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Will Embedded Flash Provide Zilog a New Future?

February 27th, 2007 by Yehuda Fruchter   |   2 Comments

Background:

ZiLOG (Nasdaq: ZILG, current price: $4.20) is a brand name in the semiconductor market, having been founded in 1974 by Federico Faggin, a co-inventor of the microprocessor.

The company, saddled with debt after a Texas Pacific Group LBO in 1998, and facing plummeting semiconductor prices in subsequent years, reorganized under Chapter 11 bankruptcy protection in 2002. Following its emergence from bankruptcy, ZiLOG has since refocused its business by eliminating manufacturing facilities and becoming a fabless semiconductor supplier of 8-bit microcontroller semiconductor devices. In particular, the company has refurbished its product portfolio to focus on opportunities presented by the fast-growing embedded Flash microcontroller market.

A microcontroller (MCU) is a computer-on-a-chip that is optimized to control electronic devices such as motors, remote controllers and user interfaces on appliances. Such a device typically comprises a central processing unit, non-volatile program memory, random access memory for data storage and various peripheral capabilities. Analysts estimate the 8-bit MCU market to be approximately $4 billion per year.

For additional information on ZiLOG’s colorful history, you can follow this link:

http://www.fundinguniverse.com/company-histories/ZiLOG-Inc-Company-History.html

For additional information on the MCU market, please use this link:

http://en.wikipedia.org/wiki/Microcontrollers

Capitalization:

Approximate Shares Outstanding: 17 million

Current Stock Price: $4.20

Cash: $21 million

Debt: $0

Enterprise Value: $50 million

Estimated Fiscal 2007 Sales: $80 million

Cash-Burn: $2 million to $4 million a year. Company is actually at EBITDA breakeven.

Comments:

The quality of ZILG’s balance sheet is offset, in part, by the fact that ZiLOG’s legacy business is rapidly deteriorating. In each of the past three years net sales have declined significantly, i.e. net sales were $78.8 million for the twelve months ended March 31, 2006, $95.6 million for the calendar year ended December 31, 2004, and $103.6 million for the calendar year ended December 31, 2003.

So while our EV/Sales calculation suggests a significant discount to industry multiples, as we’ll show below, whether the discount is warranted or not depends entirely on the company’s potential to stabilize revenue, and more importantly reignite growth in the coming years. Our investment thesis hinges on the company’s probability of realizing that potential.

Significant Financial and Personnel Changes

ZiLOG has undergone countless changes over the years, as can be seen by reading the historical link referenced above. In this section, we’ll just focus on the recent changes that we deem to be important.

  • Recent Financial Changes: Revenue Growth and EBITDA Positive Results

One of the things that caught our attention about ZiLOG (ZILG) was that despite a decline in revenues in recent years, the last few quarters have demonstrated a stabilization of the revenue stream, as well as some glimmer of renewed top-line growth and EBITDA profitability. All of this reflects initial success with new product lines.

For instance, in the last quarter, as reported by the company:

“Sales for the quarter were $20.7 million, an 18 percent increase over sales of $17.6 million for the comparable period a year ago and a decrease from sales of $21.2 million for the immediately preceding quarter. The increase in sales from a year ago reflects continued growth in new product sales including embedded flash MCU and Universal remote control solutions. Embedded flash sales were $3.6 million for the quarter, an increase of 89 percent from the comparable quarter a year ago, reflecting growth in the health & fitness and digital communications markets. Additionally, net sales of universal remote control solutions including the CRIMZON family of solutions increased 38 percent as compared to the third fiscal quarter a year ago, reflecting growth in the home entertainment and consumer gaming markets. The Company reported adjusted EBITDA (as defined below) of positive $0.3 million in the quarter as compared to positive $0.2 million in the preceding quarter and negative $1.8 million in the third fiscal quarter a year ago.”

As can be seen above, it would appear as if the company is approaching a major inflection point in the business, wherein new product growth could lead to substantial top- and bottom-line gains. As evidenced by past examples, i.e. RBAK or INAP, this type of financial situation is the best time to get invested in these types of tech turnarounds, assuming, of course, that the valuation is still reasonable.

  • Recent Management Changes: Growing the Flash Business

In addition to seemingly improving its operations, ZiLOG has also started to beef up its management ranks. Recently, the company hired Darin Billerbeck as CEO.

