Richardson Electronics, Ltd. – “Finding Gold in Green (Energy)”

Investment Thesis

Richardson Electronics, Ltd. (“RELL” or the “Company”) has long been considered a sleepy small cap company. RELL operates in the no-frills electrical components market, with an emphasis on manufacturing tubes and related components. Over a nearly 40-year history of being publicly traded, RELL has experienced limited profits and revenues peaked at $600 million back in 2007. However, the Company embodies a “never say never” attitude rarely seen in corporations today, custom designing components to solve customers’ issues, even when it is not profitable to do so. Together, these factors make it easy for investors to overlook or misunderstand RELL. Our view is that RELL is much more than a sleepy small cap electrical component manufacturer. RELL is a true customer solutions provider, and their relentless niche focus on creating specialized components has led them to an attractive growing market with tailwinds which may result in the explosive growth.

RELL has experienced rapid growth with the development of a new product dubbed the ULTRA3000. This product is a design of multiple ultracapacitors engineered to replace traditional lead acid batteries used in wind turbines. In CEO Ed Richardson’s own words “we have designed a lot of these products that were a dead-end street, they never went anywhere. But, on the other hand, there are a few that have turned into real big home runs”. With the ULTRA3000, RELL has potentially hit the biggest homerun in the company’s 75-year history of designing and manufacturing electrical components due to the new markets that the product unlocks. RELL is in the early innings of a multiyear growth runway between expanding the use case for the ultracapacitor technology, other new products/technologies in development, and core business lines with exposure to growing end markets. Electrification is a tide lifting all boats, and RELL is in the right space at the right time. Their experience gives them a major advantage in this rapidly expanding market.

Company Overview & History

Richardson Electronics, Ltd. is an electrical components manufacturer and distributor headquartered 50 miles west of Chicago in La Fox, Illinois. The business was founded by Arthur Richardson in 1947 as a power grid tubes distributor out of a barn in rural Illinois and has grown to serve more than 20,000 customers worldwide in both the OEM and end-user markets. Arthur Richardson’s son and current CEO, Edward (Ed) Richardson, took over leadership of the Company in 1974 and led the Company through a public listing in 1983. The Company currently designs or manufactures about half its products and serves as a value-add distributor for the rest. With 500 employees, 100 of whom are engineers, there is a focus on what the company calls “engineered solutions”, which consists of developing specialized components that address very specific needs or issues for customers.

Overview of Four Segments

Richardson Healthcare:

Summary: Healthcare is the smallest segment within RELL and has transformed over the past 10+ years. In 2011, RELL sold its radio frequency (“RF”) business to Arrow Electronics for $238 million. At the time, RF was the largest business within RELL. Since the sale, RELL has shifted its focus in this segment to CT and MRI replacement tubes. To accommodate this shift, the Company built a state-of-the-art 250,000 square foot tube factory for $35 million. It is one of, if not the, most modern CT tube factories in the world and currently has the capacity to build about 1,000 tubes per year. This capacity is severely underutilized with current production levels at less than 300 tubes per year, resulting in a $5 million loss. Breakeven production levels are approximately 400 tubes.

Catalyst/Growth Potential: Developing replacement tubes for Cannon (ALTA750D and ALTA750G) is driving current capacity, but RELL is actively developing replacement tubes for Siemens, which would create potential demand to reach breakeven levels of 400 tubes. RELL expects the Siemens replacement tubes to launch in 2023. A successful launch would result in this business segment generating a positive profit with additional tubes driving revenue growth and margin improvement as factory utilization rates improve. If the Siemens replacement program is not successful, management has indicated they would likely sell this business. We view this as a win-win scenario as either 1) this segment will become profitable from a successful Siemens launch, or 2) the business will be sold – adding back ~$5 million to the bottom line (TTM net income was $22 million) and generating cash to invest in other higher growth segments of the business.

Market Dynamics/Competition: The aftermarket diagnostic imaging parts and service business is estimated at around $10 billion. As with many of RELL’s business lines, competition includes large players such as Siemens, Samsung, and LG but RELL’s niche is designing repaired tubes in smaller quantities that are not profitable or worth the time of larger participants in the space.

