|Shares Out. (in M):||44||P/E||0||0|
|Market Cap (in $M):||516||P/FCF||0||0|
|Net Debt (in $M):||-67||EBIT||0||0|
|Borrow Cost:||Available 0-15% cost|
DAKT faces structural challenges to its business – namely, price competition from Chinese manufacturers, who collectively are gaining wider consumer acceptance in the U.S., and are moving increasingly “up market” into segments of the LED video display market where DAKT has long enjoyed leading market share.
DAKT’s cost structure puts it at a competitive disadvantage to respond rapidly enough to this heightened competition, and to rapidly declining ASPs.
Finally, DAKT has been window dressing their operating results as much as possible in recent periods through tweaking accounting estimates here and there; consequently, the problems facing DAKT are worse than they seem at first glance.
Daktronics was founded in 1968 by two South Dakota State Professors, Al Kurtenbach and Duane Sanders - in part to provide job opportunities locally for some of their most promising engineering students (see link).
From these beginnings, DAKT has grown into an international leader in the manufacturing and sales of LED large video displays and electronic scoreboards with approximately $600mm in LTM sales.
Daktronics is best known for the large video displays at major sports stadiums – for example, the integrated LED video and scoring system hanging over center court at the Barclays Center in Brooklyn.
DAKT operates in five segments:
Live events (i.e. stadiums);
Commercial (outdoor digital billboards and large displays like those in Times Square);
High Schools (scoreboards and other digital signage for schools);
Transportation (i.e. the Departures/Arrival boards at JFK airport), and;
International (their overseas sales).
Daktronics’s main competitors include:
Increasingly Chinese manufacturers (Leyard, Unilumin, Ledman, Absen, Lintronics, and Retop).
Below is an estimate of the addressable market for just DAKT’s largest two segments (Live Events and Commercial), as well as an estimate of DAKT’s current market share:
Source: Analyst estimates
The Commercial and Live Events segments alone represent about 65-70% of DAKT’s sales and operating income.
The balance is made up by High School, International, and Transportation. High School is a smaller, niche market in which historically DAKT has enjoyed a stronghold, given its reputation and history as a manufacturer of scoreboards (~10% EBIT). Transportation (~10% EBIT) segment has recently been in precipitous decline – LTM EBIT in this segment has gone from ~$21mm in April 2013 to $10mm as of April 2015. The balance of EBIT comes from International.
DAKT has far higher market share in the higher-end, bigger projects. This is both due to DAKT’s reputation for quality, as well as their US headquarters, as a disproportionate number of the large stadium projects worldwide take place in the U.S., and often companies prefer to have a U.S.-based sales and service presence for these large, high-profile, and complex projects.
DAKT’s market share is a lot lower (and based on our research, more quickly declining) in the mid to low level projects, and rental market (i.e. screens sold to rental companies – or for “non-fixed installation” business to use industry parlance).
Please note, the above numbers are ex-China sales. China represents about 1/3 of the global market, so China alone is responsible for another $800mm+ in sales, based on our conversations with industry professionals. But these Chinese sales are entirely serviced by Chinese manufacturers – and there is no chance of Daktronics gaining share in this market. In China, there are currently hundreds of LED display manufacturers. Only maybe ten make product in accordance with international standards, according to our research.
Description of Situation
LED Video Display manufacturing is an extremely competitive business.
DAKT has historically operated at skinny GM’s. And they are getting skinnier as time progresses. DAKT’s GM% averaged ~30% from 1998-2008, but since then have averaged just shy of 25%, amid increasing competition from Chinese manufacturers, who have greatly improved the quality of their products.
This is partly because customers have adopted more of a “good enough”, conservative posture towards their cap ex spend for video displays ever since The Great Recession. This has adversely impacted DAKT, given they are the premium-priced brand.
DAKT’s EBIT margins from 1998-2008 averaged 9%, but since then have averaged 4%.
DAKT’s reputation as the premium product in the market is for good reason. For one, DAKT uses more premium LED components (i.e. they use Nichias products vs. those made by Cree, Chinese and Taiwanese companies) across its product portfolio. But this comes at a cost. Our industry research suggests Cree components can run 20% lower in price vs. Nichias, the Taiwanese options 40% lower, and Chinese options upwards of 50-60% lower than Nichias LED components.
DAKT also invests more in “product reliability” capacity than most of its competitors, as part of which they rigorously test and stress case their products.
Important to note, LED components are a very significant portion of DAKT’s COGS (some 55-70%). So price differences for this key component is crucial in the ultimate price and margins of the large video display they go into.
Historically, DAKT has insisted on using Nichias components, given DAKT’s reputation for quality – and given the highly-visible places a lot of their displays go (above center court of a large stadium). Also, DAKT typically backs their reputation for higher quality with more favorable warranty terms than their Chinese competitors.