An Intel veteran, Mr. Billerbeck was co-head of Intel’s $2B Flash division. His experience in that role makes us optimistic about his potential to ignite ZiLOG’s sales in the promising area of embedded flash MCUs. You can read up extensively on Mr. Billerbeck by Googling him. From what we have read, he characterizes the ZILG opportunity as a once a lifetime opportunity to help substantially grow a start-up operation.Our feeling is that Mr. Billerbeck clearly has the skill set and people connections to greatly expand ZILG’s flash business, which is miniscule compared to what he managed over at Intel.
As for incentives: Mr. Billerbeck received 400,000 option shares at a strike price of $4.30 per share.

Risk Control and Downside Scenarios

On the one hand, the downside of an investment here is limited due to two key factors:

  • Debt-Free Balance Sheet

The company sports a clean balance sheet, with a decent amount of cash. While we don’t view ZILG’s cash balances as extremely healthy, they do seem sufficient to support the company’s current growth plans and profitability objectives.

  • Extremely Low Relative Valuation

One of ZILG’s much larger competitors is Microchip Technologies (NasdaqGS: MCHP). MCHP currently trades at an EV/Sales ratio of nearly 6.5, while ZILG’s is at about 0.65. Of course, it is important to note that MCHP has over $1 billion in sales, nearly $1.3 billion in cash, and has a long history of top-line growth and strong profitability. Nevertheless, it should be clear from the comparison to MCHP that ZILG’s valuation is depressed.

However, the above positives must be weighed against the following negatives:

  • Non-Stable Revenue Base

The clearest downside risk at ZILG is the continual deterioration of legacy product lines at ZiLOG. The company certainly has a much less stable revenue base than that of many other companies we have recommended, and this is reflected in the extremely depressed valuation of the stock.

Somewhat encouragingly, the implementation of a leaner cost structure has been quite effective in minimizing cash burn at the company over the past few years. Were it not for the costly defense of a patent infringement lawsuit launched by rival Microchip Technologies, it appears that ZILG would be at approximately cash-flow breakeven. Therefore, with even a modest up-tick in sales, driven by strong uptake of new product offerings in the flash MCU segment, the company would start throwing off cash. At present, flash products comprise about 10% of company sales, and we expect that figure to expand significantly over the next few years as Mr. Billerbeck catalyzes growth in that area.

  • Lawsuit with Microchip

ZiLOG is currently in patent litigation with Microchip. The company will incur substantial expenses in defense against these claims. In the event of a determination adverse to ZILG, the company’s business may be harmed.

However, to put this risk in perspective, we believe that if ZILG’s sales continue to improve, the company would become a likely buyout target for MCHP, since it would probably be cheaper for MCHP to just buy ZILG than to waste time and financial resources fighting them in court.

  • Extremely Competitive Industry Environment

The semiconductor industry is intensely competitive and is characterized by price erosion, rapid technological change and heightened competition in many markets. The industry consists of major domestic and international semiconductor companies, many of which have substantially greater financial and other resources than ZILG.

The one factor working in ZILG’s favor, even considering the competitive risk, is that ZiLOG is a major brand name in the semiconductor industry.

Upside Scenarios

Why might Wall Street get on the ZILG bandwagon? The potential, of course, lies in the rapid widespread adoption of flash-based reprogrammable MCUs.

Traditional ROM-based MCUs have to be programmed by the semi supplier, resulting in significant lead times and consequently, possible inventory obsolescence. The cost of flash-based MCUs is just now becoming competitive with ROM-based MCUs, so the segment is reaching a major inflection point. The attractiveness of flash is borne out by the fact that reprogrammable MCUs are the fastest-growing segment of the MCU market. Microchip Technologies is itself having great success with flash MCUs, sales of which were up 42% YoY as of the quarter ended Sept 30, 2006.

IF ZILG continues to make permanent inroads in the flash MCU space, its sales will increase significantly and the company’s valuation could also take a nice jump.

