Pro-Dex
a fundamental analysis
By Manuel Maurício
January 22, 2020
Symbol: PDEX (NASDAQ);
Share Price: $32.14
Market Cap: $124 Million
Business
Warren Buffett is known for saying that “turnarounds seldom turn”. Pro-Dex is the exception to the rule.
Pro-Dex is an American company that designs, engineers, and manufactures surgical drivers and shavers. A driver is just the “motor” that powers an electric tool. In Pro-Dex’s case, we’re talking about hand-held screwdrivers and saws.
The screwdrivers are used by surgeons to fixate bones to each other, and the saws, well the saws are used to saw bone.
The company has a patented technology called Adaptive-Torque-Limiting that allows for a screwdriver to “feel” the bone it’s screwing on and adapt the torque in real-time. The bones of an older person are less dense than those of a younger person.
This means that a surgeon doesn’t need to apply the same torque on the bones of the older person as on the bones of the younger person. The Adaptive-Torque-Limiting technology detects when a screw is “seated” and turns off the power to prevent “striping”.
The term seated is medical lingo for the optimal placement of the screw. The term stripping refers to the effect on the bone (or on the screw) caused by screwing too much; it strips the bone (or the metal).
It would be expected that a surgeon’s job was to, among other things, know what type of bone he’s drilling and adapt the torque accordingly. But this isn’t always the case.
Apparently, 26% of the screws are damaged when they’re screwed. But the big issue is the huge disparity of results between surgeons. While some surgeons strip 90% of the screws they work with, others strip almost none. There’s clearly room for improvement.
The company is a mix between a typical Contract Manufacturer and a design+engineering firm. It manufactures devices designed in collaboration with other companies, but it also develops the products on its own and then sells them to those other medical companies.
Pro-Dex currently sells a few different products. It started by going after the cranial screwdrivers market where it enjoys a 60% market share in the US, but because its technology can be applied to many other parts of the body, it’s steadily branching out to other specialties such as the thoracic, spinal, or extremities. In fact, the cranial market is the smallest of them all.
Its clients are reputed medical devices companies such as DePuy (a division of Johnson & Johnson), KLS Martin or Striker, but it’s not easy to figure out what and how much it sells to which client.
THE BIG UNKNOWN
Medical device companies, especially Contract Manufacturers, are known for being secretive about their technology to stave off the competition. Prodex’ major client, which account for 60% of sales, is unknown. On top of that, the product that sells the most is also unknown. This is pretty interesting; and makes our job as investors a lot harder.
All we know about this product is that it’s “a device used primarily in elective surgeries” and also “a surgical handpiece designed to be used in orthopedic surgery applications (…) and we have continued to see increased demand from this customer“.
Pro-Dex sells a bunch of something to an undisclosed company. Ah! This is the perfect pond to look for inefficiencies.
The company also sells some other products such as rotary air motors and dental equipment, but that has been phased out over the years and is currently negligible.
A bit of History
Back in 2009 one single customer accounted for 40% of the revenue. That customer decided to take the manufacturing in-house and Pro-Dex lost a lot of business in the subsequent years.
But these things don’t happen over night. The management had enough time to prepare, but it wasn’t able to make the marketing efforts needed to bring in new revenue to offset the loss that they were seeing.
In 2013, after a proxy fight for the control of the company, two value oriented fund managers named Nick Swenson and Ray Cabillot bought a large chunk of the shares and took control. They immediately started making changes.
They reduced headcount, reduced costs to the minimum, set up an Investing Committee to invest the excess cash of the business, fired the CEO and promoted Richard Van Kirk to CEO in 2015. Almost immediately, the company started making a profit and it hasn’t stopped ever since.
Swenson still owns 26.5% of the company and is Chairman of the Board, and Cabillot owns 9.35% and is a director.
Financials
We can clearly see the effect of the changes made by the CEO and Board reflected on the fast growing revenue.
The company reached $35 Million in revenue in 2020 (Fiscal Year ends in June), from $27M in the previous year, or a growth of 30%.
If we now look at the gross margin, we can see that the management has been able to steadily increase it almost since the day they got in.
