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Old 06-29-2015, 10:49 PM   #1
BCI23
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PDEX - My Largest Position

I wrote this a couple month ago (before the most recent earnings release) so the stock is up about 10% from when i wrote this but when you see my price target its basically irrelevant.



Ticker: PDEX
Share Price: $2.04
Shares Outstanding: 4.17m
Cash: $1.348m (adjusted for Fineline Molds acquisition, $625k)
Stocks Investments: $1.0m
Distressed Debt Investments: $1.2m
Debt: $100k (Fineline Molds)
Market Cap: $8.5m
Enterprise Value: $5.05m
Tangible Book Value: $2.05/share ($.85/share net cash, based on my observation, you could not replicate their facilities for the $1.56m they carry their PP&E at currently)

Pro-Dex is the only company I’m aware of currently that has the potential to be many multiples of the current share price in the next year. Pro-Dex is a medical device outsourcing and manufacturing company currently 2 years into a turnaround selling for the value of its tangible assets and being run by two value investors operating as Chief Capital Allocators for the company. I believe sales are set to grow 60%+ in the next year, which the market appears to be currently oblivious to.

• $8.88m market cap/$5.4m enterprise value
• Clean balance sheet/share structure
• Selling for Tangible Book Value
• Zero Institutional ownership/Analyst Coverage
• Large number of NOLs off balance sheet
• Two new board members playing the role of Chief Capital Allocator for the company
• Turnaround story/Financials currently depressed due to large fixed costs spread over small revenue base
• Customer relationships with several multi-billion dollar companies
• New projects coming to fruition in the next 3-6 months which the former CEO described as “two of the largest in company history.”

Company Description/Industry:
Pro-Dex, founded in 1971, designs, engineers, produces, and markets powered surgical and dental instruments (Micro Motors brand), and multi-axis motion control products for medical, factory automation, and scientific research industries.

I don’t have any unique insight on the Medical Device Outsourcing industry but I thought this recent report gives a good overview of trends, dynamics, competition, and valuation/M&A activity in the space. In short, the industry trends certainly can be classified as “tailwinds” rather than “headwinds” for Pro-Dex.

http://www.capstonellc.com/sites/def..._Q1%202015.pdf

Customer Relationships:
The company’s current SEC filings do not list any of Pro-Dex’s customers and in many cases they are prevented from disclosing their customers because of Non-Disclosure Agreements (NDAs). However, the company used to be more liberal in discussing their customers. A quick look back at their pre-2012 filings reveals some of Pro-Dex’s larger customers:

“Some of our larger customers include Smith and Nephew, Medtronic, Sullivan Schein, Thermo Fisher Scientific and Monogram Systems” – 2010 10-K

These are obviously all very large companies that Pro-Dex has relationships with. Through my research, I’m also fairly confident that they also have relationships with B/E Aerospace, CMF Medicon, and Biomet.

Management
The presence of two board members who combined own 37% of the company are what makes Pro-Dex my top idea. Nick Swenson and Ray Cabillot are two value investors who arrived on the scene after winning a proxy contest against the previous management in January 2013. They purchased their stake 100% in the open market and they are paid next to nothing ($2k/yr) for serving on the board, an incentive alignment Warren Buffett often fanaticizes about yet remains incredibly rare in real life. Refusing board compensation is a small gesture ($10-20k/yr); however, to me it speaks volumes about Nick and Ray’s beliefs about how a company should be run. Nick and Ray also set up a “surplus capital investment committee”, which allows them to invest Pro-Dex’s excess cash however they see fit. Most management teams have little capital allocation ability and are usually restricted to internal company projects and dividends, while any venture into M&A or buybacks is often done recklessly. Nick and Ray’s skills allow for Pro-Dex cash to be allocated to the highest return opportunity across a wide spectrum of areas. They will decide whether internal projects, M&A, buybacks, equities, or distressed debt represent the best return prospects.

I had the chance to meet both of them at the company’s annual meeting this past December and ask them a few questions (I was the only shareholder to attend). They had no idea who I was or what I knew about them but through my discussions with them I’ve been able to verify that they are exactly who I envisioned them to be (they act and think like owners). They are very involved board members and take the capital allocation portion of their role very seriously. A direct quote from the CEO while we were talking at the annual meeting in December: (referring to Nick and Ray) “Those guys are the best thing that’s ever happened to this company. They are on the phone with us every week, are super engaged, and just want to win.”

