3

Renoworks Software: An Emerging Hidden Champion

The idea I am presenting today is one I had a lot of fun researching and putting together. I collaborated on this idea with one of Canada’s best investors (IMO), Paul Andreola (Paul’s Twitter). Paul and I are active participants on the Silicon Investor Microcap Kitchen Canadian Stocks forum – I highly recommend checking out the thread if you play in this space.

We shared this write-up with some investors on the forum a few weeks back and the stock has had a good run since. Regardless, we think this company is an emerging growth story that should be on small-cap investors’ radar screens. Just be careful as the stock is very thinly traded. Below is the original report we put out. Enjoy!

Renoworks Software (RW.V / ROWKF)

Current Price: $.12 (CAD)

Shares Outstanding Basic/Diluted: 26.6M/28.2M

Investment Highlights

  • Innovator of visualization software for home remodeling industry
  • 30+% y/y growth with long runway for future growth
  • Compelling valuation at under 2X revenues, 12X earnings
  • Incentivized management team, 50+% insider ownership

Business Overview

Deciding to remodel a home is a big commitment. Costs often run in the tens of thousands and modifications aren’t easy once work has begun. Because of this, homeowners often become anxious and delay or abandon the project. This is where Renoworks come in.

Renoworks sells digital visualization software that allows users to virtually preview products on a rendering of their home. Users upload pictures of their home into the software and can then experiment with different windows, siding, and doors as they plan out the remodeling. They become engaged in the remodeling process and can turn blueprints/graphics into visions of their dream home.

screenshot

Renoworks markets their software as a cost-effective lead generation tool for two main segments:

1. Manufacturers/Retailers

Suppliers of remodeling materials, like Andersen Windows & Doors, use Renoworks’ solution to drive brand loyalty. The homeowner loads his/her home into the software and explores the possibilities with the manufacturer’s products.

Customers experience brand engagement that pays off for the manufacturer when it comes time to buy. Renoworks’ clients have found homeowners are 5X more likely to request a quote when engaged through the software – results like these are moving this product from a “nice-to-have” to an essential marketing tool.

2. Remodelers / Builders

Homebuilders and remodelers use the software as a way to showcase their capabilities to clients. Clients play a more active role in the design process and are more satisfied with the end result. The software also gives the builder a platform for increasing the scope of the design and other upsells.

Renoworks’ begins by working with product vendors to build digital images of their products. These images power a customized solution that is then delivered on a website, a customer-branded app, or a desktop application.

Industry

The digital visualization software industry is in its infancy and there are very few independent players. The company sites only three competitors, one in the U.S. and two abroad. Renoworks competes primarily with U.S.-based Chameleon Power (privately owned).

Renoworks generates the majority of their revenues from manufacturers. The housing material manufacturer segment consists primarily of regional players. There are nearly 5,000 manufacturers in North America, with masonry and flooring comprising over half this total.

Renowork’s industry depends on the health of the broad economy and the housing sector. Renoworks software is also not “mission critical” and industry adoption of the technology is low. Fortunately, we see two key trends that should change this:

1. Recovering Remodeling Industry

Strong home sales and a low interest rate environment have kept remodeling activity buoyant. According to the National Association of Homebuilders, remodeling activity is at its highest point since 2006, up over 100% from the 2008 lows. When remodelers are flush with cash, they are more likely to commit to discretionary purchases like software.

2. Mobile Technology

Following an initial wave of consumer adoption of the iPad and other tablets, many businesses are now beginning to use them. Since remodelers must travel to the home for consultations, a tablet loaded with Renoworks’ mobile software makes for an ideal selling tool.

Growth Prospects

Renoworks’ opportunity for growth lies beyond their traditional manufacturer market in the homebuilder and remodeler segments. The builder market is concentrated with larger accounts while the remodeler segment is highly fragmented. The remodeler market alone consists of nearly 400K businesses throughout North America, representing a massive untapped market.

It will take time to reach this wide segment, but the payoff could be large. Capturing just 1% of this market would bring nearly $5M of recurring revenues (assuming $100/mo subscriptions) to Renoworks – not bad for a company doing $2M in revenues currently!

Financials

Renoworks has been adding customers rapidly over the past few years and it has shown in the numbers:

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Revenues grew 34% in 2013 and 16% over the trailing twelve months while operating income hit record levels for the company. While this growth is impressive, the financials don’t tell the full story.

Over the past year, Renoworks began transitioning from on-premise to cloud delivery,trading in up-front licenses for recurring monthly revenues. We find it impressive the company delivered double-digit growth while sacrificing up-front license revenues.

Here are the company’s results broken down by quarter:

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Renoworks sells their software through annual licenses on a per-user basis with one-time implementation fees when the software is deployed. As the company has grown, so have their recurring revenues (now ~65% of total revenues). This recurring business gives Renoworks visibility and a solid base of revenues to use for growth investments. We expect the portion of recurring revenues to incre ase as the company sells monthly subscriptions under a Software-as-a-Service (SaaS) model.

Renoworks has delivered double-digit growth in 5 of the last 8 quarters and gross margins have soared to over 90%. The business currently depends on large contracts with key clients so quarterly results can be lumpy. We anticipate that as the company grows their SaaS business with smaller contracts to a larger number of remodelers, results will smooth and sequential growth will accelerate.

Valuation

Below is a summary of the company’s capital structure and current valuation :

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Renoworks boasts a clean capital structure with only a small number of options outstanding. Shares are currently valued at 1.8X sales and 12.5X earnings – a modest valuation for a company that grew double-digits y/y. Given the company’s recent performance and long runway for future growth, we feel Renoworks should trade at a multiple more apt for early-stage technology companies.

Let’s compare Renoworks to a peer group of high-growth Canadian software companies:

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Renoworks trades at less than half the peer revenue multiple – and most of their peers aren’t even profitable yet! Applying the peer group revenue multiple gives us a price target $.25, offering over 100% upside from current levels. This valuation implies a P/E ratio of 25X, again hardly a stretch for a company with Renoworks’ growth profile.

To justify our valuation, we must ask, can Renoworks continue its double-digit growth rate? When we think about the limited competition, large untapped market, and attractive business model, we feel they can.