While it is possible that the market simply does not value Nichias components as much now as in the past, and DAKT could enhance margins through moving to cheaper components, such a move is made difficult by DAKT’s warranty offerings. The switch away from Nichias would have to coincide with a complete overhaul of DAKT’s warranty practices (i.e. lessening of their guarantees), and would also risk jeopardizing DAKT’s brand as the perceived quality leader. So in many ways, DAKT is damned if they do, damned if they don’t, given their current place in the market.
For example, DAKT’s warranty reserves as a % of sales were 4.5% LTM Sales as of April 2015. This very high relative to their Chinese counterparts. This added cost further compromises DAKT’s ability to compete on price.
The company will tell you that they often have customers switch to a lower quality brand, only to come back to DAKT once the quality of said competitor’s products let them down. But as LED component costs continue to decline rapidly, and Chinese manufacturers improve the quality of their products – the quality gap between DAKT and Chinese LED video display products is closing fast. Also, DAKT is hesitating to lower their prices in response. The result is consumers’ perceived value of the Chinese alternatives relative to DAKT’s products is much higher at present than ever before.
Further, as a U.S.-domiciled manufacturer, DAKT’s labor costs are also higher than their competitors. So given the lower wages and benefits, and the lower warranty costs that Chinese manufacturers offer on their products, prices of DAKT products vs. Chinese competitors on the very same product/components can be up to 15-30% different (this is excluding the cost a Chinese manufacturer may have to pay for a U.S. based sales presence or partner, when selling into the U.S.).
When you factor in the fact that Chinese products often include a cheaper assortment of LED components, this price difference becomes even more pronounced.
Finally, according to the company the recent strengthening of the USD has resulted in further pricing pressure for DAKT, in their overseas markets (namely Europe and Australia), as non-dollar based manufacturers have been taking advantage of their now lower cost base vis a vis the dollar by getting more aggressive on pricing of contracts in an effort to take share from DAKT.
After extensive industry research, we believe Daktronics is currently facing an abnormally elevated level of competition across all their segments, resulting in depressed gross and EBIT margins.
Further, the lack of an adequate strategic response from Daktronics has put their business model on shaky ground. Given our research suggests current conditions are likely to persist (whereas consensus is currently predicting a normalization of Gross Margins to 24% in the back half of the year), we believe DAKT’s stock price is currently overvalued by 30-50%.
As mentioned above, GM% for DAKT are trending lower, but the decline in GM’s has intensified in the most three recent three quarters:
Management’s explanation for this decline is: product mix, foreign currency, and price competition from “Asian Integrators” (i.e. Panasonic/Lighthouse).
First, larger projects for DAKT are lower margin, and chunky. So the timing of these projects can skew margins in any given quarter. Also, the amount of these projects that include subcontracted work can also skew margins. Subcontracted work happens when DAKT wins a bid – but has to subcontract out a portion of the project to a certain partner, as a condition of the bid, which impacts their margins on the project. Of course, the other explanation for this “mix” issue is that DAKT is losing market share in the smaller, but higher-margin projects at an increasing rate. We believe there is more permanence to this mix shift than management is letting on.
On the last call, the CFO had this to say: “There is some impact to us because of the strong dollar. But it's hard to just maybe see in our financials. It's more on the quoting side where we become a little less competitive in, say Europe and those sorts of areas.” So DAKT either has to drop their price to be competitive (eroding GM’s further to below B/E profitability), or lose the business altogether.
On the third point – this is perhaps the most troubling, and we would argue the most permanent of the three explanations.
“Integrators” refer to companies like Panasonic that do not manufacture the video display, but provide the distribution and other supply chain logistics for a manufacturer (in the case of Panasonic - Lighthouse).
Panasonic is the sole distributor of Lighthouse Technologies video display in the United States and Canada.
Panasonic’s partnership with Lighthouse allows customers to purchase Lighthouse technology through a more optimized supply chain. Lighthouse Technologies Limited is a Hong Kong-based, global leader in LED display technology that develops, manufactures, and markets LED video display solutions for multiple indoor & outdoor applications, media and entertainment events, and sports arenas across the globe.
As I illustrate below, we believe that Panasonic is able to achieve a significantly more attractive price point than DAKT on fairly comparable products, given their partnership with Lighthouse.
Also, Panasonic, importantly, unlike DAKT, has a massive portfolio of consumer brands. This allows them to think about their large video display business differently than DAKT does. Specifically, Panasonic may try to win a massive live event and stadium project as a “loss leader” for its broader consumer business, by using the stadium placement to increase customer awareness about the Panasonic brand, and hopefully in turn to drive sales of their consumer products, which is where Panasonic’s bread is ultimately buttered.
