Monday, March 14, 2011

Drilling Down The Deswell

Deswell Industries (DSWL) manufactures plastic, metal and electronic components for equipment manufacturers. As one might expect, business has slowed as a result of the recession. Revenues fell almost 40% in 2010, but they have started to tick back up in recent quarters. Meanwhile, the stock price has fallen some 75% since its 2007 high.

As a result, the company trades for just $55 million while it has a cash position of $33 million, zero debt and operating income of a combined $22 million in 2007 and 2008. In addition, the stock trades at a slight discount to the company's net current assets. Clearly, if earnings can return anywhere close to where they were before the recession, this investment should pay off handsomely.

Often, value investors can make money by investing in cyclical companies when things look bleak. But to be successful in doing so, they must be able to distinguish between situations that are temporary (i.e. cyclical) versus those that are permanent (i.e. secular). Deswell presents a challenge in this regard due to a key factor.

First, the company is located in China. Before you automatically close this window and return to stalking your cousin's friend on Facebook, consider that Deswell is not one of those newly arrived reverse-mergers that have put Chinese stocks in the doghouse. It has been around since 1993, and has been public in the US since 1995.

But while the company might be real, the fact that it's from China still presents a potential danger in this industry. China's high rate of inflation means the costs of labour are going up (an important cost for Deswell), but customers outside China don't seem willing to pay the higher costs. This has resulted in a consistently falling operating margin for the company, as shown below:

The chart above shows that the company was having difficulty passing on cost increases (either through competition, inflation, or both) even before the recession. More recently, China raised its minimum wage by over 20%, which was cited by Deswell as one of the reasons for the gross margin contraction in its most recent quarter. Further inflation could send customers to other low-cost countries.

Deswell appears cheap on both an assets and earnings perspective. However, it's unclear what component of its current earnings shortfall is cyclical vs secular, making it difficult to determine the company's earnings power. If the company can keep capital expenditures as low as it has recently, however, it may still be cheap on a free cash flow basis when combined with its strong financial position.

Disclosure: No position


Paul said...

"Before you automatically close this window and return to stalking your cousin's friend on Facebook"

Saj, are you speaking from experience??? :)

Unknown said...


I've just started following your blog after I noticed that your postings have aligned with other companies I've bought in the past. I'm going to watch your blog very intently.

As far as DSWL, I've personally have noticed that a TON of Chinese stocks are incredibly cheap ... almost too good to be true.


Maybe it is ;>)

Value investors like us spend a vast majority of time within the financial results, and if they can't be trusted ... then what does a value investor have?


Really looking forward to your next post!

Hester said...


Deswell is definitely not a fraud like most of the Chinese RTO stocks. I'm not sure why anyone would try to fake their poor performance.

They're not a fraud, but they are a perennial value stock. Saj your probably aware of Michael Burry. He was an investor in Deswell in the late 1990's/turn of the century when he was one of us (running a smaller personal portfolio or fund).

He had 55 posts on Deswell on a forum called Silicon Investor during that time. You can see them and other posts if you follow this link

It's kind of interesting stuff.