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.

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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

7

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

13

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.

0

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

5

Reverse Engineering the Perfect Stock

Engineering Blog Photo

Introduction

The inspiration for this post came from Richard Lazazzera, writer of the excellent e-commerce blog, “A Better Lemonade Stand” (another of my other passions). Be sure to check out Richard’s popular post “Reverse Engineering the Perfect Ecommerce Product” if you’re interested.

Reverse Engineering the Perfect Stock

I am going to tell you about the perfect stock that will make you millions of dollars. Few investors know about this stock even though it’s a multi-bagger in plain sight. Okay, on with it – what is it!? Here are a few clues…

The stock is a micro-cap, under $20M market cap, and has had three straight years of operating profits. The company is rapidly growing at over 25% per year, all of it generated organically. The company has high gross margins at 75% and a scalable business model, allowing operating earnings to grow at a 50% clip. The company’s industry is experiencing secular tailwinds and growth is expected to accelerate over the next few years.

Being a first mover, the company has no competitors in its niche and new entrants have failed to displace this company because of switching costs and the mission-critical nature of its product. The combination of pricing power and lack of capital requirements allow the company to achieve extraordinary returns on its invested capital, well over 100%. The company is debt-free and funds its growth entirely from operating cash flows.

Insiders collectively own 40% of the company and the CEO has a 25% stake. He bought in with his own money 5 years ago and has added to his stake through open market purchases. Management has maintained a clean share structure consisting of only 10 million shares outstanding and no warrants or preferred shares. The low float and small size of this company have kept its stock off the radar of institutions, which own less than 10%.

Okay perhaps by now you have figured out that I don’t have a ticker to share with you. And we all know there is no such thing as a “perfect stock.” That said, I believe there exists certain characteristics that form the DNA of any investor’s dream: a multi-bagger than you can hold on to for years. What follows is my list of 14 such qualities, organized by key fundamental, business model, and technical criteria (note I use stock/company interchangeably throughout). Enjoy!

I. Key Fundamental Criteria

1. Profitable

Profits are the lifeblood of any company and cash flows generated by the business ultimately determine the value of your investment. A company that can fund itself internally avoids financing risks, which can cause massive losses through dilution or excess debt. While bio-techs prove positive cash flows are not necessary for success, working with profitable companies will simplify your valuation process and margin of safety assessment.

At a minimum, we will want to see two solidly profitable quarters and preferably a 3-year track record of profits (or more!).

2. Rapidly Growing

Assuming a company is generating returns on capital above the costs of that capital, growth is enormously beneficial to the company and its shareholders. New products, customers, and business lines typically bring more profits and drive the company’s intrinsic value.

Ideally, all of this growth should be organic. Too often, acquisitions don’t deliver on their promised synergies and yield much of their value to the seller through premiums paid. We will want rapid organic revenue growth, a minimum of 25% y/y.

3. Attractive Valuation 

The key to investing is not finding the best companies, but rather the largest discrepancies between price and intrinsic value. Buying at a low valuation provides downside protection in the event your thesis does not play out, while allowing for huge upside if things go well. Valuation is more art than science, and finding the most useful metrics to employ can be tricky.

My valuations always begin with an adjusted EV/EBIT multiple, which incorporates the company’s balance sheet and strips out non-operating items to better present true earnings power. We will want this multiple below 10 and ideally below 7 – the lower, the better.

4. No Debt  / Financing Requirement

Debt can juice a company’s returns but often leaves the business vulnerable to the unexpected: a major customer loss, a regulatory change, or a patent infringement suit. This situation is made worse when the market knows an equity raise is coming, effectively holding the company hostage to its share price. Investing carries enough risk as it is – crossing off dilution/bankruptcy risk is key to putting the odds in your favor.

Example: A $10MM market cap company has $6M in debt, no cash, earns $2M a year in EBIT, and trades at 8X EV/EBIT. If the company suffers a major contract loss which cuts EBIT in half, you would face an 80% loss on your investment assuming the company maintains its valuation multiple(1M X 8 = 8-6 = 2M). High leverage magnifies negative events in a big way.

We will want our company to have no debt and a few million dollars in the bank for growth investment. The company should have no need for future debt/equity raises and fund itself entirely through internal cash flows.

II. Business Model Criteria

5. Durable Competitive Advantage

Durable competitive advantages, or economic moats as Warren Buffet calls them, are derived from only a handful of sources: brand power, switching costs, patent/government protection, and network effects. Economic theory holds that in absence of one of these forces, competitive pressure will reduce all company’s Return on Invested Capital (ROIC) to the cost of capital.