And the margin is expected to keep rising because the revenue mix will be more tilted towards the new thoracic drivers which are higher margin.
And if we look at the expense ratio, we can also see that the management has been able to optimize operations and reduce costs.
Consequence of all of this great management are the increasing profits.
And we can clearly see that, as the company gets to optimize its plant and machines, the operating margin goes up.
Leading to an above average return on invested capital.
Balance Sheet and Capital Structure
I love when a company has more current assets than total liabilities. Usually it means that I can sleep tight at night.
Ever since Swenson and Carrillot came on board they’ve been investing the extra cash generated by the business. There’s some concern over this in the investing community because they have invested some of the cash in AirT, a small company also owned by Swenson, but I’m not really worried about that. It’s small change, and they’ve proven to be good capital allocators.
It’s pretty interesting that the company has net cash on the balance sheet and at the same time it filed for an At-the-Market offering. Let me explain:
An At-the-Market offering means that the company is getting ready to issue more shares and sell them in the open market (just like a private investor would sell his or her shares).
Usually, if a company needs cash to grow its operations and decides that the best way to get that cash is by issuing new shares (as opposed to raising debt), it will gather a few large investors and do a private placement, meaning that it will sell blocks of shares directly to those investors.
The At-the-Market offering allows for the company to sell its shares in small amounts whenever it wishes so, and is frequently used when a company finds that its own stock is trading at a high valuation. That’s why we’ve seen a recent drop in the share price. Mr. Market thinks that the company believes that its own shares are overvalued.
The truth is that the company has been using these ATM’s for some time, often just before they buy back shares. The modus operandi has been to issue new shares in order to finance growth, and then repurchase shares later at attractive prices (even if they’re higher than before). These guys are using all of the tools of The Outsiders. I like that.
Growth from the unknown product
When you’re looking at a B2B business, you need to look at the supplier concentration and customer concentration to understand their bargaining power. I have little information on the supplier side, but 60% of the revenue is derived from one single customer. The one no one knows. That means that the customer can exert a lot of power over Pro-Dex.
Just last year, Pro-Dex announced the renewal of the contract with this customer until 2025. That customer demanded payment terms to be changed from 30 to 90 days. That’s not good.
But – and this is the important part – after the renewal of that contract, the company went on to buy a new factory that will, at least, double its current capacity. We’ve got to read between the lines here.
Here’s what I think happened. The client was so satisfied with Pro-Dex’s product that it told the company “We want to buy much more of your product. Can you make it? Oh, by the way, we want better payment terms!”.
This probably means that its largest customer is so happy with the product that it asked for so much more that Prodex feels confident enough to be buying a new building. Note that they’re not leasing the building, they’re buying it. This is a strong signal.
This new building is also located in Irvine, California, just a few minutes away from the headquarters
Growth from the other products
We’ve already seen that the company is scaling up the operations due to the increased demand for a secret product. But what about the other products?
If the new thoracic driver is anything like the Cranio-Maxilo-Facial (CMF) driver, it will become a huge success.
Currently, of the $35 Million in revenue, I would say that $20 Million is derived from the sale of the secret product and $5 Million comes from the sale of the screwdrivers. I believe we could be seeing the sale of the screwdrivers go to $40 Million in 5 years.
In 2014, Pro-Dex introduced the first ATL screwdriver to the Cranio-Maxilo-Facial market under DePuy’s brand. Almost immediately the other medical devices companies started calling Pro-Dex to get their hands on the technology.
You see, these companies make money, not from the sale of the screwdrivers, but from the sale of the plates and screws. They cannot risk losing market share just for the simple fact they don’t have that hot new screwdriver the doctors love so much.
And they must love it a lot. It has gained a 60% market share almost immediately after launch (company’s numbers).
NEW PARTS OF THE BODY
Slowly, the company has been making strides into other parts of the body. The development of the new thoracic driver has just been completed and DePuy is already using it.
The first question that came to my mind was “Ok, so Pro-Dex can just go around the building and show its products to the other divisions”, but it doesn’t work like that. DePuy’s divisions aren’t all in the same place.
