Surge Components Inc. (SPRS)

A strong, undervalued business in a secular growth market

Surge Components, Inc. (SPRS), together with its subsidiaries, supplies electronic products and components. The company offers capacitors, which are electrical energy storage devices; and discrete semiconductor components, such as rectifiers, transistors, diodes, and circuit protection devices. It also provides audible components, including audible transducers, buzzers, speakers, microphones, resonators, alarms, chimes, filters, and discriminators, as well as fuses, printed circuit boards, and switches. The company's products are used in the electronic circuitry of various industries, including automotive, computer, communications, cellular telephones, consumer electronics, garage door openers, security equipment, audio equipment, telecom products, computer related products, power supply products, utility meters, and household appliances. It sells its products to original equipment manufacturers and distributors through independent sales representatives or organizations in the United States, Canada, China, other Asian countries, South America, and Europe. 

The company operates through two sales groups: Surge Components, the main business line (passive electronic components), and Challenge Electronics, which is their wholly owned subsidiary that sells audible product components for items like speakers, microphones, etc. Their general focus for the Surge line is discrete components, which are small semiconductor components that each do one job within the final product, generally created by their customer – their largest target market is small-to-medium sized OEMs. It is important to note that their two top customers make up ~30% of their sales.

While their competition tends to be much larger, Surge’s size is their competitive advantage. They can be nimble and quick to adapt to any economic environment, which they have displayed recently. Despite rising costs, difficulty in acquiring semiconductor parts across the industry, and a more difficult legal environment (including higher tariffs), management has found a way to increase revenue 64% over the past two years and pass on tariffs to customers, all while staying in good standing with customers and continuing to deliver while others can’t, despite being in an industry with intense price competition.

The company attributes this to management’s ability to manage inventories, where continual growth might otherwise be worrisome, however they have done a terrific job providing much shorter lead times than their competition, which is why customers are reliant on Surge. Surge continues to see a large backlog in orders, and while an oncoming recession might temporarily slow growth, this is not a major worry for a management team so adept at handling change. 

The revenue growth is attributable to both increasing sales to returning customers, and new customer sales, which is a great recipe for continuing this long-term growth in what appears to be a secular growth market. So long as they can overcome supply chain issues, as management has done throughout the history of the company (and especially recently), there is no reason the growth must tail off anytime soon.

Additionally, management is committed to maximizing shareholder value, as per CEO Ira Levy, who owns 23% of outstanding shares – management as a whole owns roughly 47%. Management continues to buy shares, and there has been almost no record of insider selling in the past. They have incredible experience, with the CEO and CFO having started the company back in 1981. They tend to compensate themselves fairly well, with all-in comp being close to $500k annually for the two of them, however that is not far off from peers, and they remain heavily invested in the business. 

Getting deeper into the valuation, this is a company that has no debt, meaning their cost of capital is very low. Pair this with their incredibly high returns on invested capital – between 15-35% over the past few years, even before removing much of their unnecessary excess cash – while the industry average lags at ~5% (focusing instead on ROE yields the same result: 20% over 5Y vs. 5% for the industry). On a relative basis, no matter what your measurement of choice, SPRS is incredibly cheap. Here are some of the numbers, first for SPRS, and then for the industry average, for a company with nearly half its’ market cap in cash:

P/S: 0.38 vs. 1.51
P/E: 5 vs. 16.8
P/Tangible Book: 1.18 vs. 1.89

While I am unable to come up with industry data for enterprise multiples, SPRS also trades at an EV of 8.5M backing out cash and operating lease requirements, and has operating income of 4.7M, leading to an EV/EBIT ratio of 1.8, and with little depreciation, EV/EBITDA is much the same, sure to be much cheaper than the rest of the industry. A company, with a real competitive advantage, incredibly high returns on capital, growing revenue and revenue streams, great management, insider ownership, no debt, trading dirt cheap relative to their competitors. On a relative basis, this is one of the best bargains I have found in the market recently. If this company were to rerate at even half of the industry average on some multiples, it is a double, and the room for it to falter is very small, as it is a great business generating tons of cash and providing real value to customer in a secular growth market. 

On an absolute basis, SPRS is also very cheap. While DCFs are often a way of messing with numbers to make an investment looks good, I prefer to set it up in a way that I can back out whatever assumptions underlie the current price, and see if they make sense. Assuming the company grows revenue to ~57M next year, only 10% growth, and a maximum of $60M in two years before tailing off and shrinking revenue to only $40M a few years down the line, holding the EBIT margin constant between 8-9% and assuming D&A as a % of revenue around 0.15% (the historical average), a deferred income tax hit to cash flow of ~100k per year (historically, it has actually been positive, so this is very conservative), CapEx of roughly $80-120k per year (again, in line with historical numbers) and change in net working capital that decreases over time as the business shrinks (again, conservative, as they should continue to grow), applying a 15% discount rate and a terminal growth rate of ~2% values the shares between $3.18-5.59 on the high end. This is obviously assuming no rerate, and reflects what appears to be a worst-than-worse-case scenario, but still shows a downside of only 7.5%, and an upside of nearly double. In the scenario where the company continues to grow revenue and free cash flow over the next few years, and potentially rerates closer to industry averages, then this could easily be worth triple what it is now.

So, why is this company so cheap? The main reason is that SPRS trades OTC as a pink slip and is very thinly traded. It is much too small for any institutional investor to purchase, meaning the market is incredibly inefficient here – the company ahs less than 200 shareholders. In fact, their annual shareholder meeting lasted only 17 minutes, and there was not one question for management, as very few people attend. However, this to me only reinforces the thesis – an incredible business generating cash hand over fist in a secular growth market with strong management. 

There are also certain business specific risks, some listed in their statements, and some extrapolated, that could potentially affect the business in the long-term. They are somewhat exposed to political risks in China, have a few large customers that could affect the business if they were to leave (there is zero indication of this happening), and have certain anti-takeover provisions at hand. There is an illiquidity premium at hand here due to how thinly traded shares are for a small company, but that discount is far overblown here – as much as 50%. This is a company priced for -20% growth perpetually paired with a management team actively seeking to burn cash – this is simply detached from reality. 

As for potential catalysts? First and foremost, the egregious undervaluing of this security is catalyst enough. Even looking at a worst-than-worse case scenario would see this company worth more than it is now to a private market buyer, or public markets should the company finally elect to uplist their shares on the NASDAQ. This would allow more share turnover and would help value become realized more quickly. Management is getting old, as all directors are not over 60 years old. The company could elect to sell, but uplisting is much more likely as the company continues to grow is management wants to realize the true value of their shares as they near retirement (as mentioned previously, they own almost 50% of shares outstanding).