Sources of economic moats are not all created equal. Government protection often proves unsustainable and brand power can be just as easily eroded in some cases. We will want our company to benefit from switching costs, network effects, or both. Banks, software providers, and business service companies are all beneficiaries of switching costs. Social media and auction platforms are prime sources of network effects.

6. High Returns on Capital / Low Capital Requirements

The less capital investment a company requires to keep its competitive position, the more profits that are left over to invest in growth or be returned to shareholders. By nature, some companies require little capital while others require seemingly endless amounts to stay afloat. This intrinsic quality, along with competitive positioning determines the ROIC our company can achieve. ROIC is a key value driver – the higher the ROIC, the more shareholders stand to benefit from growth.

Example:  Capital-light/high-ROIC businesses include software, database, and franchising companies. Capital-intensive/low-ROIC investments to be avoided include railroad companies, automotive manufacturers, and above all, airlines. By requiring our company to have a ROIC above 50%, we will be big beneficiaries from any growth the company generates.

7. High Gross Margins

Gross Margin (GM) refers to how much profit is left after the direct costs of products/services are covered. The higher the gross margin, the more profits will accelerate with sales growth.

Example: If Business A has 75% GMs and Business B has 25% GMs, Business A will experience three times the impact on profits from each dollar of new business as compared to Business B. High gross margin companies include patent licensors, medical device manufacturers, and pharmaceutical companies. Examples of low gross margin companies are automotive suppliers, construction contractors, and retailers.

Gross margins will vary widely based on industry but in general, the higher the better. We will want our company to have gross margins of at least 50%.

8. Scalable Business Model

Scalability refers to a company’s ability to leverage its infrastructure as it grows. A good measure of this is the Degree of Operating Leverage (DOL), or the percent change in EBIT divided by the percent change in revenues.

Example: Once a Software-as-a-Service (SaaS) company invests in the infrastructure to create and sell its software, each incremental subscription can be delivered at virtually no additional cost. Compare this model to a restaurant, which must pay rent, labor, and food costs with every location opened. Software and database companies are often scalable, while restaurant operators and manufacturers tend not to be.

Ideally, we will want our company’s operating expenses to grow at half the rate of revenues or less (DOL >= 2).

9. Non-cyclical, Recurring Revenues

Recurring revenues afford a business the advantages of predictable cash flows to base investment decisions on and high lifetime customer values. Recurring revenues also aid investors in projecting future cash flows and performing valuations. A stable, non-cyclical business offers the similar advantage of predictable cash flows, while offering safety in case of a sharp economic downturn.

Example: Any business with a subscription model, such as SaaS or security monitoring, is likely to have recurring revenues. Food, tobacco, and alcoholic beverage companies are all classic examples of recession-resistant businesses.

We will want a business with over 50% of their revenues recurring and a low sensitivity to general economic conditions.

III. Technical Criteria

10. Micro-cap

Much like large companies forge their own anchors as they grow, small companies have the law of small numbers on their side. Small size often offers a long runway for growth and magnifies each positive development.

Example: Think of a SaaS company doing $10M per year annually that announces a $2M contract. This business becomes 20% more valuable over night, and perhaps far more given the operating leverage inherent in software.

We will want to stick to companies below a $300M market cap, and ideally less than $50M.

11. Low Float / Clean Share Structure

Low float (freely tradeable shares) results from a low share count, high inside ownership, or a combination of the two. From a technical standpoint, a low float can lead to massive price increases as investors rush to bid on a limited supply of shares. On a more fundamental level, the float is a reflection of how management has financed the business in the past and their relative ownership of the company.

We will want no more than 50M shares outstanding and preferably less than 30M. The float should be significantly lower due to insider ownership (discussed below). We will also want to see a clean share structure, with no warrants or exotic convertible instruments.

12. High Insider Ownership

We want a management team that behaves like owners and this is not possible unless they are owners. For the micro-caps we are interested in, we will want to see insiders collectively owning at least 30% of the company, with the CEO himself owning at least 15%. It is also important to assess how management got their stakes – did they buy in with their own money or was it given to them through options and share grants?

Management adding to their stakes through open market purchases is often a big plus. This demonstrates insiders believe in the company’s future and you should too.

