Perceptron

Perceptron Inc designs and manufactures process control systems for Automotive Industry. Their products are used by almost all major car manufacturers to quickly identify quality issues in final products. 40% of sales come from four biggest customers (GM, Ford, DCX, and VW) with GM accounting for 19% of the total. Company products to date have been sold mostly in US and Europe. I believe that Perceptron is worth at least $10 per share which would represent a 35% upside from a current market price of $7.12.

Reasons to Buy:
Due to diversified customer base Perceptron is able to avoid problems of other auto suppliers that depend on ability of US big 3 to sell cars
Perceptron’s revenues come from new product launches and process reorganizations rather than per car revenue.
Attractive valuation (15% normalized cap rate) for stable business
Free option for growth from Eastern European and Southeast Asian markets
Free option for growth from two new complimentary products
Recently announced share buy back program may increase shareholder value
Credit agreement that does not allow company to pay dividends expires in November 2006. This may result in future dividend payments to equity holders.
13% ownership insiders aligns management’s incentives with those of shareholders
Healthy Balance Sheet

Risks:
Perceptron’s desire to expand into non-adjacent products has potential to destroy value
Company depends on car manufacturer’s ability to develop new models.

Catalyst:
Company’s results in the short term are depressed because of increased spending on new products and development of new markets. Valuation gap will close as company will start seeing increased revenues from new products and markets.

In the mid-90’s when this company came to market it was considered a growth stock with unlimited potential trading as high as $40 per share. Company’s innovative products quickly achieved full market penetration resulting in sale stagnation and eventual fall of a once high flying stock. In 2001 current CEO started to champion a turn around which involved new product development. As a result, Perceptron’s sales reached $54M range and stayed there for the last three years. Top line stability suggests a mature market for Perceptron’s current product suite within company’s geographical footprint (US & Europe). While top line remained stable, company’s EBIT fell from over $8M two years to a FY 2005 level of $4.7M. Operating margin feel partially because of an increase in installation and manufacturing costs and partially due to spending on new product development. Company has spent heavily on development of two new complimentary products (Autofit & Autoscan) without so far seeing much revenue from the additions to their product suite. Similarly, company has been increasing sales force in Eastern Europe and Asia in an attempt to bring their services to developing markets.
Current market price represents a 14% cap rate on the normalized basis (once one time charges related to A/R and inventory write-offs are take out). I believe this is a reasonable price to pay for a stable business with a history cash flow generation. While the case could be made that the company is destroying value through attempt to expand, additions to Perceptron’s product suite and geographic footprint are a natural extension of company’s current business. Improvement in the bottom line that could come from these initiatives is not reflected in today’s valuation and comes as a free option to the holder of the security.

Valuation
In valuing the company I only assumed that the one time charges related to client bankruptcy, inventory write-offs, legal expenses and other should be taken out. The target price of $10 reflects normalized EBIT level and a 10% cap rate in FY 2007. If we take into account value added through the recently announced share repurchase program, remaining shares would be worth over $11 representing an even bigger upside. I decided to exclude this factor from value of the company because they have had a share buy back program in the past which did not result in significant share repurchases. Circumstances suggest that this time company would be more willing to buy its own shares due to the presence of Richard Scott (activist investor) who has been bugging the management to increase shareholder value.