Introduction

 Deswell Industries, a stock trading below $3.00 per share, commands a fair value of $6, and could potentially unlock this valuation in the near future. So what does this $2.50 microcap stock have that I saw? Well let’s dive in!

 Deswell Industries, Inc. produces injection-molded plastic parts and components, and engages in assembly of electrical products, metallic molds, and accessories. The company was founded in 1987 and is headquartered in Macau, China. Looked at in the early 2000's by Michael Burry, Deswell has attracted value investors for over two decades, grabbing my eye due to its high cash balance, and the extent to which it was undervalued encouraged further research, which suggested there was a sizable opportunity to exploit.

With a dividend yield of 8%, Deswell clearly has a significant amount of cash handy, but the amount relative to its market cap will likely surprise you. With a market cap of just under $40M, Deswell holds over $96 million (USD equivalent) worth of current assets, comprised primarily of marketable securities, time deposits, and accounts receivable, and when subtracting $9 million (USD equivalent) to account for inventories, Deswell holds over $83 million (USD equivalent) worth of highly liquid current assets, ~$5.20 a share, more than double Deswell's current share price.

Throughout this analysis, I'll discuss the potential reasons for Deswell's low valuation relative to our $6.00 price target, the risks inherent to investing in a company of this size, and the potential reward of being a long term holding in Deswell, a holding you can gain significant exposure to through our DAM Core Top Five (Coming soon) strategy, as well as many more on our platform!

Reasons for Low Valuation

With it being clear that Deswell holds enough capital to make a significant payout to shareholders, we need to dig into the cause for Deswell's shares to be trading for a nearly 50% discount to its highly liquid current asset base. I believe it stems from the following factors, all of which will be discussed in further depth.

• Deswell's subsidiaries are required to hold $52.7M USD worth of assets aside due to China's "Registered Capital" regulations.

• Deswell's net income is derived primarily from non operating income, showing its potential reliance on this strong current asset base

• Deswell's management has little reason to be concerned with minority shareholder value, given the overwhelming (70%+) control the board holds

• Deswell's primarily Chinese operations are discouraging to US investors

While the reasons outlined above may be initially contradictory to our bullish thesis on Deswell, we at Daly Asset Management have constructed a strong argument outlining the reasons that Deswell Industries is worth roughly $6.00 per share, that we will explore in this article. Core to our thesis is information gained directly from IMS Investor Relations (the IR team that Deswell hires), that’s allowed us to model the true value of Deswell in a way that nobody else may be doing!

China’s Registered Capital Regulations

Being a British Virgin Isle's holding company, Deswell is not required to follow Chinese regulation, however its two Chinese based subsidiaries are. Most importantly, Registered Capital regulations. Registered Capital is a number declared upon the incorporation of the company, and upon receiving an annual profit, the company must contribute a minimum of 10% towards "completing the capital requirement", by setting it aside for "future business use" (this capital often ends up doing very little to support business activities, and is primarily there for creditors in the event of a liquidation event.)

Directly from Deswell's 20-F filing is the following quote

"Each of our PRC subsidiaries is required to set aside at least 10% of its after-tax profits after making up previous years’ accumulated losses each year, if any, to fund certain statutory reserve funds until the total amount set aside reaches 50% of its registered capital."

The requirement is considered fulfilled when 50% of the declared amount of Registered Capital is set aside. For Deswell, their declared Registered Capital was roughly $105M (USD equivalent), calculated with their declared restricted assets of $52.7M (USD equivalent) 

Being frank, Registered Capital was quite a struggle for me to grasp, however it completely changes the game with regards to Deswell's maximum payout, more than halving the assets that Deswell can pay shareholders, and being a considerable contribution towards what would otherwise be Deswell's seemingly low valuation.

Deswell still trades for an extremely low valuation, however understanding Deswell's Registered Capital requirements and its implications gets us closer to knowing this company in and out prior to approaching the board with a request for a higher dividend.

Why Care?

While the majority of investors in Deswell may believe that the entirety of its book value is free to be paid to shareholders, Deswell states that $52.7M (USD equivalent) is held aside to complete their Registered Capital requirements. Being in business for multiple decades, Deswell has already reached the 50% threshold, meaning the $52.7M (USD equivalent) is the most Deswell will see restricted, but this capital is considered inaccessible for one very important thing, rewarding shareholders.

Deswell may not pay a dividend, or buyback shares if this Registered Capital requirement is not met. They must have the requirement met before the issuance of a dividend/buyback, and the implementation of the dividend/buyback must not place Deswell out of compliance with this regulation. In other words, Deswell may not get access to this capital for anything other than "business activities," and may not pay out shareholders if this requirement is not actively met.

Importantly, Deswell may dig into its Registered Capital Reserve account to pay off debt and continue business operations, meaning we can effectively withdraw all money off the top, and leave Deswell its Registered Capital account to continue operating, with no disturbance.