13. Low Institutional Ownership

For a variety of reasons, many institutions cannot invest in the micro-caps we are interested in. Some have restrictions against stocks under $5 or companies that trade on the Over-the-Counter Exchange (OTC). With all the desirable qualities discussed thus far, institutions will be drooling over our company waiting for the company’s size/liquidity to reach their buying criteria. When this happens, look out! Triple digit gains are quite likely as institutions pile into a “must own” stock.

To leave this big catalyst open, we will want to see institutional ownership under 10%.

14. Secular Industry Tailwinds

Never forget to look beyond the fundamental and technical factors to understand the underlying trends in the company’s industry. Beyond a company’s own efforts, secular industry tailwinds are often necessary to sustain our 25+% revenue growth target. Industry tailwinds also have the bonus of attracting investor attention, which can lead to big gains as our company is viewed as a unique play in a hot sector.

Example: Organic foods, mobile applications, and network security software are all industries undergoing secular growth phases.

Conclusion

So there you have it, all the ingredients that go into my “perfect stock.” In practice, few stocks will meet all these criteria and employing a 1-5 scale rating for each is a method I like to use. You may have to analyze 1000 companies to find one that scores well on all the criteria, but trust me, it will be well worth your time!

If you are interested in learning more, check out theses posts (1, 2) by investor Mike King on his “secret recipe” for stock picking. His near-perfect stock was Biosyent (RX.V, BIOYF) and it is been an absolute monster, up some 400% since his post.

In a follow-up post, I will share with you my biggest winner of all time and how well it scored across these criteria at the time of my analysis. Until then, on to searching for the perfect stock…

Disclosure: No position in any stocks mentioned

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

2

The Five Blogs Every Investor Needs to be Reading

Close that Bloomberg tab, cancel your subscription to Barron’s, and don’t you dare even think about turning on “Mad Money.” These media outlets are comparable to drugs: they initially provide an exhilarating rush but ultimately leave us no better off than we were before. Actually, there is a good chance these financial vices are making you worse off. Consume enough mainstream financial news and you may start believing that you can profit from macro trends, currency plays, and high-flying “momo” stocks – a disastrous recipe for the average investor.

I suggest you dedicate just one week toward freeing your mind from the noise and living off a steady diet of reading material certain to improve your investment process. And for my money, nothing beats investment blogs. The ability to critique a writer’s thesis and judge their analysis as it plays out (or doesn’t…) is a valuable experience that few other mediums can offer. In this post, I’ll share the top five investment blogs that would be at the top of my reading list if I were to start over today.

1. the red corner 

If you only plan on reading one value investing blog, close your browser now – this is the one. No idea is off-limits for writer red, as he analyzes businesses from India to the UK, from obscure micro-caps to billion-dollar enterprises. Expect not an elementary analysis, but rather red ‘s uncanny ability to go beyond the reported numbers to uncover the true earning power of a business. Red puts all his picks in a portfolio tab so you can track his every move. And I highly suggest you do – since its inception in July 2012, red’s portfolio has generated a 120% after-tax return.

2. Oddballstocks 

A blog that needs no introduction in the value investing community, Oddballstocks has made its mark looking for bargains in obscure places. From African stocks to liquidating banks to companies at 1X earnings, writer Nate Tobik offers ideas you won’t find anywhere else. In addition to unknown stocks, Nate’s blog is full of investment philosophy. Be sure to check out his posts on diversification, margin of safety, and bank valuation.

3. Gannon and Hoang on Investing 

A high school dropout and self-taught investor, writer Geoff Gannon has grown to be one of the most prolific bloggers since his start in late 2005. Geoff and co-writer Haong’s posts can admittedly be lengthy, but trust me, they are well worth your time. You’ll be hard pressed to find the depth of business analysis and investment philosophy they offer. For Buffet-esque investors looking for above average businesses selling at below average prices, this blog is a must read.

4. Alpha Vulture 

A Europe-based professional poker player, writer Alpha Vulture brings a scientific and calculated approach to his investment ideas. Alpha Vulture is a master at assessing downside risk and has a sharp investment process that any investor can learn from. If you are interested in international deep-value plays, merger-arb ideas, and even a short thesis or two, be sure to add this one to your reading list.

5. Bronte Capital 

The popular Bronte Capital is the brainchild of John Hempton, an Australia-based hedge fund manager. From shorting dodgy Chinese companies to exposing fraudsters, Bronte Capital offers a skeptical eye to the markets that is both refreshing and insightful. Where this blog falls short in actionable ideas, it makes up in downright entertainment. But don’t take my word for it – read John’s now famous post on Latvian Hookers and see for yourself!