Risks

Here are the key risks we see with an investment in Renoworks:

  • Renoworks software is not “mission critical” and awareness of the product is low. Great time and resources must be spent educating customers of the software’s benefits.
  • Penetrating the remodeling market will mean selling the software to a much larger base of customers. Renoworks will likely have to upgrade their infrastructure to target this fragmented market.
  • Revenues can be lumpy quarter to quarter. The company just became profitable and a weak quarter can quickly become loss-making.
  • The company is resource-constrained and has little capital to invest in growth.

Management / Insiders

Renoworks was founded in 2002 by Greg Martineau, an industry veteran with 30 years of home remodeling experience. Greg became Chairman and hired longtime friend Doug Vickerson as CEO in 2008. Doug was previously Vice Pre sident of Selling and Marketing at Guest-Tek Interactive and leads the sales efforts at Renoworks as CEO.

Rounding out the board are Nairn Nerland and Bob Schultz. Nairn Nerland is technology veteran who served on the executive team alongside Bill Gates at the Corbis Corporation. Bob Schultz is a renowned business professor at the University of Calgary and claims Greg, Doug, and Nairn all as former students.

Renoworks is tightly held, with insiders owning 53% of the shares outstanding. Nairn holds the largest stake at 20%. Greg owns 13% and and Doug owns 9%.

We have been impressed with management’s accomplishments thus far. They take modest salaries, built positions in the company with their own money, and have grown the business from scratch with minimal dilution to shareholders.

Conclusion

Renoworks has nearly everything we look for in a stock – high insider ownership, excellent growth prospects, a compelling valuation, and an attractive business model. The company is a market leader in a niche industry that we feel is at the early innings of widespread adoption. Renoworks remains virtually unknown by the market and we see significant upside as the company’s growth story gets out to a larger audience of investors.

Disclosure: Long RW.V

0

JEMTEC II: You Never Know

This past week, I sat down to begin my daily ritual of checking every filing on Canada’s SEDAR system. Every filing that is, except for anything containing “resource, ventures, or mining.” This process takes about 15 minutes and helps me get an edge in this overlooked market.

About halfway down the list, I came across a press release filed by a company called JEMTEC. Normally this wouldn’t catch my eye, but this was the company’s first press release to hit the wire since, well, ever! The cynic in me thought it must be another option grant for 10% of the equity to insiders. The optimist in me thought, well, I don’t know… Anyway, here is the news:

JEMTEC declares a one-time special dividend

 “VANCOUVER, Sept. 11, 2014 /CNW/ – JEMTEC Inc. (TSX-V: JTC) (“JEMTEC” or the “Company”) announces that the board of directors has approved the payment of a one time special dividend of $0.59 per common share (the “Special Dividend”).

 ..The Company has decided to pay a special dividend at this time after considering a number of factors including:

  1. The Company is returning surplus cash to the shareholders that is not needed to execute the Company’s business plans.
  2. The Company’s share price has been trading at a substantial discount to the book value per share for an extended period of time. It is hoped that a special dividend will help increase investor returns.
  3. Even after payment of the special dividend, the Company will continue to have cash reserves of approximately $1.5 million, which will allow it to continue to pursue acquisitions.
  4. The Company’s electronic monitoring business will continue to operate which will provide continued cash flow for operations.”

JEMTEC’s shares last traded at $.58 before the release. Shares are now at $.82. An investor who bought earlier this week will probably make one heck of an IRR (depending on where shares trade down to post-dividend).

You may remember JEMTEC from a blog post I did earlier this year. The thesis was simple: shares were trading at ~.5X cash and the business was operating stably at break-even. It wasn’t hard to see. And many other value investors found it (See: Oddballstocks’ JTC post).

Most investors, including myself, stayed out for two reasons:

  1. No catalysts
  2. Shareholder-unfriendly management

Reason #2 has its merits. Management has essentially sat idly while the business has withered away since 2007. And they have demanded high salaries from shareholders to do this. They even granted themselves options for 10% of the equity – after a year of disastrous performance in 2009!

Reason #1 is a bit trickier. The idea of catalysts has a certain elegance in investing. Identify the catalyst, hang tight, and cash out once the market reacts. Sometimes it works like this. But many times the most critical developments come out of left field – both good and bad.

The point of this post is not to express regret in passing on JTC’s cheap shares. I don’t at all. I would have underperformed buying this at $.72 when I presented in February – both the TSXV and my own portfolio. And investors who bought a few years ago when it was just as cheap would have massively underperformed.

The point is to show that many “catalysts” lie outside our comprehension. And the idea of buying dollar bills for $.50 will always have it merits. I think Nate from OddballStocks drove the point home with his conclusion of the company:

“The truth is I, and no one else has any idea what happens next.  An investment like Jemtec is impossible to model, there is no model that handles infinite possibilities.  The company is just as likely to wind down as they are to start selling slap bracelets or pet rocks.”

I’ll leave you with this tweet from fellow blogger Paul:

screenshot

You never know.

Disclosure: No position

3

XPEL Technologies II: The Art of Averaging Up

If you’re like me, you love the thrill of combing through thousands of stocks in search of the next great undiscovered company. It’s just exhilarating to feel like you’ve found a potential multi-bagger before anyone else. But investing isn’t about excitement, it’s about generating returns. And often times, the best ideas are in our own portfolio, staring straight at us.

It takes a long time to understand a business, research the industry/competition, and perform a proper valuation. And even after entering a position, it takes time to get comfortable with management and build conviction in your idea through the market’s wild swings. So that is why when I looked at all the new ideas I have generated over the last few months, I decided to put cash right into my top holding, XPEL Technologies (XPLT, DAP.U.V).

We got XPEL’s Q2 report recently and results exceeded even the most optimistic projections I had seen. Revenues increased 70% y/y and hit a record $8.3M. Gross margins were stable and operating income grew inline with revenues, reaching nearly $1M. If there was one knock on the results, it was the lack of operating leverage. This was of little concern to me – XPEL is wisely investing in sales & marketing and earning were impacted by some one-time professional fees.

