share price may drop to more attractive levels. If, at the same time, the company’s backlog of work looks to be increasing, or new contract wins seem to be in the offing, or if its biggest customer opts to renew its current purchase agreement, then the case for long-term upside will be strengthened and I would consider a share price below $25 to be a strong buy signal.

Investors will have to make do with the current company ownership structure, which is dominated by its 2 main shareholders, but may also benefit from further share buybacks, whilst the prospect of an acquisition by a medical device company – e.g. Medtronic – keen to bring Pro-Dex and its expertise in-house cannot be discounted.

To conclude, I think the market slightly overvalues Pro-Dex stock at its current price of $29, due to the uncertainty around whether the company can match or exceed its sales performance in recent quarters. On the other hand, there is no question that if management can find more use-cases for its manufacturing expertise, the company has the capacity to grow quickly.

I will be scanning for any indications that this is likely, and for signs of a genuinely innovative marketing and new business development strategy, and hoping that management provides them.

Gain access to all of the market research and financial analytics used in the preparation of this article plus exclusive content and pharma, healthcare and biotech investment recommendations and research/analytics by subscribing to my channel, Haggerston BioHealth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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