IEH Corporation (IEHC): May Be a Good, Cheap Stock – But, Definitely in the “Too Hard” Pile for Now
As this is an initial interest post, it’ll follow my usual approach of talking you through what I saw in this stock that caught my eye and earned it a spot near the top of my research watch list – and then what problems I saw that earned it a low initial interest score.
I’ll spoil it for you here. IEH Corporation (IEHC) is a stock I’m unlikely to follow up on because of the difficulty of digging up the kind of info that would make me confident enough about a couple key problem areas I’ll be discussing below.
I think I have a pretty biased view of this stock. Or, at least, some of what I’ll be discussing in this article might give you a negative, biased impression of the stock. And there are actually a lot of good things here. So, I’d like to start by linking to some bloggers who have discussed this stock in-depth in a way that’s different from some of what I’ll be focusing on here.
I recommend you read theses posts:
“My Trip to the IEHC Annual Meeting” – Bull, Bear and Value (2014)
“Why I Bought IEHC” – Bull, Bear and Value (2013)
“IEH Corporation (IEHC)” – OTC Adventures
“IEH Corporation: A Tiny Company with the Potential for a Big Dividend” – Weighing Machine (2013)
“Recent Numbers at this Company Say Buy, Hand over Fist” – Dylan Byrd (2015)
“IEH Corp (IEHC)” – Value Investors Club (2013)
In case you chose not to click those links, I’ll give you a quick explanation for why I might be interested in this stock at first glance.
It’s Overlooked
The stock is overlooked. I manage accounts that focus on “overlooked” stocks.
This stock has a $40 million market cap – of which, probably close to 50% doesn’t actually trade (it’s owned by insiders, etc.). So, we’re talking about a “float” of about $20 million or $25 million. Something quite small.
The company also does something quite boring. It makes connectors which go into products assembled by defense contractors serving the military, space, and aerospace industries. Investors would know the end products this company’s output goes into – Boeing 737, Airbus A380, F-35, Apache AH-64, Hubble Telescope, etc. And investors would know the customers who buy connectors from IEH – Raytheon, Northrup, Honeywell, Lockheed, NASA, etc. But, neither the company itself nor the products it produces would be high visibility to investors. I find this tends to make it more likely a stock is overlooked. For instance, in the movie industry – investors would focus immediately on the theater owner, the studio producing the film they’re watching, etc. and less on the companies that make the theater’s sound systems, digital projectors, etc. or provide the ticketing kiosks or run the theater’s loyalty program.
In this way, IEH Corporation could be something like George Risk (RSKIA) – a company that has a market cap of under $50 million, is about half owned by insiders (so, the float is even lower), and makes a product that is far enough upstream in the chain of production that investors have never thought about it.
Product Economics Could be Good
The product economics of something like what IEH makes can be good. Bear with me, because this gets a little theoretical. But, if I haven’t seen a stock at all – read about its industry, what it does, etc. in any detail – I can still form some very rough opinions about the basic microeconomics of what it is involved in. Right off the bat, you get some ideas about how capital intensive producing a certain product could be, how critical it is for the customers who buy it, how big a cost item relative to the projects it is going into it is, how high-tech or low-tech it is, how likely it is to face competition from imported products, how “sticky” the product could be for its customers, etc.
A one sentence description of what IEH Corporation does is enough to give me the impression that “hyperboloid” connectors could be a good product to make because they are a “high-reliability contact system ideally suited for high stress environments” and that commercial aerospace is 35% of total sales and military is 45% (space is another 10%). The relative size of IEH and how fragmented its sales are by customer relative to the size of the projects it says these connectors are being used in also suggested to me that the products IEH sells are a very small part of the overall cost of the projects it is used in. These connectors are not a large part of the cost of a helicopter, jumbo jet, fighter plane, or something you’re launching into space. So, I immediately got the impression this could be a business that isn’t especially high tech nor especially low cost driven. It’s the kind of business where reliability, compatibility, past experience, etc. might be determining factors.
The company’s actual economics are not as good as something like George Risk, though. For example, the gross margin of this business has never been that high for a manufacturer. You will often see a gross margin in the 30% – 40% range for IEH. Something like George Risk probably is 50%+ in its core product. There are lots of possible explanations for why this might be. For example, George Risk has a completely non-unionized work force based in Nebraska whereas IEH has a completely unionized work force based in Brooklyn, New York.