Upside and Downside Targets

A good comp for determining the upside in ZILG is its aforementioned rival, Microchip Technologies. For obvious reasons, one cannot casually apply MCHP’s multiples to ZILG to generate an upside target, because ZiLOG has a lot of work to do before it can ignite its top-line and perform even remotely as well as Microchip. However, it is clear that ZILG’s multiple can expand from here many times over, assuming modest sales growth. Over a two to three year time horizon, we think an attainable multiple would be 1.5x-2x EV/Sales, on $90 million in sales. This would place the stock’s value in the $10-$12 range.

On the downside, one can easily envision a complete erosion of legacy product revenue, a small share of the flash MCU market, and a little cash. Assuming continued erosion of the revenue base, we put the downside around $3/share. However, we should note that the CEO’s recent options were given at $4.30 per share, so we consider this scenario to be less likely than the potential upside.

Assuming a 60% chance of the upside scenario and a 40% chance for the downside case gives us an expected value of about $7/share, or about 60% upside.

There is, of course, still some question as to whether our probability weightings are justified, but another way of looking at this valuation is that we think the shares have about 30% downside and over 100% upside. This type of risk/reward is definitely something we would bet on, every single time.

The key thing to watch here is the continuation of company announcements surrounding the rollout of the Flash business.

Please Note: We hold a position in ZILG. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Special thanks to Toby Shute for helping to prepare this write-up.

Additional Notes:

Here are some additional facts that we wanted to add to our initial report on ZILG:

  • Before the TPG takeover, ZILG had a peak revenue year in 1996, when it reported nearly $300 million in sales and EBITDA of about $90 million, for margins of 30%. The company , at that time, reached a peak market cap of nearly $800 million.
  • TPG acquired ZILG on July 21, 1997 for $25 per share, or about a $420 million Enterprise Value. This would equate to about $23 per share using the current capitalization. At the time, ZILG’s sales were about $280 million.

As you can see from the above, when times are good, ZILG has almost never traded at an EV/Sales ratio of less than 1. So with some growth, we definately see the current ZILG trading at 2X EV/Sales ratio or about $11 per share.

  • One of ZILG’s largest shareholders is LiteSpeed Management LLC, run by Jamie Zimmerman. This hedge fund specializes in restructuring, bankruptcies etc. and has an excellent track record. Seemingly, Litespeed picked up their shares in ZILG during the bankruptcy. For an interesting interview with Mrs. Zimmerman, please click here. Having such a fund invested here, gives us confidence that ZILG will pursue shareholder-friendly strategies.

Grupo Financiero Galicia (GGAL) Reports Improving Results

February 19th, 2007 by Yehuda Fruchter   |   No Comments

Last week, Grupo Galicia (GGAL), a leading Argentinian bank, reported fourth quarter financial results which demonstrated significant financial improvement. As we noted when we first wrote up GGAL, the company´s financial statements are quite complex, and as such we´ll just focus on two big picture points in this post and reiterate why we remain bullish on the shares for the remainder of the year.

Balance Sheet Strengthened

Perhaps, the most important event for the company in the quarter, were a series of deals with the Argentine Central Bank that both increased the company´s cash position, while simultaneously significantly decreasing its liabilities to the Argentine Central Bank.

As the company explains:

The execution of the above-mentioned advance and its repayment, strengthens the Bank’s balance sheet by reducing risk concentration and making an asset of a very significant amount available for the expansion of the business.

Standard & Poor’s in considering an upgrade of the bank commented on the: 

“improvement in the Bank’s medium term operating results, following the significant repayment of debt with the Central Bank and the subsequent reduction in the cost of funding” and that it also reflects Standard & Poor’s “expectations of an increase of the Bank’s capitalization as a result of the forthcoming stock offering”.

Deposit Growth Is Very Strong and Loans are Increasing

Reflecting renewed faith in banks, and solid economic growth, the Bank’s deposits in Argentina reached Ps.10,592 million by year end 2006, representing a 30.7% increase from December 31, 2005. Total loans to the private sector granted by the Bank’s Argentine operation increased 50.1% between December 31, 2005 and December 31, 2006, while the regional credit-card companies’ total loan portfolio increased 36.2% during the same period.

Interestingly, as we predicted in our initial write-up, mortgage loans and mortgage interest were among the fastest growing parts of the banks balance sheet and income statement.

Where to Now?