Leadership: Executive Vice President and Chief Operating Officer Wendy Diddell leads this division. Ms. Diddell has worked with RELL since 2004, initially working in the Security Systems Division, and serving in her current capacity since 2007.

Canvys:

Summary: The Canvys segment provides custom designed smart displays primarily used in healthcare equipment. An example of a major customer for this division is Medtronic (MDT), who integrates the RELL displays into their robotic laser guided surgery system.

Catalyst/Growth Potential: Revenue in this segment increased an impressive 23% YoY in the most recent quarter (Q1 FY23). Despite recent growth, we see this as the segment with the least amount of sustainable growth potential as there is no meaningful catalyst on the horizon. Any new growth will need to be generated organically from increased demand for blue chip medical and industrial OEM systems. There is also a glass ceiling to growth as RELL is looking for the “sweet spot” in terms of production quantities in the 2,000 to 3,000 unit range. At larger quantities of 5,000 or more units, companies such as LG and Samsung enter the picture. Although long term growth may be muted, this is still a consistent and profitable business. This segment will likely surpass $40 million in revenue in FY23 and currently has a $50 million back log.

Market Dynamics/Competition: Displays developed by RELL are a few thousand-dollars piece of equipment that go into what is a multimillion-dollar medical system. This provides considerable stickiness with customers as it becomes an integral part of a medical system that the OEM does not want to change due to the low-cost relative to the cost of the overall product, FDA approval hurdles, and any potential for the system to malfunction due to one piece changing. RELL has found a niche focus on the smaller and more specialized end of the market in which large, multi-billion-dollar companies are not incentivized to participate.

Leadership: Jens Ruppert has led this segment since 2015. Prior to RELL, Mr. Ruppert was the Managing Director of Envinet GmbH, a German based high-tech company. Prior to that, Mr. Ruppert was with NDS Surgical Imaging from 2006 to 2013 serving in a number of roles.

Power & Microwave Technology:

Summary: Power & Microwave Technology (“PMT”) is RELL’s largest segment and can be viewed as their core legacy tubes business. Within the PMT segment, there are two primary business lines: The Electron Device Group (“EDG”), which provides tubes for a wide range of use cases (communications, semiconductors, industrials, etc.), and the Power and Microwave Group (“PMG”), which provides discrete components for semiconductors. RELL’s largest customer across all segments is Lamb Research (LRCX), for whom they build tubes used in semi-conductor wafer fabrication equipment. This is the segment where RELL flexes its innovation and engineering capabilities, developing custom technologies/applications to meet customer needs. Focusing on “engineering solutions” specific to the customer’s needs may hamper the addressable market of a specific technology/product but it can also lead to new innovative products that address a more widespread market.

Catalyst/Growth Potential: There are no near-term catalysts due to the most innovative technology being moved to Green Energy Solutions (more on this in next section), but there are multiple tailwinds in the form of attractive end market exposures. Two of the largest end markets are semiconductors and communications. Semiconductor wafer fab equipment has benefited from market growth as chip shortages drive demand for new wafer fabrication installations. Semiconductors are a cyclical market, but we believe will continue to grow over the long run. The segment also continues to have excellent sales growth related to the roll out of 5G infrastructure and technology. We forecast this segment realizing approximately $165 million in sales for the fiscal year and currently has a backlog of $95 million.

Market Dynamics/Competition: There is limited competition in the commercial tube market due to size (~$400 million annual demand) and the lack of long-term growth prospects for older technology such as tubes. RELL is the leading distributor of power grid and microwave tubes and related consumable parts and has cornered the market outside of government contracts.

Leadership: Gregory Peloquin leads this segment and has been the Executive Vice President of PMT since 2014.  Previously, Mr. Peloquin spent three years as President of Arrow RF from 2011 – 2014. Prior to that, Mr. Peloquin was Executive Vice President and General Manager of the RF, Wireless & Power Division of Richardson Electronics from January 2002 to March 2011. Mr. Peloquin joined Richardson Electronics in 2002 from Motorola Semiconductor where he was Director of Global Marketing for the RF Division. Mr. Peloquin is the epitome of a boomerang employee and is typical of the passion and loyalty employees have for RELL.