The Business Might Not Be Economically Sensitive
Demand for products in the military, commercial aviation, and space industries does bounce around. It doesn’t have the stability of consumer non-cyclical products or something like that. But, it’s also not tied to the same economic cycle that most stocks in a portfolio I put together likely would be. For example, there is a stock in the managed accounts that depends in some part on volume in stock market trading. That’s very tied to consumer confidence, a buoyant stock market, etc. For most portfolios, adding a company that gets almost all of its profits from customers in military, air, and space is going to be a diversifying selection. So, it’s usually a plus.
The Business Might Be Scaling Up Nicely
Again, this gets a little theoretical. But, there’s a huge difference between growing sales from $2 billion to $20 billion and from $2 million to $20 million. There just aren’t many economies of scale gained by going from $2 billion to $20 billion. There are a lot of economies of scale when you go from doing $2 million in sales to $20 million. You probably don’t need 10 times the number of top executives, 10 times the square footage, or 10 times the costs of being a public company filing with the SEC when you go from $2 million to $20 million.
So, I get excited when I see a company growing sales a little but growing earnings a lot – if I know that isn’t a cyclical expansion in earnings, but a result of continuous economies of scale as a very small business becomes a much more middle sized business.
The EV/EBITDA Looked Reasonable
This one isn’t worth talking much about. I’ll just say the EV/EBITDA, P/E, etc. on this one was about as low as you’d expect on a no-growth microcap stock in today’s high valuation stock market. The past history here was good. It was growing. The business seemed to be getting better over time.
Liabilities Were Nearly Nil
This is a big one. IEH showed $2.3 million in total liabilities against $1.4 million in cash and $4.6 million in receivables. Cash and receivables covered all liabilities nearly 3 times. This means whatever the inventory is worth or not worth, whatever the equipment is worth or not worth – it doesn’t much matter in terms of the safety of the common stock here. The default risk here should be very low. It could survive some small losses. I can’t overstate how helpful it is to find a stock with very, very low liabilities relative to cash, receivables, “normal” earnings, etc. It means the company could pay dividends, buy back stock, acquire things, etc. while you own it through the use of debt instead of issuing stock. It also – just as importantly – means you could misjudge the company’s future earnings badly and still never get close to a 100% loss in the stock.
Share Count Stayed Exactly the Same For Close to 25 Years
This is another point I can’t overstate. Most public companies – and this is especially true of big public companies – have a significant amount of drag on their annual per share growth caused by an increasing share count. Some companies buy back stock. But – very, very few companies simply never issue shares. Now, as I write this, IEH actually does have some stock options out that will dilute shareholders. So, yes, they have now grown the share count to give more stock to management. However – despite having a stock option grant plan that would’ve allowed them to grow their share count – this company did not increase its share count one iota throughout the 1990s and 2000s. You can read the company’s 1995 10KSB (a form of the 10-K used by small businesses) which shows the share count for 1994. You can then check the share count shown in every 10-K thereafter – it is always 2.3 million shares. This is a big deal. Compared to most stocks in your portfolio, you’ll find that a zero share issuance policy over time will add probably a bit over 1% per year to your annual returns in a stock. In other words, your portfolio is probably – before buybacks – transferring about 1% of your stock ownership to management each year. When a company closely guards its own shares – I take notice. This is especially good news if you’re looking at a high ROC stock. The worst thing a great business can do is use its own shares to acquire other companies. That dilutes the good economics shareholders are buying into. This company kept its share count steady for about a quarter century. That definitely got my attention.
However, some other things got my attention in a bad way. We’ll deal with those now.
The Auditor Issue
I don’t short stocks. And I don’t talk about a company’s auditors in my write ups. I think discussions of changes in auditors, who is auditing a firm, etc. tend to play towards the conspiratorial mindset that some investors have. They’re afraid not just of losing money – but, of being made to look foolish by a fraud.
Despite not talking about auditors with you – because, in almost all the stocks I’ve written up whatever I know about the auditor is irrelevant or at most inconclusive when it comes to my final appraisal of the stock – I am going to talk about IEH’s auditor.
In the company’s SEC filings, it just has the normal boilerplate language describing how the company’s long-time auditor, Jerome Rosenberg, resigned as the company’s auditor and the company subsequently chose Manuel Reina as the replacement auditor. The generic language used in the SEC filing goes on to say that there was no disagreement with the auditor, etc. This is exactly the language companies use when replacing one auditor with another.
However, in this case, it’s completely misleading.
Well, not completely. The company did mention that Reina was affiliated with the company’s former auditor and had done auditing work on IEH before. But, this could make it sound like Rosenberg was retiring or something and that’s why the change was made. As we’ll learn in a second, Rosenberg’s resignation as auditor was not truly voluntary.
