Sunday, March 3, 2019

A Current AIM Small Cap Equity Holding: Methode Electronics, Inc. (MEI, $28.76): “Pump The Brakes on This Stock” By: Derek Gross, AIM Student at Marquette University

 Methode Electronics, Inc. (MEI, $28.76): “Pump The Brakes on This Stock”
By: Derek Gross, AIM Student at Marquette University

Disclosure: The AIM Equity Fund currently holds this position. This article was written by myself, and it expresses my own opinions. I am not receiving compensation for it and I have no business relationship with any company whose stock is mentioned in this article.


Methode Electronics, Inc. (NYSE: MEI) is a global manufacturer of component and subsystem devices used primarily by OEMs in the automotive industry.

• As Methode’s fiscal year begins in April, the company most recently reported mixed Q2 results in December 2018. Revenues increased by 14.7% from 2017 but were below consensus forecast. Bottom line profitability dipped, as net income decreased by 39.6% due to increases in selling expenses.

• In September 2018, the company acquired Grakon Parent, Inc., a global leader in customized lighting solutions for transportation applications. The company hopes this acquisition will fuel growth in the Industrial segment (16.3% of revenue in 2018).

• Automotive outlook came in weaker than expected. Management has revised organic automotive revenue outlook down by roughly $51 million due to lower global production expectations.

• Dabir, comprising all of Methode’s medical segment, continues to be a source of optimism. New business representing $19 million in organic growth was awarded to Dabir in the 2nd quarter of FY19.

Key points:

Methode Electronics, Inc. continues to disappoint in comparison to both Wall Street consensus forecast and in comparison to past results. Although benefiting from top line growth in revenues that beat forecasts, the company has been unable to grow net income at all. Q2 net income is down 39.7%, while net income through the first 2 quarters of FY19 is down 14.3%. Exposure to foreign currency seems to be a significant problem for the company. Although earning nearly 54% of revenue domestically, profitability is being sapped by foreign currency translation adjustments, reducing comprehensive income by over 66% through the first 2 quarters of FY19!

The decrease in overall margins and profitability can be partially attributed to the active acquisition strategy management has pursued. The latest strategic move by the company was acquiring 100% of the stock of Grakon Parent, Inc. for $428.5 million. Grakon manufactures custom designed lighting solutions for industrial applications, including automobiles. This is part of management’s strategic plan to grow the Industrial segment into a larger driver of revenue, which represented roughly 16% of revenue in 2018. However, debt load remains a concern, as the Grakon acquisition increased long term debt by nearly 7x in one quarter to $342.2 million. Both liquidity and solvency ratios have followed a decreasing trend over the past several years, with LT debt now outnumbering EBITDA by 1.5x.

Customer concentration continues to add uncertainty to future forecasts for MEI. While identified as a risk when the stock was originally pitched, General Motors (43% of revenue in 2018) and Ford’s (12% of revenue in 2018) production outlook may hurt future sales. GM announced it will close 5 plants in 2019 and reduce employment by 15% in North America, while Ford announced it will halt production of all passenger cars for North America. Global automobile sales are expected to be flat in 2019, fueled by weak economic outlook in Europe. With 77% of revenue tied to the Automobile segment, MEI has a lot to lose if auto sales forecasts are correct.

However, not everything about this company has been bleak as of late. Dabir, the company’s lone inhabitant of the medical segment, continues to provide an optimistic outlook. Dabir was recently awarded $19 million in organic growth during the 2nd quarter of FY19. Considering the segment has only grossed $600,000 in sales through 2 quarters, this presents an incredible growth opportunity and a cause for celebration as MEI aims to diversify its product mix by expanding this segment.

What has the stock done lately?

On December 24th, 2018, the stock hit a 6-year low in price of $21.38, falling to the lowest levels since late 2013. Since then, the stock has mirrored the market surge in technology shares, increasing by over 34% back up to $28.73. The stock has been quite volatile as of late, but I expect that volatility to subside a bit as the overall market experiences clarity around interest rates and a possible trade deal with China.

Past Year Performance:

Despite the recent climb back to over $28/share, the stock is still down over 30% over the last year. After hitting an intraday high of $45.25 on June 20th, 2018, the stock has followed a steady decline in share price, exacerbated by mixed Q2 earnings results that missed on revenue and disappointing guidance on 2019E EPS. The stock lost nearly 20% of its value from this announcement alone. Relative to the Russell 2000 benchmark, the stock has drastically underperformed. The loss in value over the past year begs the question: is the stock now a bargain, or has the market valued this stock correctly due to its fundamental flaws?

 Source: FactSet
My Takeaway:

As you could probably tell, I am very bearish on this stock. Sliding profitability is a major concern to me, as the company has not produced earnings increases with the aid of top line growth. Foreign currency translation adds a considerable risk that cost over $26 million through the first two quarters of FY19 that causes wild swings to comprehensive income, and this should be too much to swallow for the risk averse investor. Additionally, fundamentals seem to be slipping. When added to the AIM Small Cap Portfolio, the stock was praised for its relatively high ROA (14.7%), ROE (23.8%), and ROIC (18.8%). ROA has fallen to 4.68%, ROE has fallen to 8.13%, and ROIC has fallen to 5.98%, compared to a WACC of 15.1%. Weak guidance from GM and Ford in the auto segment gives major cause for concern in MEI’s most important segment. Although slightly undervalued on a relative basis, I do not have confidence in MEI in the long term. 

Source: FactSet