Want to get the most out of these blogs? Try reading them from start to finish. This will allow you to understand the writer’s thought process at the time and see how the investment ultimately worked out. Were their assumptions overly optimistic? Did they improperly assess downside risk? Or perhaps they were right on the money and picked a multi-bagger. The best part about this method is seeing how the writer’s investment skills are sharpened over time, something I’m looking forward to doing with my blog after it has a few years under its belt (assuming I do actually get better, that is…).

Whether you are a fan of currency arbitrage, distressed debt investing or classic bargain hunting, there is a great blog out there for you to read and learn from. Then, of course, after reading a few blogs and deciding you want to improve your own investing process, what better move than to start your own!?

9

The Dolan Company and the True Meaning of Margin of Safety

Last week, during a leisurely morning read through the Wall Street Journal, I came across this headline:

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“Hmm,” I thought to myself, “that company sounds familiar.” Oh yeah, it was a 5% position in my portfolio just a few months ago! Now it and its equity are worth nothing. Zip. Zilch. Just like that, a stock I argued was worth $5 in a sum of parts analysis was at $.02. A picture is worth a thousand words, so let’s take a look at the stock chart along with my entry and exit points:

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How could I have been so spectacularly wrong? Well for one, my thesis lacked an adequate margin of safety. Okay, we have all heard that term before but what does “margin of safety” really mean? Let’s start with what I have learned margin of safety is NOT: the difference between the current trading price and one’s appraised value. In my original post, I valued the Dolan Company (DOLNQ) at $5 per share, which measured against the $2.75 share price at the time, implied a 45% margin of safety.

The fatal flaw in this calculation is it ignores the balance sheet and the extreme effect leverage can have in the event of an unforeseen negative development. With this in mind, I would like to propose a more complete definition of the term: margin of safety is the amount a company’s enterprise value could decline and still be greater than all of the company’s debt and the price you paid for the stock (credit Geoff Gannon). Now, when we bring Dolan’s net debt of $4.55/share (as of June 30th, 2013), our calculation looks radically different: ($5-4.55)/2.75 = 16% – yikes!

While this definition gets us closer to assessing downside risk, I believe margin of safety must be also gauged qualitatively through negative scenario stress testing. Ask yourself, what could wrong with this business? What might happen to the equity if a recession strikes and revenues decline 20%? The scenarios chosen for your analysis should be severe, yet realistic.

In Dolan’s case, their litigation service business, DiscoverReady, was the only line growing and generating steady profits – the future of the firm rested on this division. Well, DiscoverReady had extreme customer concentration with 40% of their revenues derived from one client, Bank of America. Never mind the longstanding relationship, the question must be asked – what would happen if Dolan lost BofA’s business? You can do the math, but the loss of this client would have sliced the company’s operating profit in half and put their ability to meet interest obligations in question.

We all know how this story ended. Completely unexpected, the company reported a 21% decline in revenues, including a 33% decline at DiscoverReady in their Q3 release on November 21, 2013. As It turns out, Bank of America had become concerned about the company’s financial strength and stopped sending business to DiscoverReady. Dolan’s financial condition caused their business to deteriorate, which only worsened the financial condition – a death spiral that sent the stock from $3.00 to 0 in 5 months.

I was fortunate to see the impending danger in the company’s November 6, 2013 8-K filing that revealed Dolan’s lenders were requiring the company to raise $50M through asset sales or an equity issuance. With my thesis called into question, I exited the position literally hours before the company reported their Q3 earnings and endured a 50% stock price decline. Hardly deserving of congratulations, I suffered a 25% loss in a position that could have been avoided with proper assessment of the downside risk.

Demanding a margin of safety is essential to achieving long-term investing success, and though investors are familiar with the term, it is easily misused in practice. If you want to know the true margin of safety inherent in your investments, incorporate the company’s balance sheet and stress test your thesis. A company’s debt load and customer concentration can be gleaned from a 5-minute read through the 10-K and may save you from painful losses down the road. I paid a hefty tuition for these lessons and would be glad for you to learn at my expense!