Green Energy Solutions:

Summary: Green Energy Solutions (“GES“) is effectively comprised of the most innovative high growth technologies/products which were previously held in PMT. Management wisely separated this division from PMT to isolate the financial growth of these products more effectively and to simplify the high growth story for investors. This is the segment where the RELL narrative comes alive as there are several innovative products that are primed for considerable growth over the coming years. Technologies/applications that have the most potential include:  

ULTRA3000: RELL developed and patented the ULTRA3000, a design consisting of ultracapacitors and an integrated circuit to replace traditional lead acid batteries (“LABs”) in GE wind turbines. Batteries in wind turbines are used to dispel energy in short stints to adjust the pitch and rotation of the turbine’s blades, ensuring the maximum amount of wind energy is being generated. Ultracapacitors have a clear advantage over LABs in this application for several reasons:

• 10-15 year life span compared to 3-5 years for LABs (which saves operators a significant amount on replacing batteries);
• More environmentally friendly;
• Operate more efficiently in a greater variety of weather conditions; and
• Discharge energy at a faster rate.

A turbine operator named Nextera initially contracted RELL to develop batteries for 1,000 of their 10,000 GE wind turbine fleet, a $10 million order in the first year. Nextera now wants RELL to convert roughly 1,000 batteries a year for their growing fleet. Outside of Nextera a growing number of turbine operators are also contracting RELL for ultracapacitors to replace LABs in the GE turbines they operate. There are about 30,000 GE wind turbines currently operating in the U.S. which presents an immediate TAM of $370 million with a rapid adoption rate.

Other Ultracapacitors Applications: RELL has a very low hanging growth opportunity in applying the ULTRA3000 technology to other wind turbine designs outside of GE. RELL is already making headway on this front and is actively working with Siemens to design a private label product. RELL is also in initial conversation with Vestas, the largest wind turbine manufacturer. According to usgs.gov there are currently over 70,000 wind turbines in the U.S and an average of 3,000 have been built annually since 2005. There is a large and growing TAM domestically, which would increase exponentially once the hundreds of thousands of turbines outside the U.S. are considered. The longer-term opportunity for this technology is other applications where ultracapacitor technology can be applied more efficiently than LABs. Management is currently focused on replacing LABs in generators at the base of cell towers, and is currently in beta testing with T-Mobile (TMUS) and AT&T (T). Other potential use cases include hospitals, fire stations, and energy storage for solar and wind farms.

EV Locomotives: RELL is working with Progress Rail, a division of Caterpillar Inc., who is building locomotives in Brazil for use in the Australian market. RELL was contacted by Progress Rail to inquire if ultracapacitors could be used to replace LABs in EV locomotives. RELL engineers determined that the electrical current was too low to use ultracapacitors, but lithium-ion phosphate batteries could be an alternative. Progress Rail agreed and ordered $18 million of batteries which RELL was able to source via an agreement with Amogreentech, a Korean based supplier. This illustrates the unique and customized approach RELL uses to solve customer problems, source international contracts/resources, and ultimately create new business opportunities. Another large opportunity spawned from the relationship with Progress Rail is the development of battery compartments to replace diesel train engines. Progress Rail is contracting RELL to build the battery compartment for their initial roll out of U.S. constructed EV locomotives. RELL is contracted to develop four prototypes, with each battery compartment accounting for $1 to $3 million in revenue. Progress Rail is planning to convert 50 locomotives in the U.S. over a three-year period. After this initial trial period the expectation is that Progress Rail will start aggressively converting their North American fleet, which numbers in the thousands. This is still very much in the early stages but could represent a massive growth opportunity if RELL is successful with the initial prototypes.