The stock had run-up before earnings and has since edge up slightly. Still, the price has a long way to go to reflect the underlying value. I found two key clues in the earning release I think market is missing in its assessment of XPEL. Let’s go through each of them.

1. International Growth

We learned from the earnings release XPEL’s international business went from 31% of revenues last year to 36% this year. We can now break out their business and make a few projections:

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The domestic business grew ~55% and the international business nearly doubled y/y. The key insight here is that since the international business is growing about 2X the rate as the domestic, international growth could actually accelerate the overall growth rate (as it becomes a larger part of the business). You almost never see this in a company’s growth profile. And when you do, it’s almost always accompanied by a sky-high valuation.

2. Company-Owned Retail Stores

XPEL first experimented with opening a company-owned installation shop in Houston, TX in late 2012 (outside of their flagship San Antonio shop). Since then, they have opened shops in Austin, Palm Springs, and most recently, Atlanta. The fact they dedicated a line in their brief PR to these tells me they are serious about expanding their footprint with this model.

Rolling out retail stores will of course drive revenue growth. But what the market may be missing is how these shops will alter the company’s margin profile. From my research, here’s an estimate of the shop unit economics:

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These shops require little capital to set-up beyond computers, the film cutter, and initial inventory. I estimate start-ups costs are ~$50K per shop. And OPEX is essentially just rent and salaries. It’s not hard to see the company rolling out 20 of these over the next couple years with their cash on hand.

Twenty shops up and running likely adds $5M EBIT – not bad for company on a $4M earnings run-rate!

The roll-out will need to be done with care. Local install shops form XPEL’s customer base and they don’t want to upset them by stealing business. I think we see the “Apple Store Model” for their retail expansion, with a large installation shop in each major market to build brand awareness and support their local customers.

So what’s XPEL worth? Putting it all together, I think it’s easily worth over $5/share – if not a whole lot more:

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You’ll note the conservatism in these projection. Any number of positive outcomes – accelerating international growth, an aggressive retail roll-out, operating leverage – could put the actual numbers far higher. I’ve played with a number of scenarios and believe $10/share may be more likely as the company comes on the radar screen of institutional growth investors.

I continue to search far and wide for misunderstood and undiscovered stocks. But right now, there is not a better risk/reward set-up I know of than XPEL Technologies. That’s why I’m adding here.

Disclosure: Long XPLT

8

Thoughts on OptimizeRx’s Q2

Few housekeeping items to start. I hope everyone is having a good summer. Apologies for the lack of posts lately, I have taken the last few weeks off to do some traveling and am just now getting back up to speed. I have a few long posts in the works on some under-the-radar ideas (and I mean really under-the-radar!). I also have an exciting investing-related project I am working on that I will be in announcing in next couple of months.

The main news I missed while away was OptimizeRx’s (OPRX) Q2 release. Headline revenue came in at $1.45M, up 33% from last year. Distributions were up 30% sequentially, but revenue only increased 10%, indicating some compression in payout per coupon. Earnings and cash flow were roughly breakeven. On the positive side, gross margin came in a good bit higher than I have been modeling with the LDM royalty impact (63% vs ~55%).

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I think I speak for many investors when saying these results are disappointing. I wasn’t expecting much, but language in their July shareholder update led me to believe revenues would at least recover to the ~$1.7M level we would have had without the setbacks in Q1. Novartis was brought back, but Allscripts (MDRX) remained offline due to “technical issues.” Not only has this taken out an estimated 20-25% of their business, but it has delayed the expanded roll-out to Allscripts PRO. If this estimate can be believed, the company should be on a ~$2M run-rate and business is actually accelerating ex-MDRX.

On one hand, this is the one-time solvable issue we look for in buying opportunities. On the other, this is now the second quarter in a row with negative operational surprises –skepticism is justified. Management has brought their case to Allscript’s senior management and walked away with a commitment to resolve the issues and complete the roll-out by September 30th.

Management is also taking action to reduce barriers to adoption and address the risks of working with larger, more bureaucratic customers. From the 10-Q:

“We will also be launching downloadable code which will streamline the integration requirements for our solution from a few weeks to a few days if they choose to utilize this method. This addresses one of the biggest hurdles in getting health systems and EHRs to implement our system based on minimal available resources.”

Execution issue aside, expansion looks to be on-track. So far in Q3, SampleMD was launched into Quest’s Care360, into eHealthline on a limited basis, and will be launched into LDM’s network of 100K doctors. Management expects these three integrations alone to double the platform’s active users. And then buried in line 7 of company highlights section was this line:

“Successfully tested automated e-coupon solution at Walgreens to automate received coupons, versus manual upload.”

What this could mean in terms of revenues is anybody’s guess but I see it as evidence of the growth optionality in this business the market is giving little credit for.

Valuation / Conclusion

I originally based my valuation on management’s loosely guided 1M quarterly distribution run-rate (eq to $4M revenues) by Q3 14. This goal is now out of the question this year, but I think it’s still quite doable. Bringing MDRX online should put them back on $2M quarterly run-rate. Double the platform’s reach with consistent utilization and you get $4M. Annual revenues of $16M would give us ~$4-5M in operating income and a $80-100M EV. Whether this happens in 2015, 2016, or even 2017 the IRR will be quite attractive for an investor purchasing shares at these levels.

The shares it seems are priced for disaster. Accounting for the business qualities and prospects, it may be one of the cheapest US equities I know. And if you figure in the $3M in cash and reduced FD share count from the Vicis buyout, you’d have to go back to 2010-2011 to find a valuation this low for OPRX.

There are risks one could argue are significant and increasing. Specifically, the drug coupon macro environment (see comments in my last OPRX post and SA article). I’d contend the risks are priced in and the stock’s path to revaluation appears clear to me. If management can prove to the market that all the exciting developments in their business translate into meaningful revenues, shares will be far higher. If not, they will likely stay where they are. I believe odds favor the former.

Disclosure: Long OPRX. Added a few shares at $1.15 following the release.