We still think that the vast majority of US investors and market commentators are completely oblivious to the revival of the, previously-bankrupt, Argentinian economy. As more investors discover Argentina, particularly its lively real estate market,  they will gravitate towards shares of GGAL, one of the leading banks in Argentina, and one of only a handful of Argentinian ADR’s. In fact, the low supply of Argentinian ADR’s, and the potentially strong demand for foreign investment in the country from emerging market funds, supports the notion that GGAL could perform very well for quite some time. Interestingly, it was only last week that JPMorgan finally decided to upgrade shares in GGAL, demonstrating that Wall Street is only beginning to warm up to the story here. 

At the same time, from a basic economic perspective, GGAL should continue to benefit for quite some time, from the renewed growth in Argentina and the booming real estate business in Buenos Aires.

Based on the above, we still remain bullish on GGAL for the remainder of the year. However, please refer to our first post on GGAL for the risks you face when investing in Latin American stocks, like GGAL. As you may have already noticed, these stocks can be quite volatile. However, if you keep in mind the current strong underlying economics of the Argentinian economy, coupled with the lack of suitable ADR’s from the country, it should be easier to withstand the volatility and possibly buy more on any dips.  

Please Note: We first recommended GGAL at about $9.55 per ADR share, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Crown Crafts (CRWS.ob): Buying Opportunity on this Dip

February 14th, 2007 by Yehuda Fruchter   |   No Comments

After a stock has steadily risen from $0.60 to $6 in less than a year, it´s not surprising to see a correction even after solid financial results are reported. As such, we were not entirely taken aback by the drop in Crown Crafts (CRWS.ob) today, after the company reported what we believe were excellent 3rd quarter results.

It´s possible that some investors were not happy with the quarterly sales growth, but fluctuations in the top-line are to be expected in this type of business, which is heavily dependent on “big” retail buyers. Overall, we think it´s important to note that, year-to-date, the company has managed to grow the top-line, even amidst a major recapitalization. Furthermore, with the addition of two new licensed properties, the company has laid the foundation for solid potential growth over the next year.

Perhaps, the key thing to take away from today´s financial results is that Crown Crafts remains a solid cash generator. During the quarter, the company further reduced debt by $4 million, to $6.5 million. This compares to $24 million in debt only a year ago. We believe that about half of the company´s remaining debt is interest free. So for all intents and purposes Crown Crafts is now debt free. An amazing feat considering the company was on the edge of bankruptcy not too long ago.

Now with the company´s financial position strengthened and cash-flow stabilized, we fully expect management to aggressively grow the business via additional license acquisitions. We still think that with the stock trading at a substantial valuation discount to similar businesses (e.g. Russ Berrie: RUS), that Crown Crafts´ shares could provide 50%+ appreciation over the next twelve months, if top-line growth accelerates, as we predict.

Finally, we think that since the company meets all the requirements for a NASDAQ listing that the shares will move off the bulletin board and onto NASDAQ sometime in the next twelves months. This move could bring new buyers into the stock and provide a catalyst for renewed price appreciation.

Please Note: We first recommended Crown Crafts (CRWS) at $3.60, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Extreme Networks (EXTR) Boosted By Upgrade

February 14th, 2007 by Yehuda Fruchter   |   No Comments

It´s always nice to get the Wall Street hype machine rallying behind our stock picks. So we were quite pleased this morning when Ryan Hutchinson, over at WR Hambrecht, upgraded Extreme Networks (EXTR) and published a 12 month price target of $6.50 per share for the stock.

Mr. Hutchinson had this to say about Extreme:

“We are upgrading EXTR shares to a Buy from a Hold rating and establishing a $6.50 price target based on 1.5x our C2007 EV/Revenue estimate. Our upgrade is based on our belief that the corporate reorganization that has been underway over the last six months is beginning to take hold. As expected, such turnarounds take time to materialize; to date, gains have been slight. However, we believe that under the new leadership of CEO Mark Canepa, the Company is at the brink of resuming a growth trajectory. Our recent meeting with CEO Mark Canepa reinforced this notion due to several actions Canepa has taken, including 1) focusing on key verticals; 2) realigning the product groups; 3) de-layering the management structure and adding key hires; and 4) reinvigorating the North American sales organization. Furthermore, with the option review nearly complete and EXTR shares trading at less than 1x our C2007 EV/Revenue estimate, we believe the risk/reward profile is compelling.”