Catalysts: Rebuilding the Revenue Base
After right sizing the company’s cost structure to cash flow breakeven in Q2 FY14, the company then shifted its attention toward rebuilding its revenue base. As was well documented in the proxy contest, the company did not previously have much of a sales force and when the company’s former largest customer decided to bring their design and manufacturing in-house in 2011-2012, the company was left with no sales pipeline. The company is currently transitioning toward being a full service medical device outsourcing company and is pursuing multiple avenues for rebuilding sales: MedTech Projects, Contract Manufacturing, M&A, and Engineering Services. To sum up the strategy going forward:

“In parallel to our pursuit of medical device projects, we are diversifying our product lines to leverage our core competencies – marketing our expertise on an outsourcing basis in such areas as engineering, precision machining and assembly, and regulatory consulting, to prospects in a variety of manufacturing-based industries. “ – Nov 2014 Proxy

MedTech

This is the sexy side of Pro-Dex’s business and has been their bread and butter historically. In MedTech projects, Pro-Dex works with OEMs to design, engineer, and manufacture new medical devices where they retain the intellectual property. The projects can take years to begin generating manufacturing revenues but once they are up and running the sales last for years, are high margin, and are protected by IP and exclusive manufacturing agreements. These projects are lucrative but have a long sales cycle. The company is working to diversify its sales base by adding more stable revenue streams via contract manufacturing, M&A, and engineering services.

Example project:
Battery Powered Surgical Screwdriver - CMF Medicon/ Biomet
http://www.swedishtrading.com/medica...roBrochure.pdf

http://www.pro-dex.com/media/55770/p...t.%20final.pdf

http://www.cmfmedicon.com/images/upl...ro_Plating.pdf

Contract Manufacturing
Contract manufacturing is unsexy and Pro-Dex’s old leadership did not pursue contract manufacturing opportunities very seriously. In my discussions with management and as called out on conference calls, this will become a much larger focus moving forward. The new CEO and CFO both previously worked in contract manufacturing companies in previous jobs. Contract manufacturing is not sexy but the new leadership is not focused on sexy, they are focused on building, growing, and maximizing the company’s assets for shareholders. The Pro-Dex facility has excess capacity and this leadership team is focused on utilizing that capacity.

M&A: Huber Precision/Fineline Molds
Another very logical option for Pro-Dex to utilize their excess capacity is the acquisition of other small manufacturers that they can plug into their Irvine, CA facility. Nick and Ray have extensive M&A experience and will ensure that this is done responsibly (there are several instances where you can see that Nick strives for AT LEAST 15-20% ROIC). The company has recently closed on two acquisitions: (1) Huber Precision $210k and (2) Fineline Molds $725k. Few details have been given around these and the intention maybe be more about acquiring assets/capabilities rather than revenue streams. However, some quick searches online seem to point to Fineline Molds having a revenue run rate around $1.3m/yr. If they are able to move the Fineline Molds operation into their Irvine facility, I would expect some significant cost savings and would expect a lot of the gross margin from Fineline to drop to the bottom line going forward. I think the Fineline Molds acquisition could also be with the intent to acquire plastic injection molding capabilities to assist in their MedTech projects. Pro-Dex’s VP of Engineering was recently quoted in a trade publication:
“Stu Gallant, vice president of engineering and product development for Pro-Dex, told MPO that while rapid prototyping can provide fast turnaround, this method outputs components that lack in robustness and overall quality. "Rapid (1-2 week) small runs of plastic components are now also readily available," he added”

I expect Nick and Ray to continue searching for other potential M&A opportunities that they can incorporate into the Pro-Dex facility to help better utilize the capacity they have. This is a huge service to shareholders they are providing for free and I am very thankful for that!

Engineering Services
Engineering Services is a recently launched division of the company. This division will allow Pro-Dex to better utilize its engineering talent and create new and more consistent revenue streams for the company. As mentioned before, Pro-Dex has customer relationships with several very large companies that they will be able to market these services toward and it is a natural extension of the company’s capabilities. It is also not capital intensive at all. I don’t have great insight into what sort of revenue this segment will be able to produce in the near/medium term but based on recent job postings on the company’s website, Monster.com, and Linkedin, it appears this division is getting off the ground and I would expect to be generating revenue by FY16 (3 months out).