4

Sangoma Technologies: Growth for Less than Net-Net Working Capital

Sangoma Technologies (STC.V, $.295) is a provider of hardware and software solutions to the rapidly growing Voice-over-Internet Protocol (VoIP) industry. The company is a tale of two businesses – growth in new products has masked the inevitable decline of their legacy business. Despite management’s progress in saving the business, shares remain dirt-cheap, trading at a 5% discount to net-net working capital and under 7X depressed earnings levels.

Legacy Business

Founded in 1984, Sangoma built up its legacy business as a manufacturer for hardware and software that enabled computers to communicate with telephony networks and other Wide Area Networks (WAN).  In short, this meant connecting a PC to the Public Switched Telephone Network (PSTN – legacy global telephone network) or a Private Branch Exchange (PBX – enterprise telephone system). The company developed a reputation as a market leader behind Digium, creator of Asterisk, the original open source software that became the standard for these telephony applications.

Sangoma’s legacy business was a good place to be. Gross margins were over 70% and business boomed in the early 2000’s.

Business Transition

In 2008, a shift in Voice over Internet Protocol (VoIP) methodology from PSTN-based to internet-based was underway. Technology to support voice transmission over the internet had evolved and enterprises jumped at the opportunity to reduce costs by running voice/data communications on a single network. Despite the warning signs, previous management stood idly and milked the PSTN business just as competitors started fleeing the market.

New management was brought on in 2011 and saw two choices for Sangoma: innovate or die. Fortunately, they chose the former and launched an accelerated product development program that pushed new product introductions from 3 per year to 10. Now after burning through half their cash reserves, Sangoma has a full product line of session border controllers, VoIP Gateways, and innovative Microsoft Lync products for small business.

screenshot

In layman’s terms, these products ensure security and interoperability between various enterprise communication systems (fax, voicemail, SMS, etc.). The trend, dubbed Unified Communications (UC), has grown in complexity as companies now want all communications delivered via any means to any device.

Sangoma is a small fish in a big pond but industry trends are on their side.According to Infonetics research, the VoIP/UC  market grew 8%  last year to $68B and is projected to grow 6% over the next five years. The main driver cited is “SIP-trunking” (50+% growth), which is the key technology standard Sangoma’s products address.

Financials

Sangoma’s picture is neatly painted in the financials:

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Note: R&D expense was not broken out until 2011

The years 2005-2009 were heady times for Sangoma. They had strong brand recognition and didn’t need to ramp marketing spend.  R&D spend was kept modest because competitors were leaving the market. The result was big profits, topping out at $4.6M in EBIT and $2.5M in FCF in 2008.

With new management’s strategy came soaring R&D and marketing expense to build out new product lines. These investments appear successful as profitability was maintained and the revenue decline reversed. But the consolidated financials don’t tell the whole story. Here’s the breakdown of new product and legacy sales over the last few years:

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Note: This breakdown is not disclosed in details and these figures are my estimates based on management’s comments in the conference calls

We can now see management grew the new business from nothing in 2011 to a nearly $7M run-rate today. As tough as 2013 was for Sangoma, it would have been a disaster without new products to offset a 30% dip in legacy sales.

Valuation

Whether we’re looking at assets or earnings, Sangoma appears quite cheap:

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The market is valuing Sangoma at a discount to NNWC and less than 7X EBIT. The EBIT multiple doesn’t look unduly low but remember the company has spent heavily to build out new products and sales channels. Profitability may never reach 2008 levels, but I think we could easily see $2M in a couple years.

And what happens if they fall short of achieving scale in the new business? Well then I think a competitor come in and sees a full product suite and high-margin revenues available for 40 cents on the dollar.  A strategic acquirer could easily combine sales forces and merge R&D to lower the purchase price – taking just 10% out of Sangoma’s OPEX would effectively double EBIT.

From this angle, I’d argue for a valuation at 1X revenues + excess cash. This would put shares at $.55 on a FD basis, leaving 85% upside.

Even this valuation would be at the absolute low end of their industry. Direct comps include AudioCodes (AUDC) at 1.1X revenues/26X EBITDA and Acme Packet, acquired by Oracle in early 2013 for 6.2X revenues. Less direct comps include 8×8 (EGHT) and Shortel (SHOR), both of which are viewed as premier plays on VoIP/UC trends and command high valuations (2-5X sales, 40-50X EBITDA).

Risks

The biggest concern I have with this investment is technological obsolescence. A shift in technology already threatened their existence and another shift could happen any time. Their products are also not simple to understand and I doubt I’d be able to keep up with shifting trends in the industry.

Sangoma arrived late to the VoIP/UC party and faces the challenge of making inroads on competitors with far higher engineering/marketing budgets. Results will be lumpy as they sell to larger OEM customers and I believe the longer sales cycles will be a drain on their resources.

Insiders

Insiders collectively own 20% of the company, with Chairman David Mandelstam having the largest stake at 18.5%. Current CEO Bill Wignall and CFO David Moore both came from Truition in late 2011 and have led the effort to revitalize Sangoma’s business.

I’ll credit current management with transparency. They go to great lengths on conference calls to detail their strategy and address the company’s challenges. Management ownership is not as high as I usually like to see, but they have acted like owners thus far, returning the business to growth and buying back shares at depressed prices.

Conclusion

I like the risk/reward scenario with Sangoma. As I see it, either management will be successful in scaling the new business or a competitor will come in and seize the opportunity. And in the worst case, Sangoma’s rock-solid balance sheet should provide downside protection if business falls off a cliff again.

Personally, I don’t have much cash available for new ideas so I’ll be on the sidelines for the time being. I’ll be closely watching the company’s progress in stabilizing their legacy business and growing new product sales.

Disclosure: No position

2

ViryaNet to be Acquired

Earlier this month, ViryaNet (VRYAF) announced it had signed an agreement to be acquired by Verisae for $18.8M in cash. Verisae is a SaaS company that serves many of ViryaNet’s verticals, including grocery, retail, and food service. Here is how the proposed transaction breaks down:

VRYAF

At first glance, it doesn’t look like too bad a deal for the company. A deal at 1.7X revenues is only a slight discount to where ClickSoftware (CKSW) trades and 20X EBITDA is no paltry multiple. But keep in mind the deal comes after an awful loss making quarter for the company. Based on last year’s FY numbers, they are selling out for 11X EBITDA – and remember,  this business converts a high percentage of EBITDA to FCF.