This allows Panasonic to take an even more aggressive posture versus DAKT in competitive bidding situations (which all large projects are) beyond just the advantages they enjoy due to lower component, warranty, and labor costs. The larger and larger profile of stadium projects as of late make the “loss leader” economics for Panasonic increasingly compelling, which is why this dynamic has been worsening for DAKT lately.
Also, Panasonic, like other Asian competitors, are increasing their sales presence in the U.S. both directly and through strategic partnerships. For example, Panasonic just acquired TS Sports, a company that handles the “sales & service” component of large stadium contracts. This will in turn allow them to win an increasing number of big stadium contracts.
Also, fast-growing Chinese company Leyard, for example, now has a small sales presence in the U.S. One industry professional we spoke to believes Leyard is now doing about $200mm in annual sales globally from almost nothing five years ago.
Unilumin, Lintronic, and Absen all do an estimated $150-$180mm in sales annually. Also, these companies have been innovating in small pixel pitch (i.e. Leyard), or acquiring other innovative manufacturers, like Absen’s acquisition of Viss Lighting for example, or Unilumin’s stake in Radiant. There is a chance that these manufacturers will further increase their sales presence, either via integrators or directly, in the U.S. over the coming years – pressuring DAKT further, particularly in the indoor market.
“The Chinese screen market made such a compelling argument with low cost, decent-quality-products that they destroyed the quest for perfection. It no longer makes sense for Barco to try and out-do them on new product launches, because no one will be able to afford it. This is not a knock on Barco, just an economical truth.” April 2015, Upstagevideo.com/blog (a rental company for large video displays).
“Stiff competition in the traditional LED video display market has led to price wars and shrinking profit margins, driving manufacturers to seek new opportunities.” January 2015, IHS Technology.
“…this year’s demand growth [in the LED market] has been considerably weaker. The main factor behind this is the volatile global economy, which in turn causes big exchange rate fluctuations in several regions. Currency depreciations in Europe, Japan, and the emerging markets have made imports of LED bulb and other electronic products more costly for consumers. Consequently, demands are scaled back and LED manufacturers are now undercutting each other in order to maintain their capacity utilization rates.” May 2015, Roger Chu, Research Director at LEDinside.
The above three quotes summarize well the current state of the complete LED supply chain.
First, as the third quote shows, the price of LED components are declining rapidly. Since this is a cost input for DAKT, one might think this is a good thing. But it is not. Given the vertical integration of the supply chain in China, and the price transparency for LED components, declining ASPs for LED components are ultimately flowing through to lower ASPs on video displays themselves (as the second quote demonstrates).
Amid rapidly declining ASPs, DAKT has to rapidly grow volumes just to maintain flat sales growth. DAKT’s LTM sales growth as of April 2015 YoY was 12%. DAKT does not disclose volume growth – so it is impossible to ascertain price/volume contributions. But we believe video display ASPs are likely declining 10-15% per year, based on industry research. So ~12% sales growth would suggest 22-27% growth in volumes. This will be tough for DAKT to maintain, especially if economic growth slows.
Surely, this cuts both ways – i.e. if price competition abated while demand for DAKT’s products remained robust, margins would obviously improve. But given the cyclical component to DAKT’s business, where we are in the cycle likely, and given they have had to aggressively cut price to drive these volumes to-date, I do not view growing volumes double digits, while maintaining price, as a risk at this point.
Also, DAKT’s growth has recently been coming at the expense of margins. When volume growth eventually slows, the industry is at risk of falling into a death spiral. Keep in mind, DAKT did $581mm in sales in ’09. By ‘10, sales had troughed to $393mm. As of April ’15, sales have climbed back to $615mm. This is a cyclical business.
Also, as noted above, EBIT margins have not recovered – and likely never will - to pre-Great Recession levels. So as DAKT approaches arguably peak-ish levels in sales this go-around, they are on much weaker ground than they were before the last turn in the cycle.
Finally, the first quote highlights how Chinese manufacturers are closing the quality gap in the eyes of consumers – who now feel the Chinese, lower-cost option in many instances is “good enough” – and are opting for that option over the more premium brand (DAKT).
Poor earnings quality a risk
Warranty Expense: DAKT’s warranty reserve as a % of sales has been declining (from 4.9% in the twelve months ending April 2014 to 4.5% of sales in April 2015, providing a 40 bps boost to GM %, over a time when LTM GM% declined 220bps inclusive of that 40 bps tailwind, from 25.7% to 23.5%).
This suggests that DAKT perhaps under expensing for warranties over this time period, providing an unstainable boost to GM’s, and masking the negative impacts from enhanced price competition.