Disclosure: No position

5

ViryaNet: An Innovative Player in a Rapidly Growing Consolidation Market

After a crazy month of non-stop traveling, it’s great to be back blogging! It appears an exciting thing has happened during my brief absence: the frothy market we find ourselves in has started to show its first signs of jitters, and a number of the micro-caps I follow have sold off considerably. One such company that I believe has a good chance of doubling by this time next year is ViryaNet, the subject of today’s post. Enjoy…

ViryaNet (VRYAF, $3.55) is a mobile workforce and field service management software provider. The company has carved its niche in a booming mobile workforce management industry that remains just 25% penetrated, and is expected to grow by 40% annually for the next few years in North America. These industry tailwinds helped the company report a blowout of a fourth quarter, with earnings doubling and software license revenues increasing over 80%. Despite a 4-fold rise in 2013, I believe ViryaNet’s shares offer one of the most attractive risk/reward profiles in the market today, trading at merely 7X my estimated 2014 earnings and less than half the valuation of their larger publicly traded peers.

Business

Companies in field service intensive industries, such as utilities and telecoms, rely on ViryaNet’s solutions to optimize their mobile workforce and respond to real-time scheduling changes. The company’s core product, ViryaNet G4, provides web-based solutions, optimizing the full lifecycle of field service operations. This software allows service intensive companies to perform critical tasks, including creating work orders, scheduling and dispatching field personnel, and receiving real-time reports from the field.

As anyone with Comcast experience knows, poor service provided by field technicians can be a prime cause of customer attrition. A recent survey conducted by TechValidate showed that ViryaNet’s software proved effective in finding a solution to these issues, with over 75% of customers reporting improved field technician efficiency, on-time arrival, and workforce utilization. This value proposition has allowed the company to achieve nearly 100% client retention rates and a blue-chip customer base rarely experienced by a company of ViryaNet’s size:

Blue Chip VRYAF

Up to now, ViryaNet’s solutions have been primarily deployed through an on-premise model with up-front licenses (ranging from $300-500K to a few million) and recurring maintenance contracts priced at ~20% of the up-front license fee. A key feature of the ViryaNet sales strategy is the utilization of channel partners that “white-label” the company’s software and sell it as their own mobile workforce management solution. Accounting for roughly 30% of the company’s sales, channel partners include household names such as GE Energy and Vodafone.

Industry Overview

Over 70% of the world’s economy is comprised of service businesses and they’re continuing to grow in share. Gartner estimates the field service management market is valued at $1.5B annually, with software sales making up $329M of that total (ViryaNet February 2014 Investor Presentation). Most importantly, the market remains underpenetrated and is expected to grow at a rapid pace; research by Frost and Sullivan points to a 40% CAGR in North America through 2018 (source).

The mobile workforce management market is highly fragmented and consists of a large number of niche players in addition to that traditional ERP and CRM software vendors. ViryaNet’s primary competitors are ClickSoftware Technologies (CKSW), Astea International (ATEA), TOA Technologies, and ServiceMax. Despite the competitive landscape, the company has found its niche and been recognized as an innovator in the industry. Lately, ViryaNet’s markets have been in a heavy consolidation phase with two of the company’s primary competitors acquired in just the last three years: Ventyx (acquired in 2010 by ABB Ltd.) and Metrix LLC (acquired by IFS in 2012).

Financials

Below is a summary of the company’s financial performance over the past seven years:

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Note: The company’s 2013 10-K was not filed at the time of this writing so CFO for that year has been excluded.

ViryaNet’s recurring business has kept revenues stable, and a rationalizing of the cost base brought the company to profitable operations over 2008-9, which it has since maintained. The company experienced a breakthrough year in 2013 with record revenues, operating income, and a large jump in shareholder’s equity as debt was paid down. A closer look at the company’s quarterly financials reveals that the business accelerated in the fourth quarter of last year:

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The company’s maintenance and service revenues have remained stable over the last seven quarters, but a surge in software licensing revenue doubled operating income and put it at a record 27% margin. This outsized effect can be attributed to software licensing gross margins, which – at approximately 95% – are far higher than the 60% margins associated with services revenue. The company accredits the strong licensing revenue to the performance of their channel partners, particularly GE Energy, which have become increasingly adept at selling their product as these relationships have matured.

Valuation

Here is where ViryaNet’s valuation stands in relation to their larger publicly traded competitor, ClickSoftware Technologies:

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As seen above, ViryaNet trades at just over 1X revenues and 8.8X TTM EBITDA – a modest valuation for a software company that grew EBITDA 38% y/y. The market has awarded ViryaNet less than half the revenue multiple of Clicksoftware, which was not even profitable and experienced a decline in revenues. Recent transactions in this space also illuminate ViryaNet’s undervaluation, with Metrix LLC being acquired at 2.2X revenues in 2010, and the larger Ventyx being acquired at 4X revenues in 2012.