Two Large New Engineering Projects:
The near term catalyst that is set to bolster revenues higher for the company over the next year are two engineering projects that have been in development for approximately 2 years. The first project appears to be a traditional MedTech project where Pro-Dex will retain the intellectual property and the second project is a contract manufacturing project that they may not be retaining the intellectual property but may still be signing exclusive manufacturing contracts for. Through some digging in trade publications and supplier press releases, I’ve put together that one of the projects they are working on is for an intelligent torque surgical screwdriver, which is used to insert bone screws during surgery. The company has described this project as “potentially market disruptive.” (http://www.marketwired.com/press-rel...ce-1982380.htm) (http://www.mdtmag.com/articles/2015/...cal-technology). This new driver appears to be the company’s next generation of screwdriver and should compete directly with the iQ Intelligent Screwdriver made by Biomet. (Old driver: http://www.pro-dex.com/media/55770/p...t.%20final.pdf Biomet’s Intelligent Screwdriver: http://www.biomet.com/wps/wcm/connec...1-e8dca6ada5a4)

The second project I’ve had less success in finding information on but the company has also described it as “a new platform for surgical devices.” The big question is “How large are these projects and when will revenues arrive?” The company has said that they will be wrapping up the engineering phase of these projects over the next two quarters (Q3/Q4 FY15), which will allow them to recognize the deferred revenue related to this project. This amounts to $500k in revenue (per most recent B/S), which look to be $250k for each project. Once this phase is complete, the customers begin placing orders for the products. I expect to see product revenue in either Q4 FY15 or Q1 FY16 (3 – 6 months out). This is supported by a recent press release from one of the suppliers Pro-Dex is using for the new screwdriver:

“Trelleborg Sealing Solutions is providing shoulder-to-shoulder engineering seal design support to Pro-Dex for this intelligent powered screwdriver prototype that will be commercially available in 2015”

Now when it comes to determining the size of these projects, we haven’t been given much to go off of from the company. The only quantification the company has given us is that these are “large projects” with “large customers” and these two projects are “two of the largest design projects in company history.” A search through past years projects gives us an idea of the size of these projects. In the following articles, Pro-Dex was paid $200k to design a product with annual revenues of $1.4 - $3.0m/yr and another project where Pro-Dex was paid $250k to design a product with annual revenues of $2.4m/year.

(http://www.digchip.com/companies_new...2010_01_22.php) (http://www.bloomberg.com/apps/news?p...d=aJCQ4s9..dp8)

Combining these facts with the statement that these two current projects are “two of the largest in company history”, I think it’s a reasonable conclusion to say that each of these projects should easily produce $2.5m/yr in revenue, if not more (they currently do over $5m/yr in sales to their current largest customer). At 35 – 40% gross margins, this is an additional $1.75m - $2m/yr in gross margin. At the annual meeting back in December, the former CEO stressed that the current cost structure is currently almost entirely fixed costs and that any incremental business will almost all fall to the bottom line. In separate conversations, the former CEO and current CEO both estimated that their current Irvine, CA facility could support $35-40m/yr in sales (currently does $9.5m). This is a large fixed cost infrastructure currently being spread over a small revenue base, significantly impacting their gross profit %. As sales grow, overall gross profit rate will expand back to the mid-high 30s (see 2010-2011 financials).

Update: One of their projects will be launching May 2015 (Q4 FY15) according to their website (no press release issued), company also has 5 jobs postings (not insignificant for a company with 60 employees that laid off 40% of their workers only 2 years ago )

Financials:
I believe Pro-Dex revenue is set to grow 60%+ next fiscal year and I don’t believe the market is reflecting any of this in the stock right now. Here is my rough build out for Pro-Dex’s income statement in FY16 (July ‘15 – June ’16), assigning no revenue estimates to the new engineering services division, organic growth, any additional M&A activity, or gains/losses from the $2.2m in equity/distressed debt investments:

FY16 (Calendar July ’15 – June ’16)
TTM Revenue: $11m
+ Huber Precision Revenue: $.25m (est.)
+ Fineline Molds Revenue: $1.3m
+ Project 1 (Surgical Screwdriver): $2.5m
+ Project 2 (Unknown): $2.5m
+ Engineering Services ?
+ Organic Growth ? (backlog is at a 2+ year high)
Total Revenue: $17.55m
Gross Profit (35%): $6.1m
SG&A: $3.8m
Operating Income: $2.3m
EBITDA: $2.8m


PDEX currently trades right at Tangible Book Value, EV/TTM Rev: .43x, and 1.5x my EV/FY16 EBITDA estimate (Calendar July ’15 – June ’16). They have gotten a low valuation for quite some time due to horrendous mismanagement from 2007 - 2012. In 2004 – 2005 the company achieved high teen EBITDA rates and traded for EV/Rev of 2x. I believe when PDEX grows back into their cost structure and achieves these 15 – 20% EBITDA rates again, they will also get that valuation back. Many of their larger comps currently trade for 10 -12x EV/EBITDA and 2-3x EV/Rev. 10x FY16 EBITDA = $28m and 2x FY16 Revenue = $35m (Current EV = $5.05m). I believe investors will get the double whammy from both earnings growth and multiple expansion. The company also has $2.5m in federal NOLs, $6.3m in state NOLs, $.9m in federal tax credit carry forwards, and $.56m in state tax credit carry forwards all with full valuation allowances against them on the balance sheet.

Risks:
Pro-Dex largest customer currently makes up 55%+ of their sales and the loss of this customer would be a major setback. This risk appears to have been mitigated recently as called out in a recent CFO conference bio for Hal Hurwitz (former CEO):

“He (Hal) took leadership of the company at the request of the largest shareholder in the wake of his successful proxy contest. Imperatives Hurwitz accomplished during the turnaround include: conceptualizing and implementing initiatives to strengthen relationships with major customers, resulting in the retention of the largest customer that had been at risk”

http://www.cbjonline.com/a1ocbj/supp...wards_1501.pdf

The near term catalysts here are these two new engineering projects that are expected to be ramping up in the next 6 months and the failure of these to come to fruition would be a major setback as well (1 of the projects is confirmed to be launching in May 2015). In terms of personnel risk, alarms will be going off for me if Swenson/Cabillot, Rick Van Kirk, or Stu Gallant leaves the company.

Recent CEO Departure:
CEO Hal Hurwitz recently resigned from the company. At the annual meeting I got a much better feel for the organizational hierarchy at the company. I learned that Rick Van Kirk (old COO/now CEO) was in charge of all the day to day operations/manufacturing while Hurwitz was responsible for all Finance/Accounting/SEC Reporting/Human Resources/IT. His resignation I believe was planned well in advance and I actually see as a good thing as it should save the company $235k/year in costs going forward ($05/share EPS). The current CFO was hired about a year ago as Senior Director of Finance. This company is too small to support a Senior Director of Finance role, hence my belief that this transition was planned in advance.

Conclusion:
I think an investment in Pro-Dex requires two things. First, you must develop trust in Swenson and Cabillot. Their ability to hold management accountable, allocate capital, and ensure that the company is run for the benefit of shareholders is central to my conviction. Pro-Dex is no longer hosting conference calls and they are not extremely forthcoming with any sort of forward looking discussions. You can also be certain these guys are not going to be promoting the stock in any way; you need to trust them. Second, developing the conviction to hold will perhaps be the most important concept with investing in Pro-Dex. Like I’ve shown, I think Pro-Dex can become an $8+ stock quite easily and potentially very quickly. It will certainly be tempting to sell on the way up but as I’ve said, this company has the infrastructure in place to grow to over $40m+/yr in revenue and adjusting their current cost structure to their historical financials show that the company is capable of 20%+ EBITDA margins. $40m * 20% = $8m * 10x multiple = $80m EV (current EV = $5.4m). I’m confident that this management team is striving toward that $40m number. Overall, I think Pro-Dex is an incredibly rare combination of many factors that I find attractive in an investment, and it is currently my largest holding (by far).

I think its always important to think about what your edge is and when it comes to Pro-Dex I think the biggest thing I point to is the fact that the company has not issued any forward looking financial guidance whatsoever, all of these projections/estimates I've put together have come from my own research. Combining this with the fact that the company is not promotional, this company is a microcap with few people following, and that I think I've identified a top notch management team, I think my edge is huge here.