But even being far apart, it seems that other areas of DePuy are waiting to see if the thoracic driver will be successful and have already engaged the company to develop new drivers for other parts of the body such as extremities. They’re just waiting to see the market adoption of the thoracic driver.
Apart from this, there is also the spinal market. The company has been mentioning this for years, but it seems that they’re finally having conversations with major players to fund the R&D.
You see, the company’s technology can be used to detect if a screw is malpositioned because it can detect the density of the bone it’s being screwed on. This can prevent serious and permanent injuries to the patients.
Now, I don’t know how frequent it is for a surgeon to screw up and perforate a patient’s spinal cord, but as low as it may be, I would be much more relaxed if I knew that the screwdriver would just stop when it sensed it was going in the wrong direction.
But even after they find the right partner it will take them a few years (4-5) before a product is ready to be launched so this isn’t actually a short term catalyst.
On top of this, there are also other products that may help the company to grow. The company has an option to buy 5% of Monogram, a surgical robot startup and it has also recently been awarded a contract by NASA to develop a new ventilator for COVID-19 patients. I don’t put to much weight on these bets.
INTERNATIONAL EXPANSION AND ESTIMATES
The company has been seeing this explosive growth and it hasn’t even begun to sell overseas. They’ve been trying to get CE approval for the drivers, but with no success so far.
It seems that they’ve chosen the wrong company to handle the process. In August 2020, they’ve switched to a new company. I’m not sure how things are going on this front. What I do know is that this will be a big market for them.
And I’m not even counting on China where the company doesn’t do business currently. 2 of the 3 CMF customers want to sell in China. It will be big.
If the company is now selling 5M Million in CMF drivers in the US, it might be selling another 5 Million in Europe and, say, another 5m in China? These are just guesses, but they go to show the potential.
The thoracic drivers may represent $6-$7 Million from DePuy alone. We could be seeing another $6-$12 Million from the two other customers. Let’s say that China could be another $5 Million.
We could be talking about $20-25 Million in thoracic screwdrivers alone. Add to that the CMF drivers and we could be talking about $35-40 Million in screwdrivers versus the $5 Million that they’re selling today.
If the company is able to get the same market share in the thoracic and other parts of the body as in the CMF, these numbers may turn out to be very conservative.
Competition
There are a lot of contract manufacturers around the world. In fact, Pro-Dex is located in a sub-optimal geography where labor is more expensive than in other parts of the world such as Asia. That’s why many years ago they’ve decided to focus on high end devices.
The clients can be the biggest competitors if they choose to take design and manufacturing in-house.
One important competitor is Zimmer with its iQ Intelligent System, but I’ve heard from one source that their product is no good. Either way, this should be monitored.
Risks
- Customer concentration: top 3 customers account for 92% of sales. One customer represents 60% of sales and the second largest 25% of sales.
- Any liability relating the devices, warranties, or complaints.
- One manufacturing facility (about to change).
- Supply chain disruption.
Valuation
After going up 10 or 20 times over the last decade (depending on where you start counting), and at 20x earnings, the company doesn’t look cheap, but this metric tells us nothing about the future.
I believe that the growth will actually accelerate in future years. How much is anyone’s guess, but I wouldn’t be surprised to see the company doubling or tripling its sales in 3-5 years as stated above.
Conclusion
As you might’ve noticed by now, I like Pro-Dex. There’s a big risk which is customer concentration, but there is no doubt in my mind that the company is going in the right direction and that the potential is very high here.
With a Price/Earnings of 20x, the potential isn’t on the multiple expansion but rather on the growth of the business.
Whereas Nephros was sort of my Venture Capital play, Pro-Dex is more like a Phil Fisher type of play. A great company, ran by a great management team, with great products, selling at an attractive valuation.
I believe we could be seeing the company making $100 Million in revenue 5 years from now. Actually this was the number that the CEO mentioned when he announced the new factory and he’s usually very conservative.
At a 20% margin, this would mean $20 Million in Net Income. At a conservative multiple of 15x, even with some dilution, we could be talking about a share price of $65, or a double from here.
I’ll be buying €5000 worth of Pro-Dex’s shares on the coming Monday stated that the price doesn’t go over $32.5.
Further research material
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