I like to write about undervalued microcap companies, and today I’m looking at Espey Manufacturing & Electronics Corp (NYSE:ESP). It’s a power electronics design and manufacturing firm focusing on the military vehicle sector, and I believe it has a strong balance sheet and a good track record of profitability. Furthermore, the company pays a $0.10 per share quarterly dividend, and it’s selling at little more than 6x EV/EBITDA at the time of writing.

A Business and Financial Overview

Espey, established in 1928, specializes in the design and manufacture of power supplies, power converters, filters, power transformers, magnetic components, power distribution equipment, UPS systems, antennas, and high-power radar systems. Its products are utilized in military vehicles, radars, and locomotives, among other things, and are built for military and harsh environment applications. Espey has a design, manufacturing, and testing facility in Saratoga Springs that is over 150,000 square feet in size. It employs approximately 150 workers, approximately 35% of whom are members of the International Brotherhood of Electrical Workers. There is no seasonality, and the company is vertically integrated because it manufactures individual components, populates printed circuit boards, fabricates metalwork, paints, wires, qualifies, and completely tests items all in-house.

Espey spends very little on R&D (R&D expenses in FY22 were only $32,362) because the company is mostly driven by client product demands and custom product creation, with some customer finance. The company is on the eligible list of contractors with the US Department of Defense, and it appears that it has carved out a nice niche for itself, with annual revenues typically ranging between $27 million and $37 million over the past decade. Furthermore, Espey’s operational income has been positive in nine of the last ten fiscal years.

Looking at the most recent financial statistics, the company appears to be benefiting from increased global defense spending as a result of the war in Ukraine, as net sales for the first nine months of FY23 jumped by 15.3% to $27.2 million. Because of economies of scale, the operating income margin increased to 12.17% from 5% the previous year. Furthermore, the company earned $0.13 million in interest income in Q3 FY23 alone since it elected to invest the majority of its cash reserves in investment securities.

As of March 2023, the investment securities totaled $13.9 million and included certificates of deposit, municipal bonds, and US treasury bills. With interest rates rising around the world, I believe Espey’s annualized interest income will shortly exceed $0.6 million.

Looking at the balance sheet, I believe Espey is in good shape. As of March 2023, the company has $4.58 million in cash and cash equivalents and an asset-light business plan. At the end of Q3 FY23, there were no debts. As of the time of writing, Espey had $18.5 million in cash and investment securities, accounting for 41.7% of its market capitalization.

Looking ahead, I believe that FY23 revenues and net income will exceed $36 million and $3.5 million, respectively, due to the robust backlog. Espey had a total backlog of $82.1 million as of March 2023, up from $76.2 million the previous year. The company expects to fill at least $8.7 million in orders in Q4 FY23, and the FY23 results should be revealed around September 20. The strong Q4 FY23 financial performance, in my opinion, could shortly lead to an increase in the quarterly dividend to at least $0.20 per share. Between 2012 and 2020, the corporation paid a quarterly dividend of $0.25 per share.

As of the time of writing, Espey has an enterprise value of $25.8 million (assuming we treat the investment securities as cash) and is trading at an LTM EV/EBITDA ratio of 6.2x. Given that Espey has a solid business with a track record of profitability and that FY23 financial results are expected to be strong, I believe it should be trading at more than 9x EV/EBITDA. This equates to $20.65 a share, or a 26.2% upside potential.

Looking at the risks to the bull case, I believe the most significant is an economic slowdown in the United States, which might result in decreased defense spending and potentially a weaker backlog for Espey. Although the US economy has shown resilience in recent years, many experts believe that inflationary pressures, rising interest rates, and geopolitical uncertainty will cause a slight recession in late 2023 or early 2024. Furthermore, investors should be aware that this is a lightly traded stock, with a daily trading volume that rarely exceeds 5,000 shares. There may be severe share price fluctuation, and it may be difficult to sell a large stake.

Bottom Line 

Because of its high backlog, Espey should have a good conclusion to FY23, with revenues and net income above $36 million and $3.5 million, respectively. This paves the way for a quarterly dividend rise, and I believe it’s also a favorable development that the company has placed a large portion of its cash position in deposits since annual interest income might soon exceed $0.6 million. Espey appears to be undervalued at present, with a TTM valuation of only 6.2x EV/EBITDA. Having said that, this is a sparsely traded business, and there may be major share price volatility ahead, which is why I’m giving Espey a speculative buy rating.

Featured Image: Freepik @ wirestock

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