Subsequent Events:

Since I wrote this, the company has released one quarterly earnings report that i would argue was outstanding in terms of revenue growth (the turnaround is a done deal) but they are incurring a lot of start up costs with these new programs so the profits did not come and the stock only moved up 10%ish. I would argue the stock is a better deal now at $2.30 than it was when I wrote this originally.

Stu Gallant left the company but i've looked into that and i'm not worried about it at all.

I think next year revenue will be closer to $22m instead of $17m but my GP rate assumption might need to come down to the low 30%s.

The company's organic growth on top of these two new projects looks to be significant now

The former CEO posted on his linkedin profile that one of the two new projects was "THE largest contract win in company history". I think this one contract will equate to $5-6m/yr in revenue rather than the $2.5m I originally assumed.

The second new project launched right at the end of the last quarter so that should be ramping up as we speak as well

Company announced they have landed a new medical device design contract where they will be paid $500k to design a new device (hopefully leading to new manufacturing revenues 12 months from now for another $2.5m+/yr revenue stream)

The CEO was buying shares in the open market recently and Cabillot just filed with the SEC that he will begin an automated buy program to purchase an additional 6% of the company (currently owns 12%) starting at the end of June.
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Old 06-30-2015, 02:33 PM   #2
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Re: PDEX - My Largest Position

1. How did you find this?
2. Is the low volume any concern?
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Old 06-30-2015, 02:49 PM   #3
BCI23
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Re: PDEX - My Largest Position

Quote:
Originally Posted by JoshSp View Post
1. How did you find this?
2. Is the low volume any concern?
1. I've followed the story since the activists won the proxy battle in 2013

2. No, it takes extreme illiquidity to scare me off
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Old 06-30-2015, 02:50 PM   #4
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Re: PDEX - My Largest Position

Good write up thanks for sharing. It would probably take a month to be able to take a decent position without moving the market, still a great write up.
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Old 06-30-2015, 04:26 PM   #5
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Re: PDEX - My Largest Position

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Originally Posted by trade2win View Post
Good write up thanks for sharing. It would probably take a month to be able to take a decent position without moving the market, still a great write up.
the volume varies from day to day, you can build a position pretty easily if you are patient. You probably have until September when they release year end results to build a position around the current prices.
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Old 07-08-2015, 02:56 PM   #6
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Re: PDEX - My Largest Position

Quote:
Originally Posted by BCI23 View Post
the volume varies from day to day, you can build a position pretty easily if you are patient. You probably have until September when they release year end results to build a position around the current prices.
Great write up, BCI. Thanks for bringing it to the attention of BFI. I've started building a position, albeit 1k shares at a time. I'd be keenly interested in any updates/developments that you learn of.
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Old 07-08-2015, 04:48 PM   #7
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Re: PDEX - My Largest Position

^lol at this level of liquidity, that post by itself is enough to buy in.

May be a good play, but with this level of liquidity, downside here is maybe 50-100%. It'll be impossible to sell out if anything goes really wrong. Just pointing that out.
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Old 07-08-2015, 06:28 PM   #8
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Re: PDEX - My Largest Position

It's not as illiquid as Bobble_Wobble's post suggests.
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Old 07-09-2015, 03:49 PM   #9
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Re: PDEX - My Largest Position

it trades $16k/day on average, its not that bad.
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Old 07-09-2015, 05:02 PM   #10
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Re: PDEX - My Largest Position

TS is saying that if something goes poorly the liquidity will evaporate and that average levels aren't relevant.
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Old 07-09-2015, 06:07 PM   #11
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Re: PDEX - My Largest Position

I know what he's saying and I'm not disagreeing. I was simply pointing out that the poster before him made the liquidity sound even worse than it is.
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Old 07-22-2015, 12:44 PM   #12
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Re: PDEX - My Largest Position

new insider buys reported last night, looks like their automated buying program is set up to buy at $2.30 and lower.
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Old 07-29-2015, 01:03 AM   #13
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Re: PDEX - My Largest Position

BCI - It would appear that the automated buying program you mentioned is being done by Farnam Street Partners. See this link: http://www.sec.gov/Archives/edgar/da...3/cabillot.xml