The other kicker is this nugget buried in the company’s 20-F:

“The Preferred A Shares have all rights and privileges that are possessed by the Company’s Ordinary Shares, including, without limitation, voting rights on an as-converted basis, and have an aggregate liquidation preference of $ 2,500 over the Ordinary Shares in any distributions to the Company’s shareholders.”

Note: The filing has the 000’s omitted so the figure is actually a $2.5M claim over the common equity.

Accounting for this and other working capital adjustments, management expects the final payout to shareholders to be in the range of $3.15-.3.40/share.

I have to question why management would sell literally weeks after an awful earnings release and 40% sell-off. Revenue multiples aside, I believe ViryaNet could have done $.50 in EPS this year, which puts this deal at just 8X earnings. I also feel ViryaNet’s sales had yet to fully reflect the value of their solution in the marketplace. My sense is they could have negotiated a much better offer if they took another year to build out their cloud delivery model and recurring revenue base.

But alas, there is no crying in micro-cap investing and it looks like I’ll be taking 5-10% loss on the investment after the payout. I’m not enthused about the deal price but who knows, maybe business had continued to struggle and management felt now was the time to cash out before things got worse. I’ll also admit I may have let VRYAF’s strong Q4 skew my projections and the risk/reward turned out to be not as enticing as I had originally thought (after all, my base case had only 39% upside against 37% downside in the bear case).

I am now a perfect 2-for-2 on predicting buyouts on this blog (VIFL, VRYAF). Before you congratulate me, keep in mind I will have net lost money on these predictions! I never bought VIFL and will take a 5-10% loss on VRYAF. Overall, a disappointing investment but I’m glad to at least almost break even after the company’s disastrous Q1. On to the next one.

Disclosure: Long VRYAF

8

How to Find Great Ideas with Stock Screening

There are 52,063 stocks out there in the world. Over 10,000 in the US alone. You can invest in just about any one of them. How do you decide where to start?  And how do you avoid wasting countless hours building a research list that won’t generate actionable ideas?

For many, the solution is stock screening – using custom criteria to narrow down the investment universe. With today’s technology, you are limited only by the screens you can think of. Looking for a German appliance-maker with double-digit revenue growth and recent insider buying? You got it – it’s only a click away.

Investor opinion of screening spans the gambit. Some think it’s a waste of time. Others couldn’t live with out it. I’m a believer screening is as good as you make it so today, I’d like to share my methods for finding great ideas with screens.

Selecting a Screening Research Tool

Step one is finding a screening tool to use. Your options range from free web applications to $20K/yr professional services like Bloomberg. Here are a few tools I have used:

Yahoo! Finance (free) – a free screener that covers the basics. Screen across basic profitability metrics, valuation ratios, and analyst estimates.

Financial Times (free) – a basic screener much like Yahoo Finance, but with access to global markets. The screener also supports 50 fundamental criteria, making it more powerful than the Yahoo screener.

The Screening Company ($25/mo) – this tool take screening to a new level. You can access the entire universe of stocks and sort by almost any fundamental/technical criteria you can think of. The best part is being able to write functions for your own free form criteria.

Note: The rest of this post will feature examples from the Screening Company Screener.

Shrinking the Investing Universe

I’m a practitioner of 80/20 investing. Essentially, this means figuring out the 20% of your investing activities that are delivering 80% of your results.

I like to start by asking, “what markets/businesses do I have no chance of investing in? “

Don’t be scared of missing out on a great idea by excluding entire markets/sectors. You will miss a lot of good, even great ideas. But we are on a mission to optimize our investing time.

For me, this means:

1. Micro-caps Only

Reader’s will know I feel the best opportunities lie where institutions can’t reach them: in the tiny and illiquid. Micro-caps are often defined as under $300M market cap, but for my screens, I start with a $50M cutoff.

2. No Banks/Financials

Investing in financials requires different mental models than most other businesses. Balance sheets have a unique structure and cash flow statements are often meaningless. I don’t have much experience investing in financials, so out they go.

3. No Mining/Resource Companies

Junior mining companies usually don’t have revenues and are valued on the basis of their deposits. These companies consume heaps of capital, dilute shareholders, and then only rarely make it to production.  Analyzing these businesses is beyond my skillset.

4. Non-Chinese

Screen for Chinese companies in the US/Canada and you will find plenty trading for less than cash or P/E ratios under 2. Why? Because enough investors have been burned by fraud that the market no longer believes the reported numbers.

I’m sure there are gems out there, but to stack the odds in my favor, I eliminate these risky stocks.

5. Operating Business

While I will consider unprofitable companies, pre-revenue companies are typically off-limits. This simple constraint takes out ~25% of the stocks from our shrinking universe.

6. Full Reporting

There is nothing more frustrating than thinking you found a growth company trading at 2X earnings, only to find out the financials are from 1997. Adding a recent filing date constraint ensures I only consider companies that are currently filing with the SEC.

I’m not opposed to investing in dark companies but for a first pass, full reporting makes life a lot easier.

The last constraint I apply is to require the stock price be above $.05. This eliminates companies that have diluted shareholders into oblivion.

Put together, this is how my starting screen typically looks:

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Notice how our investment universe has shrunk from over 50K to a more manageable 6K. This is still a lot to handle, so let’s take our screen one step further by targeting an exchange.

Targeting an Exchange

I like to start my research with a hypothesis for why a company is undervalued. Selecting an obscure exchange can be a great way of uncovering perfectly good companies suffering from investor neglect.

Here are my three favorite exchanges to hunt on:

1. TSX Venture Exchange

If I could invest in only one exchange for the rest of my life, this would be it. The Toronto Venture exchange exists for one purpose: to fund early-stage mining ventures. Most everything else gets ignored. The general rule is, if it’s profitable, Canadian investors aren’t interested!

2. UK Alternative Investments Market (AIM)

Critics correctly note that investors would be better off had this exchanged never existed, having lost nearly 25% since its inception in 1996. Let their negativity be your advantage – there are tons of profitable niche companies floating on this exchange.

