Benchmark Electronics: Overvalued and lacking moat ($BHE)

Benchmark Electronics, Inc. (NYSE: BHE) provides a full range of electronic manufacturing services to OEMs, and industrial end-users. The company is trading (as of 7/1) at $16.98, which is about the mid-point between the 52 week high and low, though a significant decline from the company's pre-recession highs which exceeded $25.

Initially, I was attracted to the fact that the company was trading at a P/B of 0.91x, had relatively few intangibles, and a fairly impressive capital structure:

Benchmark Electronics Capital Structure, 1995 - 1Q 2011

As you can see, the company carries a massive cash hoard, with net cash (Cash – Total Debt) of $5.31/share, or 31% of the current purchase price.

The bulk of my portfolio is made up of companies with little to no debt and large cash balances. This capital structure effectively eliminates the potential for bankruptcy, and introduces some downside protection in that the cash balance can be deployed to repurchase shares should the share price decline to an absurd level. However, as often is the case, the reduction of one risk gives rise to another risk. Namely, the risk that management will waste the cash on ill-considered acquisitions that generate sub-par returns.

From BHE's 4Q 2010 conference call (emphasis added):

Ryan Jones – RBC Capital Market

Okay, that's helpful. And then, any update on cash priorities going into calendar year ‘11? It seems like the company's more open to acquisitions at this point, having done two in the last one or two years. Does that mean, when the buyback eventually is totally consumed, that the company will focus more aggressive – retain cash more for the use of acquisitions versus returning cash to shareholders?

Cary Fu – Benchmark Electronics C.E.O.

Well, we will – this is Cary. We will continue to look at the use of the cash. As we've discussed in the previous call, two priority is the acquisition front as well as the buyback program. We will continue to do both. You are right as a significant efforts looking in the acquisition front. We have been very active in that particular area. We'll have nothing to announce at this point in time for 2010 and we'll continue 2011. We'll have a very focused effort looking at acquisition. We are expecting our skill capabilities as well as the penetration in new industries.

From this, we see that the company is planning on using its cash balance for both share repurchases and acquisitions. The company's discussion of share repurchases is not simply wasted breath – they have repurchased $238M in shares since 2007, reducing its share count from a peak of around 72M to approximately 61M today, or 15%. Though this isn't as impressive as some other companies we've looked at, it is nice to see nonetheless.

Unfortunately, the discussion doesn't end with the company's net cash balance and repurchases. Readers of Financial Shenanigans know to watch a company's cash conversion cycle for potential problems (especially companies like this, with fairly significant receivables and inventories):

Benchmark Electronics Cash Conversion Cycle, 1995 - 1Q 2011

From this, we see that BHE certainly doesn't have the advantages that Dell Inc DELL has. However, the greater concern is the fact that the company's cash conversion cycle has been growing quite steadily for the last eight years, primarily as a result of increasing Days' Sales Outstanding (Receivables), which leads to concerns about the quality of its sales (I would be hesitant to invest in a company which could point only to customer financing terms as its value proposition).

Unfortunately, the negative aspects don't end here.

As I've discussed in my analysis of several other companies, it is important to consider the company's stewardship of shareholder capital. The questions generally take on the following format, in order of importance:

1. Has the company been able to earn strong returns on a consistent basis?
   • If so, are these “real” returns, or simply accounting gimmicks related to increasing leverage
2. Has the company also been able to grow revenues without sacrificing returns?

Let's look at BHE's returns:

Benchmark Electronics Returns, 1995 - 1Q 2011

Ignoring the two troughs, which are related to impairments (In an attempt to avoid accusations of manipulating the numbers, I have not adjusted these figures), we see that the company has generated returns in the double digits only a handful of times throughout its history.

These are essentially unlevered returns (remember, the company hasn't had a significant debt level since 2002), so that would normally indicate a potential opportunity for improving shareholder returns. However, as we see from this next chart, the company's revenues are anything but stable, which makes the addition of debt even less prudent than it is for companies operating in other industries:

Benchmark Electronics Revenues and Margins, 1995 - 1Q 2011

There is very little about BHE's performance that is attractive, which indicates some rationale for the fact that it is trading at a discount to its book value. However, it is important to look at what the market's current valuation of BHE implies in terms of future growth, and then determine whether these are realistic. As every value investor should be aware, the best deals are often found in companies that execute poorly.

At the current share price of $16.98 (as of 7/1), the company appears to be overvalued. I reach this conclusion because the growth rate implied does not appear justified (indeed, the company has shown little real growth for the last half-decade, so I am wary of assuming any growth going forward). Additionally, on a residual value model, the returns that are required in order to yield residual income that would justify the current price exceed the company's long-term track record, so there is little empirical evidence to support these assumptions.

As always, I accept the possibility that I am missing some portion of the value that BHE presents. If you think this is the case, let me know! What do you think of Benchmark Electronics?

Author Disclosure: No position

Talk to Frank about Benchmark Electronics

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