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Daktronics: Displaying Signs Of Trouble
Must Read | Sep. 15, 2015 9:44 AM ET | About: Daktronics, Inc. (DAKT)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
Summary
Daktronics (NASDAQ:DAKT) lacks a competitive advantage, this makes it a weak candidate for a long term portfolio.
The company competes in what is becoming a commodity industry with narrowing margins.
Don’t be fooled: this dividend doesn’t look sustainable, and could signal few worthwhile investment opportunities.
The company has significant off balance sheet commitments, and may not have such a pristine financial position.
We believe the consensus is overly optimistic, and there is a greater probability of earnings falling short.
We can all agree that most investors would love to achieve a track record even half as phenomenal as Warren Buffett's. Unfortunately, that is easier said than done. Much can be learned by Mr. Buffett's patient approach, and his disciplined selection of only outstanding companies that can become compounding machines, creating enormous wealth. With that in mind, we believe that Daktronics (NASDAQ:DAKT) is a mediocre company, competing in a commodity industry, and this stock will not generate the returns needed to help your portfolio outperform.
At first glance, Daktronics seems like an investor's dream. The stock yields 4.78% at a P/E of ~23x, and the stock has increased revenues over the last five years. However, when looking more closely, prudent investors will realize that the company lacks many of the essential characteristics of an outstanding common stock.
Company Description
Daktronics is a producer of digital displays used in various public places, such as sports venues, billboards and other advertising displays. The industry demand is cyclical, as well as seasonal. Seasonality is dictated by sports season, when customers may be renovating venues, while cyclicality is dictated by the broader economy, advertising expenditures, and technological developments, which typically leads to display replacement every 8 to 12 years. The company operates in five segments: Live Events, High School Parks and Recreation, Transportation, Commercial and International.
Where's the moat?
Perhaps the most important factor that determines a company's success is the presence of a competitive advantage. Unfortunately, Daktronics lacks this advantage, as evidenced when analyzing sales, earnings and ROE over the last ten years. DAKT essentially sells a low margin, commodity product. Other articles have pointed to sales growth as a sign of prosperity, but a closer look displays a much more troubling situation.
Exhibit 1: Revenue Growth Vs. Net Income Growth
(click to enlarge)
As illustrated above, revenues appear to be cyclical, so much of the growth can also be seen as a return to the top of the cycle. However, digital signage is still in its early stages and there could in fact be a reason to believe in accelerating sales growth. However, this brings us to the most troubling aspect of the DAKT story. Since 2006, revenues have roughly doubled, but earnings have remained flat (barring the 2010 loss).
What does this mean? Well, DAKT is being forced to increase sales volumes simply to maintain profits, as they struggle with declining margins and a downward pressure on prices. We believe that this is primarily driven by a lack of differentiation and moat. A display is a display, and we believe that large buyers (governments for the Transportation segment, and sports teams and stadium owners in the Live Events segment) have sufficient bargaining power to force DAKT to accept lower margin sales, or risk losing out on projects to competitors. Management has admitted to as much in their discussion and analysis to Q2 2015 (Seeking Alpha).
Exhibit 2: Gross Margin, Net Margin, ROE and ROA
(click to enlarge) (click link below for charts/tables)
Analyzing the trend in margins and returns, we see a clear downward trend. Increasing sales activity is actually driving lower marginal returns. This is similar to the PC or television set business, where hardware manufacturers experienced declining returns as penetration increased. While digital signage for commercial use is considered a growth area, we believe that the lionshare of returns will go to companies providing content for these displays, not to hardware manufacturers.
How Safe is the Dividend?
DAKT shareholders are currently enjoying a pretty hefty dividend, yielding 4.78% at the time of writing. In the current interest rate environment, this would appear to be the income-producing stock that yield-hungry investors have been looking for. We don't disagree, on the surface, the yield is very enticing. Though our best investments have come from looking below the surface, and that is where the cracks appear. We take issue with certain areas of the dividend policy. For one, a very high payout ratio makes us wonder if it is even sustainable. Over the last twelve months, the payout ratio has been 108%, and in the last fiscal year it was 85%. The cyclicality of the industry, and the long revenue cycles do not cooperate with such a high payout ratio. We do not feel comfortable when the company has to dig into their cash reserves to satisfy dividend payments. Rather, the company should be protecting cash reserves in order to meet future commitments, or as a buffer during low points in the business cycle.