3. US OTC Markets

You will find plenty of pump and dump schemes and frauds on what is known as the wild west of US investing. Hidden in the junk, however, are some America’s most promising growth companies. Start on this exchange to find them before institutions.

After shrinking the universe and targeting a market, the options are endless. You could start with classic value screens and go for low P/E or P/B.  Momentum or growth screens. Technical or fundamental criteria. It really depends on your investing strategy.

Here are some custom screens I use to find ideas that mirror my investing style:

1. High FCF Margins

FCF margins refer to the percentage of revenues a company converts to free cash flow. High FCF margins typically results from:

  1.  A low-CAPEX business model
  2. Competitive advantages that afford pricing power

The classic example is Moody’s with its astounding 35% FCF margins. This quality often indicates the presence of moats and this screen is one of the best ways I know of finding them.

Here are the results of a screen for US OTC companies that meet all our criteria and have high FCF margins:

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This screen turns up many micro-caps that I have invested in (OPRX, NROM) or researched intensively in the past (ITSI, PBSV). Many of these are little companies with great business models.

 2. High Insider Ownership / Low Institutional Ownership

If I could have just one piece of information to invest on, it would be insider ownership. The only thing better than investing alongside these owner-operators is getting in before institutions.

Here are the results of our screen with insider ownership > 20% and institutional ownership < 20%:

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Right away we find a core holding (OPRX) and a stock at the top of my research list currently (INTZ). DIRI and JGPK are also interesting ones I know a few saavy investors are in.

 3. High Growth/ Low Float

I like both of these qualities separately. Low float reflects how management has financed the business in the past and the ownership they have in it. And growth is almost always a positive for a company.

Put together, these factors can be like rocket fuel for a stock as investors rush in to a thinly traded growth stock.

Here’s our screen with TTM/TTM revenue growth > 30% and float <5M shares:

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Down on the list is a classic example of this effect, PFHO – a stock up nearly 600% y/y. USEL is an interesting story but I can’t say I have heard of any others on the list. Looks like I have some work to do!

Conclusion

With screening, we’ve managed to turn the entire investment universe into lists of 30 or so names we can work through in under a day. We have optimized our investing time and uncovered some under-the-radar opportunities.

Of course, your screens will likely look different than mine. Perhaps you have a specialty in community bank investing or a knack for junior miners. It’s all about defining your circle of competence and sticking to it.

So, what are your favorite screens for finding great investing ideas?

Disclosure: Long OPRX

16

OptimizeRx Update: Gearing Up for a Big Second Half of the Year

It’s been an eventful three months for OptimizeRx (OPRX) since my initial write-up in February. Let’s recap what has unfolded and why I have decided to make OPRX one of my largest positions.

Financing

OptimizeRx announced on March 17th, 2014 that it had completed the long-awaited financing necessary to buy out Vicis Capital by the month-end deadline. The key terms disclosed in the filing:

On March 17, 2014, the Company entered into a securities purchase agreement (the “Purchase Agreement”) with the purchasers identified on the signature pages thereto (the “Investors”), pursuant to which the Company sold to the Investors an aggregate of 8,333,333 shares (the “Shares”) of the Company’s common stock, par value $0.001 per share (“Common Stock”), for $1.20 per Share, or gross proceeds of $10,000,000 (the “Offering”).

The company also paid the underwriter, Merriman Capital, 9.7% of the gross proceeds and issued them 804,139 share purchase warrants exercisable at $1.20 per share. The financing was below my anticipated pricing but did not require warrant coverage. Appetite for the deal appeared strong and the company came away with $3M of growth capital after taking out Vicis.

Here is how OPRX’s simplified capital structure looks post-financing:

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I view the deal as very positive for the company, reducing the diluted share count by 7M, separating themselves from Vicis, and adding large, sophisticated investors to the shareholder base.

LDM Lawsuit Settlement

On the negative side, OPRX took a hit in their legal dispute with LDM. Buried in Note 19 of the latest 10-K, was this nugget:

“…On April 23, 2013, however, LDM reinstituted the patent infringement action in the United States District Court for the Eastern District of Missouri, Eastern Division claiming that OptimizeRx breached the Settlement and Patent License Agreement. The Company continued to vigorously defend the OptimizeRx technology, preparing for litigation, depositions and patent protection while also positioning for legal actions against LDM. On February 28, 2014, a Settlement Agreement was reached with LDM, and the judge dismissed the case with prejudice on March 18, 2014. Per the terms of the settlement agreement, the Company paid a one-time fee of $400,000 and will pay LDM the greater of $0.37 per patient discount distributed by OptimizeRx or 10% of the total revenue earned by OptimizeRx for distribution and redemption of all patent discounts.”

Essentially, the company will now pay out 10% of their gross coupon revenues to LDM in perpetuity (split between them and the EHRs). This is a big hit for the company. Management spun the development as a positive, citing a partnership that now allows them to integrate SampleMD in LDM’s network of 100K doctors. Perhaps things will equal out in the short-term, but LDM will surely be the winner as OPRX’s business grows down the road.

In my opinion, management could have done a better job disclosing the development to shareholders but hopefully they can move past this overhang and reap some benefits from the partnership.

Q1 Results

For Q1, the company reported revenues of $1.3M, a 97% y/y increase, and a net loss of $600K. On the face, these results seem disappointing but were impacted by a few factors:

1. Novartis Suspension

Novartis suspended SampleMD use from January through April to assess the ROI of the program. An independent firm found SampleMD delivered a 3:1 ROI and Novartis has since resumed their program. The company estimates the impact at $100K/mo.

2. Allscripts Technical Issue

Allscripts encountered a privacy issue that brought the system down for one month. The issue was resolved and Allscripts is now rolling SampleMD out to their entire user base on an opt-out basis. Management indicated the issue caused one month of lost revenue, which I estimate to be ~$100K.

3. LDM Settlement

The company booked a one-time $400K charge to cover the settlement payable to LDM.