As regards to the competitive environment that EXTR must face, Mr. Hutchinson had this very interesting piece of commentary:

“Our discussion with Canepa revealed much about his new strategy for approaching the Company’s traditional verticals-carrier and the enterprise. Within the carrier vertical, we believe the Company can ultimately compete for a sizable portion of the carrier Ethernet market, valued at $1.6B during 2007 by IDC. While the Company’s traditional carrier base has consisted of about two-thirds Tier II and one-thirds Tier I, we believe the Company will more aggressively pursue a few key Tier I accounts through OEM relationships, rather than head-on. On the enterprise front, we believe the most potential is coming from healthcare, hospitality/gaming, and education-sectors marked by transient usage populations that are well served by Extreme’s best-of-breed emerging wired/wireless platforms. Moreover, we believe the Company holds a strong competitive position in this market because it largely focuses on smaller implementations that are often overlooked by larger competitors like Cisco.”

Overall, with another analyst getting bullish on Extreme, it will probably not be long before other Wall Street firms begin upgrading shares of the company. Our view, for quite some time, has been that EXTR’s share price already reflects worst case scenarios, and with ample evidence to suggest that substantial positive business changes will be coming in the next year, the shares still have limited downside and substantial upside.

We would note, however, that we are more bullish on EXTR than Wall Street. We think that if the company continues to report improving financial results and US sales begin picking up, there is absolutely no reason why the company should trade at a substantial valuation discount to its peers. In fact, a valuation more in line with industry comps, would suggest a potential target price of $8 to $10 in the coming year, if results continue to improve. It´s also possible that the company´s large cash pile and stabilized revenue stream, will attract suitors from either larger competitors or private equity firms.

Please Note: We first recommended Extreme Networks (EXTR) at $4.22, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Globix (GEX): A Closer Look At This IP Transport Play

February 12th, 2007 by Yehuda Fruchter   |   No Comments

Introduction

Note: As of this writing, Globix (AMEX: GEX), was trading at about $4.60 per share.

In this post we are going to take a look at Globix Corp. (AMEX:GEX), a post-bankruptcy Internet services stock, that provides IP Transport solutions over a wholly-owned and operated high-bandwidth fiber optic network. Though we are not terribly excited by Globix´s risk/reward ratio at current share prices and do not own shares in the company, we thought a review of the company would be interesting to those looking for additional plays in the hot IP services sector. Furthermore, we think that the valuation of GEX provides some interesting insights into the potential upside in FiberNet Telecom (FTGX), another IP transport stock we´ve been writing about for some time.


Business Summary

Globix was a former high flyer back in the first Internet Bubble. However, under the weight of significant leverage and the collapse of the telecom sector, the company declared bankruptcy in 2002, after suffering cumulative net losses of hundreds of millions of dollars. Following its emergence from bankruptcy in 2002, the company significantly restructured operations.

In 2005, Globix acquired NEON Communications, another former telecom high-flyer that traded for over $150/share before declaring bankruptcy not long thereafter. Following some major divestitures in 2006, Globix, through its sole subsidiary NEON Communications, is now a provider of IP transport services to telecom carriers (i.e. local, long-distance and wireless telcos) and a limited number of higher education and financial institutions in the Northeast and mid-Atlantic regions. The company’s network stretches 4,800 route miles and over 230,000 fiber miles from Maine to Virginia. The company offers lit fiber (i.e. with network equipment installed) and dark fiber (without network equipment installed) services, and also provides co-location services through its data centers.

In the full year of 2006, revenues from the transport segment, Globix´s only remaining business, were $66.4m, up 25% over our annualized figure for 2005. In the most recent quarter, about 90% of revenues were derived from lit fiber leases, which are booked long-term and billed ratably over the term of the lease, providing a highly predictable revenue stream.

What Changed?

In a former life, Globix was a full-service Internet Service Provider (ISP), providing hosting and streaming services in addition to bandwidth and co-location. Globix entered the IP transport business when it acquired NEON in 2005 for $113m.

Following a strategic review in 2006, the company opted to divest the US and UK hosting businesses and the NYC real estate related to that business in order to focus exclusively on the IP transport business through its NEON subsidiary. Proceeds from the above sales were used to pay off nearly all of the company’s debt, and left a good amount of cash on the balance sheet as well. In essence, starting in 2007, we are looking at a radically different company than that which existed even a year ago.