Is there any type of relationship between PDEX and Farnam to your knowledge? They've committed to buying 260k shares over the June '15 to June '16 period.
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Old 07-29-2015, 02:54 PM   #14
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Re: PDEX - My Largest Position

Farnam is Ray Cabillot's investment fund. Cabillot is on the board.
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Old 07-29-2015, 07:07 PM   #15
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Re: PDEX - My Largest Position

What are your thoughts on Riverside? You haven't mentioned it but it looks like a big deal.
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Old 07-30-2015, 01:14 AM   #16
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Re: PDEX - My Largest Position

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What are your thoughts on Riverside? You haven't mentioned it but it looks like a big deal.
so this is an investment in the debt of Riverside Manufacturing, secured by $1m in real estate (appraised value). The logic here is that if Riverside can pull it together and pay back the debt, PDEX will earn a good return in a short amount of time. If not, PDEX will inherit an operating business that they are comfortable running. This deal was obviously engineered by swenson/cabillot.

Mostly speculation: I'm sure there are also strategic factors with this purchase too. PDEX is trying to expand their services into industries beyond Medical Devices and if Riverside has some industry/customer relationships that PDEX is interested in, that could be an additional angle here.

At the end of the day, they hold a $1.2m bank note that is secured by $1m in real estate if they need to foreclose. Its going to be hard for them to lose here. Again, Swenson/Cabillot have no incentive to be recklessly acquiring stuff, they only win if we win (zero board fees, huge ownership stake).
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Old 09-15-2015, 02:46 PM   #17
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Re: PDEX - My Largest Position

Does anyone know when PDEX is posting its year end results. TS mentioned that it would in September, but I can't find anything on their website.
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Old 09-15-2015, 04:43 PM   #18
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Re: PDEX - My Largest Position

Last year was 9/18 so should be any day now.
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Old 09-18-2015, 07:57 AM   #19
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Re: PDEX - My Largest Position

Results look great at first sight. This should go higher very quickly.
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Old 09-29-2015, 08:30 AM   #20
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Re: PDEX - My Largest Position

What did you think of the latest earnings BCI?
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Old 09-30-2015, 06:59 PM   #21
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Re: PDEX - My Largest Position

My thoughts are unchanged, results were as expected. The 10-K is very detailed and well written, i'd recommend going through it. I don't have any expectations for the quarter they will report in November here but sounds like the quarter they report in Feb should be a monster. I'll probably give a bigger update after the November release in a month here.
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Old 11-01-2015, 11:51 PM   #22
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Re: PDEX - My Largest Position

Company reaffirms in their shareholder letter that one of their new projects is at least $6.5m/yr as thats how much their current largest customer does in annual sales.

"We have made good progress on the Pro-Dex turnaround and we expect to continue that trend in fiscal 2016. We will continue to focus on growing our core medical device business. After two years of product development, we launched manufacturing and delivered a new product to market in June. Our large contract manufacturing project is now also in production and our customer has had a successful product launch. We are excited that purchase orders already in-house for this product will make this valuable customer our largest in terms of annual revenue; this strategic diversification is a big win. Additionally, we have another new product coming online by the end of this calendar year and a third is expected by the end of the June quarter. These launches are one of the reasons our backlog stood at $10.8M going into this fiscal year. Building on momentum, our medical device sales pipeline has a number of opportunities for meaningful development and production projects. We continue to work very hard to please our customers."
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Old 11-02-2015, 10:28 AM   #23
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Re: PDEX - My Largest Position

Did you receive an annual report in the mail?
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Old 11-02-2015, 11:14 AM   #24
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Re: PDEX - My Largest Position

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Did you receive an annual report in the mail?
http://www.sec.gov/Archives/edgar/da...1/f15-0686.htm
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Old 11-11-2015, 01:57 PM   #25
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Re: PDEX - My Largest Position

Thanks for posting about this. Definitely a very attractive risk / reward profile. Couple of questions for you:

1.) Thoughts about first quarter results? Seems like a pretty decent quarter, all things considered, although they still lost money.

2.) They mentioned that demand for their orthopedic shaver has declined. How does this affect your calculations using the TTM revenue and does it have any impact on your overall investment thesis?

3.) Any concerns about margins declining?
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