Accounting for the above, I estimate revenue growth would have been closer to $1.7, representing 150% y/y growth and a slight sequential decline from Q4:

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Adjusted net income would have been break-even, and likely even higher if not for abnormally large stock-based compensation booked in the quarter. Despite the mixed results, OPRX confirmed a strong outlook. Management expects distributions to double y/y and reach a 1M quarterly run-rate by year-end.

CFO Appointment

Management introduced Doug Baker as OPRX’s new (and first) CFO on the conference call. Doug was most recently CEO of Applied Nanotech Holding (APHD) and before that, served as CFO of APHD from 12 years. Last year’s accounting restatement demonstrated the company needs help in this function. It’s too early gauge his impact, but hopefully Doug can help OPRX raise their profile and achieve a NASDAQ/AMEX listing in the near future.

Summary

Putting it all together, here’s how I see the next few years playing out for OPRX:

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Note: From the restated financials, it appears revenue share will be closer to 40% than my initial estimate (45%).

Based on continued EHR integrations and new drugs coming on the platform, I think OPRX can double their business annually over the next few years. Putting a conservative multiple on 2015 EBIT, shares are easily worth $3.00 or double the current price.

The biggest risk remains management execution, as no one on the team has experience building a public company to uplist on a reputable exchange. Against this risk, new partnerships, new drugs, and industry tailwinds should make the second half of this year an inflection point for the company. I have been a buyer at the $1.50 level and OPRX is now my second largest position.

5

Earnings Updates: LRM.L, MBX.TO, VRYAF

It’s been a busy earnings season with many micro-caps I own reporting full-year and Q1 results over the last month. I’d like to share my take on earnings from three core positions:

Lombard Risk (LRM.L)

Lombard Risk released their FY14 results on May 17th. The company posted strong results with revenues increasing 22% and operating profit up 23%.  Operating cash flow was £5.3M but heavy software development investment drove FCF negative. Operationally, LRM signed 67 COREP contracts and landed a contract for their COLLINE collateral management solution with a Tier 1 bank.

Somewhat puzzling, shares sold off 30% leading up to earnings, hitting a low of £9.60 in early April. The only negative news was the resignation of CFO Paul Tuson, which now appears unrelated to any financial troubles at the company. Shares recovered slightly but still look dirt-cheap after earnings, trading at 1.3X revenues and 5X pre-tax earnings.

One theory for LRM’s market valuation is skepticism of earnings quality, understandable given the high capitalization of R&D costs  (~70%). This is view is a misunderstanding if you ask me. Lombard has ramped up product development and marketing expense to capture new opportunities created by the regulatory reform wave. Sacrificing profitability is a wise strategy – banking software is complex, churn is low, and customer lifetime values are very high as a result.

If I’m right, accelerating revenues from new customers coupled with declining product investment should drive soaring FCF in 2015-2016. In the meantime, the company remains an attractive acquisition target and likely fetches twice the current price in a buy-out. Lombard remains a high conviction idea and I took the sell-off opportunity to double my position.

Microbix (MBX.TO)

Microbix reported Q2 results May 15th and results were solid:

  • Virology product revenue increased 13% while OPEX declined 3.5% (ex. a one-time gain in 2013)
  • For the 6-month period, Virology revenue was up 44% and operating income swung to  $450K, from a $350K loss in the prior period
  • The balance sheet improved with cash ending above $1M and book value increasing 24% over the period

I continue to be impressed with where management has positioned the company. The core business is now cash-generative and pipeline development should proceed with minimal dilution to shareholders.  I’ll be looking for continued Virology growth and updates on LumiSort® and VIRUSMAX patent litigation to drive shares to new levels over the next 12 months.

Despite all the progress, the market still appears to be attributing little value to Microbix’s pipeline. Shares are wildly mispriced in my opinion and I’ll be a buyer at these levels.

ViryaNet (VRYAF)

ViryaNet reported first quarter results last Monday, and needless to say, the market was not enthused.

The company posted revenues of $2.4M, a 23% decline y/y and 30% decline sequentially. A combination of nil licensing revenues and increased OPEX caused operating income to swing to a $356K loss, from $340K last year. The stock has been crushed since earnings, declining 35% to $2.44.

The quarter was the weakest since Q3 2012 and the market reaction is understandable. That said, I find the sell-off a bit excessive when considering:

  • A no-licensing revenue quarter has happened once in each of the last two years
  • Licensing deals are typically $200-300K each, so results hinge on just a handful of these each quarter
  • The deal pipeline increased 50% y/y
  • The cloud business is taking shape with a new go-to market partner and first deal to be announced

Management acknowledged the disappointing results but reiterated confidence in delivering y/y growth in 2014. They have delivered growth over the last two years and I see no reason why they can’t again. I had sold half my position before earnings to raise cash for other ideas but am now getting interested again here in the low $2’s.

I am still awaiting earnings from XPEL Technologies (XPLT) and Avante Logixx (XX.V), which should be out any day now. I will say the micro-cap market has softened since the year began and it seems companies need blockbuster results to impress the market. I find the pullback refreshing and hope to add to my top ideas on weakness.

Disclosure: Long LRM.L, MBX.TO, VRYAF, XPLT, XX.V

0

Microbix Biosystems: Four Businesses for the Price of One

Microbix Biosystems (MBX.TO, $.37, MBXBF, $.34) is a Canadian bio-tech company that has a thriving core business and three products in its pipeline that could each presently be worth more than the company’s market cap. The company’s semen-sexing technology, LumiSort®, is the most promising of the three and is poised to revolutionize the $1.5B livestock artificial insemination market. Best of all, the market is currently valuing Microbix on its core Virology business alone, giving investors the opportunity to pick up the company’s pipeline for practically nothing.

Business Overview

Founded in 1988, Microbix began as a producer of infectious disease antigens for the virus diagnostics market. These antigens have a host of applications including calibrators for medical devices, immunodiagnostic assays, and vaccine research. This division has grown to produce the world’s widest range of antigens and has allowed the company to acquire and develop new technologies by providing steady cash flows.

Microbix’s intellectual property portfolio consists of three technologies at varying degrees of commercialization:

VIRUSMAX

This technology offers a rapid, non-toxic technique for increasing the yield of influenza virus strains from the fluid of embryonated chicken eggs. The world influenza vaccine market is projected to be over US$7 billion, growing at 20% per year.

