Deswell’s the model of a Contra play

Benj Gallander and Ben Stadelmann
Thursday, April 7, 2011

If the genome of a Contra the Heard stock were to be mapped, Deswell Industries would provide the template. And like any position in our contrarian, value-based portfolios, this company has its problems — naturally the case when one is buying turnarounds. But heck, even Apple has its difficulties, perhaps not as apparent in a stock that, it can be argued, is priced to perfection.

Deswell is based in China, which, though an advantage in many respects, is a land where inflation is creeping up, the yuan is appreciating, and wages are jumping. In that last category, the enterprise has been coping with two 20 percent bumps over the last year, part of the reason why the workforce was slashed from 4,100 to 2,900. The combination of these troubles makes it far more challenging to remain competitive.

The bottom line has been severely impacted. A profit of almost $9 million for fiscal 2008 tumbled into a loss of $8.4 million for the first nine months of this year. Revenues plunged to an estimated annual rate of $95 million this year from a titch less than $144 million three years ago. Pessimists and technicians could find a myriad of reasons to affix a huge AVOID stamp to this enterprise.

However, amid all the doom and gloom, there are numerous positives. Though China is becoming less competitive, that doesn’t mean that it isn’t. Revenues seem to have turned the corner, up 10.2 percent in this past quarter on a year-over-year basis. The company would have broken even except for an impairment charge of $3.6 million on fixed assets. Plus, this outfit, which manufacturers electronic products and subassemblies as well as injection- moulded plastic parts, should benefit from a global economic recovery.

A look deeper into the numbers shows how this enterprise codes the Contra the Heard DNA and epitomizes the type of corporation we love to buy. Management is reasonably conservative, so that when the red ink commenced, no dividend was declared. Often enough, businesses that eliminate dividends restore them in the future when the tide turns. Indeed, DSWL has confirmed a dividend of a nickel for this quarter, and it would not surprise if this goes higher in the future.

The balance sheet is a lovely sight to behold: there is cash of $34 million, which works out to approximately $2 a share, and not a speck of debt. Goodwill is less than $400,000, insignificant in the book value of better than $7. Plus prior to the recent losses, the firm rested in black ink.

Another item of consequence in Deswell’s makeup is that the corporation spent a number of years trading at significantly higher levels than our $3.04 (USD) purchase price in February. In addition, prior to November 2007, the stock price was well above the initial sell target of $11.24. As usual, the goal for the return is better than a home run, more like a grand slam.

In planning a portfolio, we find it worthwhile to have geographic diversification. In the President’s Portfolio, of which Deswell is a part, the value is currently divided about 50/50 between American and Canadian stocks.

Besides the fact that many of these 24 companies operate in different countries, two besides DSWL are headquartered in other nations: Flextronics is in Singapore and Magic Software is in Israel. Adding a Chinese position was a desire, now achieved.

There are a myriad of investing approaches. Some, of course, work far better than others. Those looking for an understanding of our methodology can observe in Deswell an excellent model of what Contra the Heard is all about.