Would Increasing the Dividend be Financially Responsible?

 Deswell currently derives roughly 75% of its net income from non-operating income, primarily interest and capital gains on its marketable securities and investments. This appears to be an issue, the withdrawal of a significant amount of Deswell's "portfolio" of investments via a higher dividend would likely diminish its net income, and thus damage the share price, however there are two reasons why this isn't significant enough to cause worry.

• Deswell currently trades for its current value primarily due to its dividend, not its earnings value

• Deswell's net income would only drop by the yield it receives on its investments

The first reason is quite simple. Deswell is priced by the market at a level that indicates the sole proprietor of its price is its dividend. For under 4x earnings, the market clearly doesn't believe Deswell to pack a punch in that arena, the reasons for that I can only speculate, however a 9% annual yield can't be disputed. While investors can argue the value of its future earnings, discounting them at various rates, cash in the pocket of investors is a much more tangible way of valuing a company, and thus I believe Deswell would best be described as trading for a 9% yield, rather than 4x earnings.

The second is more speculative, however it's an easy number to estimate. Deswell currently holds ~$70 million (USD equivalent) worth of cash and investments, and has returned roughly $7.5 million (USD equivalent) on that over the prior year. This is a 10% annual return, so a $20 million payout would have a roughly $2 million (USD equivalent) impact on its net income of $10 million (USD equivalent), or 20%.

Actual Valuation and Investor Relations Information

 So what is it that I actually learned on the call with John Nesbett, the CEO of IMS Investor Relations? Well, I learned that Deswell’s rule of thumb is a 1/3rd net income dividend payment. This small piece of information changes everything when it comes to modeling Deswell’s future value. 

 Deswell made 10% on its investment portfolio this year, and a fairly flat $3.0M on its actual operations.

Dividend Discount Model

 So how do we value the stock? Well, first is the worst, so let’s cover the method that gets us the lowest valuation. Assuming they continue with an 8% return on their investments. What’s the present value of the payouts they make? This is the bare minimum price I believe Deswell should trade for, because it’s effectively pricing it like a bond, placing ZERO value on the company's future earnings outside of what it pays you for holding the stock.

 Using an 11% discount rate, an 8% return on investment, and a $3M profit from operations, we get $2.73 per share of future dividends. This means that the “now” value of all the payments Deswell makes in the future are worth $2.73 per share, if you wanted an 11% return annually, which is quite impressive. Using the discount rate you’d apply to a stock like Apple (8%), just for funsies, we get $5.70 a share.

 So that’s the lowest price I’d think Deswell should trade for. It’s easy to calculate, and secures an 11% return on investment for investors if the assumptions the calculations were made on turn out to be correct.

Future Earnings Model

 Ending the valuation segment on a more positive note, a Future Earnings Model valuation calculated with an 11% discount rate, 8% ROI, and flat $3M from operations, gets us a value of $8.20. More than 325% higher than the current share price.

 This leans more on the “best case” type of assumption, but is certainly achievable by the stock in the long run, if insiders start to be more flexible/liberal with the dividend payments, allowing investors to actually see the value of the profits generated outside of numbers on a 10-k, instead as numbers in a bank account.

Conclusion, Entry, and Exit

 What to do with this opportunity is a good question to be asking at this point. The bid/ask spread is quite large, the stock doesn’t trade too frequently, and the volume is low. How do I enter and exit this position? Well ideally the exit is easy: You cash out through the 8% yield.

 The entry is more difficult, and there are a few options.

Choice 1:

 Leave a large buy order floating at ~$2.50, and increase it by $0.01 every week until it gets fully filled, taking advantage of the illiquidity to scoop up what would have been big dumps at a discount to market price.

Choice 2:

 Market buy for the entire order at once. Ideally 9:30 for the smallest market impact.

Choice 3:

 Smaller market buys for a chunk of the order each day at 9:30. (Market open to maximize volume.)

 All in all, the options above are solely for investors who are interested in the opportunity. Deswell trades at a sketchy valuation because it’s clearly a sketchy play. It’s not liquid, and has significant risks. However I believe in Deswell’s valuation being an opportunity for those investing for the long run, and if that’s you, then maybe a closer look isn’t a bad idea.

Legal notes, but also really worth understanding:

This analysis is not financial advice, and should not be taken as a solicitation of a monetary or financial transaction by Daly Asset Management. This analysis is simply designed to be educational and entertaining, and decisions made with this analysis in mind should be made in conjunction with further personal research into the investments suitability for oneself. Please make smart, educated decisions, with personal situations in mind. The reason this disclosure needs to be here is because of just that, we don’t know what you know. Your own personal financial situation is the number one factor in making investments, and as we cannot know that, we cannot encourage or discourage a decision based on this analysis.

Be smart, 

 Daly Asset Management.