The company’s current commercialization strategy is to license the VIRUSMAX technology on a regional basis, beginning with countries with the highest vaccine supply deficiency. Microbix is currently in discussions with two such countries.

Urokinase

Urokinase (trade name Kinlytic®) is a natural human protein that stimulates the human body’s blood clot-dissolving processes. This FDA approved drug was previously commercialized by Abbott Laboratories as a treatment option for heart attacks.

Microbix purchased the drug in 2008 with hopes of returning it to the North American market, but has since struggled to find a partner willing to invest in a manufacturing facility. Late last year, the company suffered a setback when their original commercialization partner, Zydus Cadila, terminated their existing agreement due to a “change in strategic direction.” The company is actively seeking a new partner for this technology.

LumiSort®

Microbix has developed a proprietary technique that promises to improve the yield and quality of sexed semen used in the livestock industry. Sexed semen allows dairy/cattle farmers to pre-select for a desired offspring sex, which can be particular powerful when applied to animals with superior genetic traits. While this advantage should improve herd economics, cell damage and low fertility caused by existing sexing technology has rendered the technique uneconomical in most cases. As a result, industry adoption remains in the low single-digits.

Research conducted thus far shows that LumiSort® offers vast improvements over conventional sexing technology: 90% (vs. 75% currently) fertility rate of unsexed semen, a 10X improvement in the speed of semen processing, and a 3X improvement in overall cellular yield. Industry response has been tremendous and Microbix has signed letters of intent with semen straw distributors representing 25% of the global market to date. The global semen market exceeds US$1.5 billion annually, consisting of nearly 200 million straws (individual units) sold each year at an average global price of $8.

Given the opportunity, the company has put its focus behind LumiSort® and engaged Lathrop Engineering to design, build, and test a prototype. With a fall 2014 completion goal, this project will serve as a key milestone for the company (technical explanation of LumiSort).

Financials

The company’s strategy of harvesting cash flows from their core business to develop new technologies has failed to create value thus far. This can be seen in the historical financials: 043c367671bbd77c13b1447ef7466c9c

Among the missteps of the past was 2008’s “perfect storm,” when the company raised $6M in debt financing just as currency movements eroded profits and the capital markets froze up. This disaster stalled the development of LumiSort® and resulted in 50% shareholder dilution as the company raised funds in a brutal market to stay afloat.

Fortunately, new management took over in 2012 and worked hard to put the company back on solid footing:

  1. Divesting the low-margin water purification business (reducing revenues ~$1M)
  2. Consolidating operations, reducing the cost base 29% y/y
  3. Refocusing the core business on higher-margin products, driving 14% organic revenue growth

These steps brought the company back to a positive cash flow for the first time since 2005 and helped shore up the balance sheet, reducing total liabilities by $1.3M.

Valuation

For valuation, we will begin by considering only the core virology business. Accounting for a recently announced long-term supply contract worth $2M annually, in addition to continued double-digit growth, puts this business on a healthy run-rate:

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Note: Excess cash assumes full conversions of share purchase warrants

I estimate the Virology business can scale up to this revenue level with minimal incremental operating expenses, which would put the underlying earning power of this business just under $2.5M.  Using the fully diluted share count, Microbix trades at <4X sales and 14X EBIT, which I would consider a fair price for a stable, high-margin business that dominates its niche market.

For the upside, let’s model the impact of LumiSort® business assuming successful validation of the technology. We will assume the company begins licensing the technology in 2016 and is able to turn half of their anticipating customer base into licensees over five years. Given the superior fertility rate expected for semen sexed with LumiSort®, these products will command a premium price, which management expects will be $20/straw (2.5X the unsexed global average). Using a simplified discounted flow analysis, we find the impact of LumiSort® could be massive:

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Under these assumptions, the LumiSort® franchise would be worth $265M, or, $2.85 per share on a diluted basis. To put this into perspective, this is nearly 8 times the current trading price – and this says nothing of the company’s other two technologies.

Catalysts

  1. Novartis Lawsuit – On January 23rd, 2014, Microbix announced that they had successfully defended themselves in a European court from a patent infringement suit launched by Novartis against their VIRUSMAX technology in 2011. Only a few weeks before this announcement, the company launched a patent infringement suit against Novartis in the US. It is difficult to predict how much the company could achieve in a settlement, but their recent victory in Europe could give them the upper hand in negotiations.
  2. LumiSort® Prototype – The LumiSort® prototype is currently under development and its success cannot be predicted until completion. Should the company have good news to share at year-end, Microbix’s stock could grow in multiples.
  3. Urokinase Partnership – The company is currently in discussion with potential partners to commercialize this technology. Given that Urokinase was once a $200M/yr commercial success, the company should be able to attract another partner, or at least a buyer for the drug in its entirety.

Risks

Microbix faces many risks common to bio-tech companies: dependency on FDA approvals, commercialization partners, and financing to progress their pipeline. While the LumiSort® technology looks promising in theory, there is no way to know whether or not it will work on a commercial scale until the prototype is built. Even if they successfully validate the technology, the company will likely need to raise more than the $2.5M they have achieved thus far for commercialization, exposing investors to further dilution risk.

Insiders

Insiders collectively own 14% of the shares outstanding, with Founder and Former CEO William Gastle holding the largest stake at 8%. Current CEO Vaughn Embro-Pantalony took the reins in November 2012 and owns less than 1%, with another 800,000 shares through unexercised options. Insider ownership is not as high as I typically like to see but management has behaved like owners thus far, bringing the company to profitability, shoring up the balance sheet, and putting them in a position to capitalize on their pipeline.

Conclusion

Microbix is currently being valued on the basis of its virology business, with little value ascribed to three technologies that could each be worth over $50M. With 25% of the $1.5B artificial insemination industry already engaged with LumiSort®, this could become a blockbuster franchise for Microbix if their prototype proves successful. Add to that optionality from the Novartis lawsuit coupled and licensing opportunities for the company’s other technologies and you have an asymmetric risk/reward profile rarely seen in the market.

Disclosure: Long MBX.TO