The People

Following the divestiture of the company´s hosting operations in 2006, Globix has installed a new senior management team, primarily composed of former senior officers of NEON.

The current CEO and President of Globix is Kurt Van Wagenen. Mr. Van Wagenen joined NEON Communications in 2001 as Vice President of Network and Operations. In 2005, NEON merged with Globix and Mr. Van Wagenen was appointed Chief Operating Officer of the NEON business and later President and Chief Operating Officer of the entire company. From 1986 through 2001, Mr. Van Wagenen was employed by Verizon and its various predecessors in several positions of increasing responsibility. Mr. Van Wagenen holds an M.B.A. from Harvard Business School and a B.S. in Engineering from Rensselear Polytechnic Institute. He is also a Chartered Financial Analyst.

When Mr. Van Wagenen was hired by GEX as CEO he was awarded 125,000 option shares at $4.17 per share.

The current Chairman of the Board of Globix is Ted S. Lodge. He joined the Board of Directors on October 28, 2005, at which time he was elected Chairman of the Board of Directors and Executive Chairman. Since April 2005, Mr. Lodge has been the principal of Lodge Special Situations LLC, a firm providing special situations advisory services to private equity and hedge funds and companies. From December 2001 to April 2005, Mr. Lodge was president, chief operating officer and counsel of Pegasus Communications Corporation, where he also was at varying times from 1996 to 2001 executive vice president, senior vice president, chief administrative officer, general counsel and secretary. On June 2, 2004, Pegasus Satellite Communications, Inc., along with its subsidiaries through which the primary operating businesses of Pegasus were conducted, filed voluntary petitions to reorganize under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the District of Maine.

Globix´s largest shareholders are various funds, some of whom have acquired stakes in recent months.

Overall, we are not too excited with GEX´s management. None of the company´s officers have had experience in managing a publicly-traded company that enhanced value to shareholders. At the same time, however, the current management team has significant operating experience in Globix´s current business.

Basic Capitalization Statistics

Based on the latest 10-Q, Globix has approximately 50 million shares outstanding on a fully diluted basis. Cash, including restricted cash, stood at about $36 million. Debt was a mere $3 million. Additionally, the company has about $14m in cumulative convertible preferred stock, which we will treat as debt for the purposes of this capitalization review. A description of the Preferred Stock, as per the latest 10Q: Globix has designated 4,500,000 shares of 6% Series A Cumulative Convertible Preferred Stock (“preferred stock”), of which 2,971,753 shares were issued in the acquisition of NEON. Each share of preferred stock is convertible into one share of common stock at the option of the holder, is entitled to one vote, has a liquidation preference of $3.60 per share plus accrued dividends, and is senior to the common stock of Globix.

Taking the above figures and using the current price of about $4.65 per share, we reach an Enterprise Value for Globix of about $215 million.

We would also note that company appears to have at least $140 million in usable NOLs. This tax asset should of course be taken into consideration when valuing the company. However, given the difficulty in valuing NOLs, we prefer to omit this factor from our EV calculation.

Relative Value Summary

In 2005, 7 months of post-acquisition NEON operations yielded revenue of $30.6m, which we can annualize to about $52.5 million. As noted above, in the full year of 2006, revenues from the transport business, Globix´s only remaining business, were $66.4m, up 25% over our annualized figure for 2005.

Based on these numbers and the EV mentioned above, Globix is currently traded at an EV/2006 Sales multiple of about 3.2.

On a go forward basis, with the increasing bandwith demands coming from Internet video, we think it´s realistic to assume double-digit top-line growth for GEX, for at least the next 3 to 5 years. In fact, Globix just reported Q1 revenue of $18.1m, representing growth of 18.5% year over year. In addition, the company reported EBITDA from continuing operations of $2.6 million in the most recent quarter.

Based on our industry outlook and using the most recent numbers, we feel comfortable estimating top-line sales for Globix at about $75 million for FY 2007. EBITDA should come in at about $11 million for the year. These estimates imply that GEX is currently trading at 2.8X EV/2007 Sales and 20X EV/2007 EBITDA.