In a podcast that hasn’t aired yet I was asked about what typical “sleuthing” I do. While I don’t focus much on auditors – I do always check four things. One, I check where the auditor is located and where the company is located (the two are often close together – especially for small companies – which makes sense). Two, I check how long the auditor has been auditing this company (which is now disclosed in the auditor’s statement in the 10-K). Three, I google the auditor and look at the firm’s website, find pictures of the key people involved in the firm, etc. And four: I go to the Public Company Accounting Oversight Board (PCAOB) website and pull past “inspections” of this auditor.
The way the PCAOB inspections normally work is that you’ll have the name of the auditor, the number of public companies they audit, and some information about the size of the firm. Even that little bit of information can be useful. For example, I’ve seen cases where the firm is listed as auditing only one issuer. That’s useful information when you’re looking at that one issuer.
In most cases, all you really get that’s useful is an inspection of some number of issuers – often a sample of about 5 issuer audits – where the PCAOB will refer to the issuers audited as just “Issuer A”, “Issuer B”, etc. They will say something like out of the 5 audits sampled, the auditor did not perform an adequate test of blah blah blah in the case of Issuer A and the auditor responded with this letter to the PCAOB.
Lots of inspections have one or more mentions of some incorrect auditing in regard to at least one of the five issuers. Often, this happens in one year and then is not present in another year. Just because there is some issue discussed in an inspection – don’t jump to any big conclusions about the auditor in general or certainly the specific company you are looking at.
Here, we have a totally different story though.
And, actually, I didn’t need to even go to the PCAOB website to notice it.
When I googled IEH’s new auditor’s name “Manuel Reina” one of the sites that popped up was “Jerome Rosenberg”. Now, Jerome Rosenberg was the old auditor. So, Manuel Reina worked with Jerome Rosenberg and yet the company accepted the resignation of Rosenberg to replace him with Reina. They didn’t really switch auditors. They basically just used a different accountant at the same firm.
Why?
The PCAOB website provides the answer (emphasis is mine):
By this Order, the Public Company Accounting Oversight Board (the “Board” or “PCAOB”) is censuring Jerome Rosenberg CPA, P.C. (the “Firm”), revoking the Firm’s registration,1 and imposing a civil money penalty in the amount of $10,000 upon the Firm; and censuring Jerome Rosenberg, CPA (“Rosenberg”) and barring him from being an associated person of a registered public accounting firm.2 The Board is imposing these sanctions on the basis of its findings that the Firm and Rosenberg (collectively “Respondents”) violated PCAOB rules and standards in connection with the Firm’s audits of an issuer audit client.
In this case – since it’s not an inspection, it’s an order – the PCAOB actually identifies what company Rosenberg violated PCAOB rules when he audited it. That company is IEH (the stock we’re talking about here).
In fact, I’m not 100% sure this violation didn’t involve the new auditor, Manuel Reina, in some way. Reina and Rosenberg are the names that show up as people involved in the firm Jerome Rosenberg. Both had been involved for a long time. The firm had been auditing IEH for a long time. And now Rosenberg is barred from auditing IEH. And now, Reina is auditing IEH.
What does it mean?
From the PCAOB order, we know the violation specifically involved:
“Rosenberg served as the head of the assurance practice at the Firm …and he also served as the engagement quality reviewer on the 2013, 2014 and 2016 IEH Audits. While serving as the engagement quality reviewer for those years, Rosenberg assumed responsibilities of the engagement team by performing audit procedures on revenue recognition, assets and inventory in IEH’s financial statements. As a result, Rosenberg failed to maintain objectivity in his role as engagement quality reviewer.”
Although I won’t quote from it. There’s a similar violation on the IEH 2015 audit – only, in that case it involved a different person at the same firm. So, the violation is basically for the 2013-2016 audits and then Rosenberg had to be removed as auditor in 2017.
Does this matter to us? We’re just investors looking at IEH stock.
I don’t know. But, it’s something that jumped out at me right away. And the accounting here may actually be more important to the investment case than at many stocks I look at.
The Inventory Issue
One thing all of the write-ups on IEH seem to note is that the company hasn’t actually converted a ton of its earnings into cash. What it has done is increased its inventory a lot.
What’s more concerning about this is that the company has a “factoring” arrangement whereby it can borrow using current assets:
“The Company has an accounts receivable financing agreement with a non-bank lending institution (“Factor”) whereby it can borrow up to 80 percent of its eligible receivables (as defined in such financing agreement) at an interest rate of 2 ½% above JP Morgan Chase’s publicly announced rate with a minimum interest rate of 6% per annum… funds advanced by the Factor are secured by the Company’s accounts receivable and inventories.”
