Maxwell Technologies: The Bottom is In
Tom Konrad CFA
In the month since Maxwell Technologies (NASD:MXWL) surprised analysts with strong second quarter (Q2 2012) earnings, the stock has maintained a trading range between $7.50 and $8, comfortably above the $6-$7 range in which it had been trading for most of the summer. Despite the roughly 20% gain, I believe the stock has plenty of upside left as it recovers from its previous depressed levels.
Why the Low Price?
A year ago, Maxwell was a cleantech darling, with analysts predicting rapid growth as the company’s ultracapacitors were used as key components in rapidly growing markets such as hybrid vehicles and wind turbines in China, North America, and Europe. But the crisis in Europe and delays getting ultracapacitors incorporated in new automotive designs caused management to push revenue growth estimates during the first quarter (Q1 2012) conference call.
What followed was a classic example of the dangers of growth stock investing. First, investors and analysts used rosy growth projections to justify high forward earnings multiples. Then rapidly rising stock prices drew in momentum investors seeking to capitalize on the continuation of rapid gains in a virtuous cycle. The rapidly rising stock price served to confirm investors’ and analyst expectations of future growth, and targets were repeatedly revised upwards. Stock market gains also lent the company an aura of invincibility, and potential risks were increasingly ignored by analysts, investors, and management who interpreted the rising share price to mean that nothing could possibly go wrong.
No company is invulnerable, and something always goes wrong eventually. In Maxwell’s case, it was the European crisis, which slowed growth in once robust markets, and the much slower-than-expected process of getting Maxwell’s ultracapacitors incorporated in new automotive designs. In the Q1 2012 conference call, Maxwell CEO David Schramm acknowledged this reality by cutting revenue guidance for 2012 from 25% growth to 15-20% growth, but maintained long term growth projections.
Virtuous Cycle Turns Vicious
Schramm clearly intended to tap on the brakes a little, but just as the positive feedback of investor psychology inflated the stock price on the upside, negative feedback exaggerated the negative effects on the downside.
First, the downward revision of one year’s guidance led analysts and investors to ask the previously unthinkable: If 2012 growth will be lower than we expect, why not future years as well? Although Schramm only cut short term guidance, investors adjusted their long term models, and in turn cut the multiples they were willing to pay.
As a rough rule of thumb, growth investors are willing to accept a Price/Earnings ratio equal to their projections of long term growth, and optimism can lead them to focus on next year’s projected earnings, rather than current or trailing earnings. So when long term growth was expected at over 30%, and 2013 earnings were expected to be over $0.50, it felt easy to justify paying over $20 for the stock, which is what it was trading for in February. $20 is about $0.60 (expected earnings) times 35 (projected growth).
When investors expected long term growth of only 20%, and 2013 earnings projections were revised downward to $0.50 (because of lower short term growth projections), growth investors found it difficult to justify a price over $10 (= $0.50 x 20).
Then the feedback effects kicked in. Analysts began to consider risks they had previously discounted, lowering acceptable price multiples. With the stock price plunging, momentum investors sold as well, driving the price lower still. Growth mutual funds also decided that Maxwell no longer qualified as a growth stock, and sold substantial holdings, driving the price down further, until Maxwell bottomed at $5.88 on July 24, when it traded at less than 12 times then-projected 2013 earnings.
The Cycle Runs its Course
In June and July, negative feedback had run its course, allowing the stock to reach a new equilibrium. Value investors like myself were attracted by the much more conservative price multiples on offer, and company insiders were signalling that they thought the stock was a good value with fairly aggressive buying.
When Maxwell reported Q2 earnings at the start of August, investors’ fears that the Q1 guidance revision would be the first of a series of downward revisions were allayed. Despite slightly lower-than expected quarterly revenues, Maxwell maintained revenue guidance for the year, and showed good progress controlling costs. Investors had become so pessimistic that even the slightly disappointing revenues combined with good cost control amounted to a positive surprise.
Now, analysts have stopped cutting earnings estimates. In the last month, eleven analysts have revised expected 2012 earnings upward, and four have made upward revisions to 2013 earnings, with no downward revisions for either year, according to First Call. Strengthening forward earnings estimates should begin to draw new investors into the stock, as should the continued confidence of company insiders. Schramm and a director (Mark Rossi) each bought an additional 10,000 shares shortly after the Q2 earnings announcement, for a total of 78,000 shares acquired by insiders since the Q1 announcement and large price declines in late April.
Although the viscous cycle of declining expectations, selling, and increased risk aversion seems to have run its course, it’s unlikely that recently burned investors will return to their former optimism soon. Fortunately, such optimism is unnecessary to produce decent returns.
Analysts are currently expecting long term growth of 25%, but the current $8 stock price means that MXWL is trading at only 24 times expected 2012 earnings (33 cents), and 17 times expected 2013 earnings. Such pricing leaves some room for mild earnings disappointments, to which the current set of relatively sober investors will likely respond in a much more measured way than the growth and momentum investors who formerly dominated the stock. Positive earnings surprises will probably also be greeted with equanimity.
To give a range of estimates of investors’ potential gains over the next three years, consider three scenarios for disappointing, in-line, or better-than-expected earnings growth:
If Maxwell disappoints and produces only 20% growth over the next three years, in September 2015 we will be looking at a stock with current (2015) expected annual earnings of $0.57. 20% growth would likely justify a 20 earnings multiple, for a price of $11.40. If Maxwell meets expectations for the next three years, expected 2015 earnings will be $0.64 cents, and the price multiple should be around 25, for a stock price of around $16. In the optimistic scenario of faster-than-expected three year growth, we would be looking at 2015 earnings of $0.72 cents, and the positive earnings surprises would have likely drawn growth and momentum investors back in, meaning that the stock would likely be trading at a 30+ multiple of expected 2016 earnings of $0.94, or $28.
|Scenario||2015 Expected Earnings||Multiple||9/2015 Expected Price||Annual Return|
|High Growth||$0.94||30 (times 2016 expected earnings)||$28.00||51.8%|
I personally consider the “High Growth” scenario unlikely, and prefer to invest in the expectation of the “Low Growth” scenario. Even that relatively conservative scenario is not a floor for future stock returns, but the possibility of more optimistic scenarios should be sufficient to compensate for the downside risks.
When a relatively conservative scenario like the “low growth” scenario above still produces 12.5% long term annual expected returns, I consider the stock a buy.
Disclosure: Long MXWL
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