Synthetic Diamonds: RELL constructs magnetron tubes, the most popular application for which is in synthetic diamond making. This is another attractive growth avenue as synthetic diamond manufacturers continue to experience high demand for sustainable and humanely sourced diamonds, specifically in Asia. According to CEO Ed Richardson, RELL built approximately 800 magnetrons in prior years, but demand has jumped to over 5,000. RELL sells magnetrons for just under $3,000 a unit and the tubes only last about 2 years, providing RELL with a recurring revenue base for these products.

Catalyst/Growth Potential: Specific growth drivers/catalysts are discussed above but looking at the segment as a whole, sales grew 230% YoY from $2.5 million in Q1 FY22 to $8.5 million in Q1 FY23, with total FY23 sales estimated by management at $40 million (which is very conservative). This segment is the future for RELL and has the potential for exponential growth, albeit from a small base, for years to come. GES could very well make up 50%+ of revenue before the end of the decade. We also believe RELL has the proven ability to expand into other growth markets due to their “engineering solutions” mindset which could lead to further yet to be discovered growth opportunities.

Market Dynamics/Competition: RELL’s ultracapacitor technology does not have any immediate threats in terms of competition but there is always the potential as the market accelerates. The closest competition would have been Maxwell, which RELL had a distribution relationship with, but Maxwell was acquired by Tesla in 2017 and production was made exclusive for Tesla. We believe competition in ultracapacitors is further deterred by the smaller nascent nature of the application. It took two years for RELL to develop the technology, and they have multiple patents on their existing ULTRA3000 and patents pending for the UltraGen3000 (cell tower generator). The patents for the ULTRA3000 are on the circuits that communicate with the GE turbines – meaning future competition would likely need support from GE to develop the technology. The competition in synthetic diamonds is limited due to the specialized tubes and the smaller market size. Similarly, the current EV locomotive opportunity is early and specific to the needs of one customer.  

Leadership: Greg Peloquin, the head of PMT, is the current incumbent. Greg has a strong grasp on this segment with all the products and technologies being developed in PMT. It would be ideal to see a senior member from PMT, if not Greg himself, be chosen to solely lead this division.

Adding it All Up – Growth Potential of Total Business

Management has stated annual top line growth expectations over the next five years of 15% to 20% for the total business – leading to approximately $500 million in sales by 2027. Although lofty, we believe this is achievable:

• The company has several developing growth initiatives.
• Tailwinds across multiple business units capitalizing on forces such as the transition to green energy, 5G roll out, and continued growth in semiconductor applications and production.
• Management appears excited and motivated to achieve these results. As historical context, RELL was a $500+ million revenue business for nearly a decade before the sale of RF in 2011 (shown below). Management operates with a much longer time horizon than most companies, but we believe they are eager to grow sales back to levels from the beginning of the millennium.    

Review of Ownership & Executive Compensation

One of the red flags that investors must get comfortable with is ownership. Specifically, CEO Ed Richardson, who owns 15.5% of the company through class B shares. Class B shares have ten votes per share resulting in Ed Richardson having a 65% voting interest in the company. This, in addition to Ed Richardson’s 60-year tenure at the company, raises questions relating to the succession plan in place for the 80-year-old CEO, president, and chairman of the board.

A certain degree of comfort is achieved by the fact that each segment has a separate leader taking point. In terms of succession, nothing has been stated publicly to provide a concrete plan on who would take the reins if Ed were to step down. RELL appears to be a flat organization which helps with any sudden transition. A possible suitor to replace Ed appears to be Executive Vice President and Chief Operating Officer Wendy Diddell. This is purely speculation based on: Wendy being listed 2^nd in the bios on the website, she is clearly knowledgeable across all business lines, and she is often with Ed during investor events/conversations providing additional color throughout the sessions. She appears to be the right-hand woman and our best guess at next in line. We have spoken with her directly and feel highly confident in her abilities.

Competition

Given their niche focus, RELL has limited pure-play competition. This is because most of the products are custom designed in smaller batches for a specific customer or purpose. RELL has established a fantastic rapport with customers to be problem solvers and going the extra mile to provide solutions. This may be a cliché, but RELL really does act as a partner for every customer, which provides stickiness and creates new business opportunities. In comparing RELL to other similar sized public companies that operate in the electrical components industry, the largest takeaway is that as these companies gain size ROE/ROI tends to increase, and peers that have higher margins have historically traded at higher multiples.