I won’t get into much detail about the factoring arrangement – except to say that if you read the 10-K very carefully, you can deduce that more than 30% of accounts receivable were due from a single customer.
There is some circumstantial evidence – and I’m talking just how it appears to me, other analysts may interpret things differently – that the company is not very conservative about how it manages either receivables or inventory. For example, the company says it buys “raw materials” in advance of expected demand for those materials to save money. Okay. But, there is also this note on the company’s inventory accounting:
“…The Company based upon historical experience has determined that if a part has not been used and purchased or an item of finished goods has not been sold in three years, it is deemed to be obsolete.”
This company has $6.6 million in raw material inventory. Total inventory is $10.8 million. That’s very significant for a company with an entire market cap of just $40 million.
To put this in perspective – the company’s entire balance sheet (all of its total assets) are less than $20 million. So, you have about 50% of the entire balance sheet in assets and about a third of total assets in “raw material” inventory. And we know the company purchases raw material speculatively. We know that inventory is part of the security pledged to the receivables factoring arrangement. And we know the company’s auditor of 25+ years was barred from public company auditing work because of violations his firm committed while auditing IEH.
What does this mean?
I don’t know. But, because the inventory build-up is such an issue in terms of determining the actual cash returns this business is producing for me as a potential shareholder – this is just too difficult a situation for me to untangle. Raw material that might be obsolete and is bought speculatively is among the toughest assets for me to value. The fact that inventory build might be seen as a good sign by investors – insofar as the company can report more earnings than actual free cash flow – and by the company’s lender (who is secured by that inventory in addition to the receivables) makes me think that it’s unusually important for me to understand IEH’s approach to receivables and inventory management and accounting and the auditor’s as well.
I just don’t have as much faith that earnings which increased receivables and inventory are equivalent to earnings that added to cash.
Nonetheless, the company did recently pay its first dividend since becoming an SEC reporting company. So, the company had gone a long time without paying out any cash. And now it has paid out some cash to investors. This might mark a turning point.
The 1990s Issue
My final concern has to do with the long-term history of this company. Some blog posts discussed this. I created my usual Excel sheet using data I entered from the company’s SEC filings (which cover the period back to 1994). What I discovered is that from 1994-2004, IEH cumulatively produced essentially no earnings. It’s not just that it didn’t grow much during that period. I’d say there was no meaningful profits. An owner could not have taken any cash out of the business as a return during those 10 years. That’s an abysmal record.
But, it’s an old record. The company completely turned things around. Sales increased by 12% a year over the next 14 years. Earnings increased even faster. EBIT margins went from essentially zero in the 1990s and early 2000s to double-digits in every year from 2009-2018. Some say this coincides with the increasing involvement of the son of the former CEO. He is now the company’s current CEO.
That may be true. But, we have to remember that IEH has existed for a very, very long time. It was founded in the 1940s. It has probably – I don’t have exact data on this – been public for about half a century. And yet, it was only 15 years ago that all of the value creation here happened. Based on the record we have – there just isn’t evidence of this company creating meaningful value for its first 60 years or so of operation. Again, I don’t have details going back before 1994. But, you can also look at a stock chart to see the value creation here is all in the last 15 years.
That means I need to understand the company’s strategy and what has been special about what it has done these last 15 years. I need to know whether that will continue.
I’m not sure if I can know that here. There aren’t a lot of details about why the company’s results exploded so positively in the last 15 years. There is some evidence of a lack of competition due to Smiths Group (a U.K. company – ticker: SMIN) owning all of IEH’s competitors in a subsidiary called “Smith Interconnect” and also that a U.S. government program favors sourcing at least some of these parts from IEH instead of Smiths, because IEH meets some requirements (as a small, U.S. business) that Smiths (as a large, U.K. company) can’t. I’m not sure how important that was to the company’s improving results.
Conclusion
Overall, IEH has a lot of appealing quantitative features and possibly some hints of an appealing competitive position. The microeconomics here might be good. The 15-year record is good. The company looks super safe based on the usual credit risk metrics. And it looks cheap enough to be a value stock despite having a 15-year record as a growth stock.
But, the amount of “sleuthing” that would have to go into me ever getting confident buying this one seems too high to me.
I won’t give IEH a zero interest score – because, at very first glance this one looks excellent. So, it does rank higher than something like my first look at Babcock & Wilcox Enterprises (BW). But – it ranks far, far below almost any other stock I’ve looked at for this site.
Geoff’s Initial Interest Level: 20%