Furthermore, the high payout ratio makes us wonder if there is room for dividend growth. Remember, the importance is on the sustainability of the dividend. Investors jumping into this high-yield stock may be left unsatisfied when they realize that the cyclicality of the business has really created a rollercoaster ride for the dividend (Nasdaq). Since 2005, the company has shown an inconsistent dividend history; between increases, decreases and special dividends, we do not feel comfortable with the current payout. The income investor wants consistency in the dividend, and Daktronics does not offer that.
Dividend Signalling
At the same time we wonder what signal management is giving by paying out so much cash to shareholders? Over the past few years, management has constantly highlighted that the digital billboard industry is a growth segment, though why haven't they driven more cash into it? Is it because the opportunity is not as viable as it seems, or is management just talking but not acting? We think the former is the case. Why? Well, the company has made acquisitions in the last fiscal year, though both acquisitions were small in size, and in the Transportation and International segments. More specifically, OPEN Out-of-Home Solutions is a European manufacturer of cabinets and street furniture for the third-party advertising market, and Data Display is a European based company focused on the design and manufacture of transportation displays. The former is a vertical acquisition, and while diversifying their operations, it is not capitalizing on their core strengths. The latter is an acquisition in Transportation displays, the most regulated business segment. The company also has "not made pro forma disclosures as the results of its operations are not material to [their] consolidated financial statements" (Annual Report, 2015). In other words, two small acquisitions in non-core or difficult segments, has us wondering if perhaps management may have realized that the industry does not possess the grand opportunities that they speak about, hence the high payout ratio.
Exhibit 3: Payout Ratio
Off-Balance Sheet Financing and Other Commitments
The company's balance sheet is debt-free, though it should be noted that operations in this industry require significant commitments and obligations. These off-balance sheet commitments come in the form of operating leases, purchase obligations, and various business functions. In terms of cash commitments, the company will require a total outflow of 12,985,000, with approx. 95% due within the next 3 years. (Annual Report, 2015)
At the same time, the company also lists "Other commercial commitments", which are made up of: Standby letters of credit ($13.6M), Lines of credit interest ($62.0M), Surety bonds ($42.7M), and Guarantees ($1.1M).
Combining the Cash and Non-cash commitments, the company has obligations of about $70.5M, with the majority due within the next 3 years. Of course, the company does have dry-powder in the form of cash in the bank ($57.3M), and two bank credit lines (total of $75.0), though we highlight this to show that a clean balance sheet does not necessarily mean that the company has no commitments. As conservative investors, we place extra emphasis on off-balance sheet items as they could pose a potential problems in the future. In other words, we look at this situation as though we were buying 100% of the company, we'd need to have the cash ready to satisfy all future obligations, and in such a cyclical industry, a low point in the business cycle that coincides with maturing obligations could cause a cash crunch. Furthermore, the nature of off balance sheet items reduces transparency.
Expectations Analysis
Contrary to popular belief, earnings are irrelevant in the short term, but fundamental in the long run. Rather it is earnings surprises that move stock prices in the short run. Currently, the consensus is pricing DAKT at a forward P/E of 11.47 vs. a trailing P/E of 23.25 (FINVIZ.com). This indicates that the consensus is expecting DAKT to roughly double its EPS. This seems beyond optimistic in our view. Perhaps DAKT could increase earnings, but a double is quite the task. As mentioned earlier, over the last ten years, a near doubling in revenue has barely moved the needle on earnings. Furthermore, in Q1 2016 diluted EPS was down 55% YoY to $0.09 from $0.20, while revenues were down 9.8% YoY to $150.2M from $166.6M.
Given the soft pricing environment, the challenges in project delivery experienced in prior years, margin pressure from buyers, and a prolonged history of soft returns, we believe that there is a higher probability of earnings coming in under consensus. This could cause some short term pain for shareholders. We believe this is a further reason to avoid DAKT.
Conclusion
Despite possible catalysts, like the entrance of an activist or an LBO, or even a strategy overhaul, we believe that the underlying fundamentals are simply mediocre to be part of a long term investor's portfolio. Buying this stock on the hope of a strategic buyer is simply speculation, and not investment. Furthermore, until we see evidence of margin improvement, or development of more unique product or service lines, which could insulate the company from the effects of competition, we fail to see the benefits of buying DAKT. We do not believe that this stock will provide meaningful returns in excess of the market, and so would recommend investors exit this position and seek better alternatives.
Additional disclosure: All financial information was sourced from 10-K and 10-Q reports unless otherwise stated. When making an investment decision always perform your due diligence, and consider suitability.
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http://seekingalpha.com/article/3510886-daktronics-displaying-signs-of-trouble
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