Valuation

RELL has appreciated 84% over the last year, which begs the question has the market fully priced in the opportunity? We do not think so. The market appears to appreciate the growth opportunity offered strictly by the ULTRA3000, but not the multiple other applications of this technology as well as the growth potential of the other products in the Green Energy Solutions segment. RELL is still an underfollowed and underappreciated micro-cap with multiple business segments that can clutter the growth story. With that said, a slight discount to the share price is warranted due to the ownership structure.

We valued RELL using a 5-year DCF model. This model yielded a price of $34.29, but we believe the shares have considerably more upside as the model was prepared using conservative assumptions. Summary of key inputs:    

• Revenue Growth Rate: Top line revenue was forecasted by segment. We believe we conservatively forecasted growth in the Green Energy Solutions segment and had a meaningful decrease in PMT revenue in FY24 to reflect slowdowns in the semi-wafer business.  Management forecasts annual growth of 15% to 20% to hit $500 million revenue by 2027 (compared to $445 million below) which we believe to be achievable.
• EBITDA Margin: We believe EBITDA margins for RELL will expand meaningfully with scale and as the higher margin Green Energy Solutions grows. We effectively have top line EBITDA margins expanding to best in class when compared to peers that have no exposure to higher margin green energy business.       
• WACC: A WACC of 15% was used which takes into account the size of the company as well as the less than favorable ownership structure.
• Terminal Value Multiple: A terminal EV/EBITDA multiple of 10x was used. This is in line with normalized levels of higher margin peers.

Risks to Investment Thesis

Inability to Scale Operations. One of the largest risks to our thesis is RELL not being able to recruit more engineers to help support continued growth. RELL is reliant on skilled and motivated engineers to accommodate customers’ needs and to innovate. Hiring has been a major focus for RELL, and employees are cross trained across business lines, which helps support spikes in demand. Regardless, the current roster of 100 engineers will need to grow as the business scales.

Semiconductor Exposure. A number of products within PMT are supported by a strong semiconductor market, which has historically been a very cyclical industry. For example, Lamb Research is currently the biggest customer, making up about $27 million in sales. We do expect a cyclical downturn in the semiconductor business, but this will just be a temporary slowdown and has been factored into our base case DCF model. Additionally, we believe any lost revenue from this line of business will be more than offset by growth from the GES segment.

Ownership. Investors must get comfortable with Ed Richardson’s ownership and control of the company. It does not appear that he plans to step down any time soon nor does he have any intention of selling the business – which effectively eliminates the catalyst of an acquisition. Compensation did not raise any major red flags. We also believe that the company has such a great opportunity in front of it, coupled with capable leadership across segments, that RELL is well positioned even if Mr. Richardson were to step down as CEO.

Supply Chain and Inflationary Pressure. As with many manufacturers and distributors, RELL is subject to headwinds from inflationary and supply chain pressures. This is compounded as RELL is a small customer for most of its suppliers and deals in very specialized products. RELL has managed to increase top line growth by nearly 50% since 2020 despite these challenges. We believe inflationary and supply chain issues will continue to alleviate in 2023 and that RELL has strong relationships with suppliers.

Conclusion

RELL has been a family-owned business operating in small and specialized industries for 75 years, 50 of which have been under the leadership of current CEO Ed Richardson. Many would view this as a negative, and in isolation, it is. The question that is hard to ignore is: why is now any different than the past 75 years? We believe this time is different because RELL has innovated itself into the most meaningful growth opportunity in decades. With their specialized knowledge and problem-solving mindset, they are primed to conquer this opportunity – it is in their DNA. Look no further than the recent book written by CEO Ed Richardson titled: “Never Give Up – The Story of Richardson Electronics and the People Who Built It”. All this to say that we believe management is highly motivated to succeed, and to a certain degree may take the success of the company personally. Couple this desire to succeed with the most meaningful growth opportunity in decades and we believe Richardson Electronics will reward patient shareholders for years to come.

All values as of 12/21/2022.