While the valuation gap has closed over the last six months, it will have a long way to go if the company delivers another record performance in 2014. ViryaNet’s business is notoriously lumpy, so, let’s consider three potential 2014 scenarios. For the base case, we will assume the company continues its high single-digit revenue growth rate and achieves operating leverage with a greater mix of software licensing revenues. The bear case will have licensing revenue trending back to the levels of 2012, and we will annualize the company’s blowout fourth quarter performance to form a bull case. Put together, here are the scenarios:

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Note: The company has a large amount of NOL carry-forwards ($35M for parent company, $62M for US subsidiary) that although valuable, have not been considered in the valuation.

In the base case, I believe that the company is capable of putting $.50/share toward the bottom line, which would put the valuation at a paltry 7X earnings. Assuming the company holds its current 10X EV/EBIT multiple, shares would then rise to $5 in the base case and provide nearly 40% upside from current levels. Should business continue to accelerate, shares could easily be valued at $7 and offer investors well over 100% upside. Considering the company revealed a multi-million dollar service order shifted from Q4 of last year to Q1 of this year, and just launched a cloud-based version of their flagship software, I feel there is plenty of upside to the scenarios I have outlined.

Catalysts

I see a number of near-term catalysts that could drive shares to new highs in 2014:

  1. Launch of ViryaNet G4 Cloud Offering – the company only began offering cloud-based deployment in November of last year and has already indicated strong demand. ViryaNet’s solution had previously been offered as a cloud model by only a couple of channel partners, but now the company is offering it to their entire direct customer base. The new cloud service should appeal to small- and medium-sized businesses that are weary of making a large up-front investment in the software, and will provide valuable source of recurring revenues.
  2. Acquisition Potential – as discussed previously, the field service and mobile workforce management markets have been consolidating rapidly. Management attributes it to the difficulty involved in building this complex software, which took ViryaNet over a decade with over $100M in paid-in capital. As the mobile workforce management market expands, I believe large software vendors look to ViryaNet as one of the few niche players left on the market – and with recent transactions occurring in the 2-4X revenue range, this scenario could result in a big payday for investors.
  3. Exchange Up-listing – with ViryaNet’s stock rising well above $1 in 2013 and the shareholder equity now at $2.5M, the company is in a good position to improve the liquidity of their shares by up-listing to an exchange such as the NASDAQ. With only a couple million shares in the float and the average daily trading volume at just over $50K, many interested investors are likely waiting on the sidelines for improved liquidity. Though management has not set a timetable, I believe an up-listing could occur as early as year-end, which should increase interest among institutional investors and assist in closing the valuation gap.

Risks

ViryaNet faces customer concentration risks, with four customers accounting for roughly a third of their revenues. The company is also dependent on the channel partners that have fueled their recent growth. Should ViryaNet experience the loss of a large customer or one of their partners find a replacement solution, the company would likely be faced with operating losses until new business is won.

ViryaNet also operates in a highly competitive and emerging industry characterized by rapid technological obsolesce. Should they be unable to keep pace with new innovations and industry trends, like cloud-based delivery, the business might face declining sales and an eroding competitive position.

Insiders

ViryaNet is a closely held company, with insiders collectively owning over 47% of the shares outstanding. Both CEO Memy Ish-Shalom and Chairman Samuel HaCohen have individual stakes standing at over 10%. Acting as true owners, management has done an excellent job achieving consistent profitability, organically growing the business, and moving the company toward a debt-free position.

Also of note, management has built their stakes with open-market purchases. In March of last year, Memy Ish-Shalom purchased 135,000 shares at $0.52 each, which increased his holdings by 50% to 10% of the company. I will point out that following the rapid rise in share price over the last six months, some insider selling has occurred – but, as Peter Lynch says, insiders sell for a variety of reasons and I don’t believe these actions are tied to management’s view of the company’s future.

Conclusion

ViryaNet’s position is enviable, with a blue-chip customer base and an innovative solution that is gaining traction in the rapidly growing mobile workforce management industry.  Investors have the opportunity to partner with a highly incentivized management team that has consistently delivered on product innovations and sales growth, at a price that is less than half of where comparable companies trade. With the company’s new cloud offering, up-list potential, and attraction as an acquisition target, I predict 2014 will be another breakout year and shares could climb a long way as more investors learn about this hidden gem.

Disclosure: Long VRYAF