Because of some recent acquisitions of other IP Transport companies by Level 3 (LVLT), there are some good comps by which to judge GEX´s relative valuation. For instance, according to LVLT, LVLT purchased TelCove for about 3.3x EV/sales, and Looking Glass was bought for approximately 2.3x EV/ sales. From what we can gather, LVLT itself is currently trading at nearly 5X EV/Sales. The company´s complex balance sheet makes valuation difficult, however.

Overall, when looking at recent M&A valuations, it would appear that Globix´s stock is probably about fairly valued, assuming our estimates are correct.

Risk Analysis

Without any significant debt, and with a nice cash position, Globix doesn’t seem to face much financial risk on a go forward basis. From a business perspective, it is also hard to see how the company is at much risk, given the growing demand for bandwith. In fact, the only real red flag here is that a substantial amount of cash from the company´s operations will have to go toward cap-ex to maintain and extend the NEON network. To be conservative, we estimate maintenance cap-ex at about $20 million per year. As such, the company is not yet free cash-flow positive, though it´s possible the company will begin generating FCF later this year.
In terms of setting a downside price here, we note that the CEO´s options are priced at $4.17 per share. More importantly, though, NEON was purchased for $113 million or $2.26 per share. Adding back net cash per share of about $0.40 and assigning minimal value to the NOLs gives us a downside price of about $3.50/share, or nearly 25% downside.

Return Analysis

On the upside, it´s possible that GEX will significantly exceed our estimates either because of accelerated top-line growth or acquisitions (i.e. the company notes in its filings that it is looking to make acquisitions, which makes sense given the NOL position). In addition, continued investor fascination with IP transport stocks, could result in higher valuation multiples for the all stocks in the sector. Assuming such scenarios, it´s conceivable that the company could trade at about 4x sales, or about $6.50 per share, for about 40% upside.

Conclusion

Considering the above and weighing each scenario, we don´t find GEX´s shares to be exceedingly attractive at current levels. However, given that the IP services sector remains “hot”, GEX is definitely one stock to keep your eye on in case of an unreasonable sell-off. The stock remains off the radar of Wall Street and not one sell-side analyst is covering the stock.

Finally, if you´ve been waiting for some FTGX commentary, we would note that GEX, given its business model and size, is probably the best publicly-traded comp for FTGX that we can currently find. Based on our FTGX estimates, and applying GEX´s multiples, as described above, we reach a fair relative valuation for FTGX of about $13 to $15 per share.

Please Note: We do NOT hold a position in GEX. However, we may trade in the stock at any time. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Special thanks to Toby Shute for contributing to this post.

ActivIdentity (ACTI): Significant Improvements and Exciting Prospects

February 9th, 2007 by Yehuda Fruchter   |   1 Comment

Last evening, ActivIdentity (ACTI) reported financial results that demonstrated significant progress in the company´s turnaround. Specifically, the company generated nearly $8 million in free cash-flow during the quarter, it´s first positive cash-flow quarter since the company´s IPO. The company ended the quarter with a hefty cash balance of $136 million (no debt), or nearly $3 per share.

Importantly, unlike another turnaround pick Network Engines (NENG), ActivIdentity (ACTI) generated this cash-flow on the heels of significant revenue growth, with the top-line increasing by 27% year-over-year and gross margins reaching 69%.

The company´s forward guidance, though, for the upcoming quarter was less than stellar. However, our understanding, based on comments made on the conference call was that guidance is somewhat conservative and does not include the potential closing of several significant deals in the pipeline.

Overall, we are not too concerned about the quarterly fluctuations at ActivIdentity, since the software business is, in general, a bit lumpy. More importantly, however, is the fact that ActivIdentity is entering what we believe is a multi-year period of high double-digit growth. Specifically, the company is and should be able to continue to benefit from the increasing adoption of Smart Employee ID badge solutions by both both governments and large businesses.

Interestingly, as we have mentioned in the past, we still do not think ACTI´s shares fully reflect the potential for the company over the next few years. With $136 million in cash, and no debt, the company’s Enterprise Value is about $105 million. Security software still remains one of the hottest areas in software M&A with takeouts going at very high multiples of TTM revenue. With an estimated $60 million in sales in the coming year, we believe that ACTI should be worth about 3X EV/Sales, especially considering that it has now managed to reach profitability amidst strong top-line growth. That would imply a takeout price for ACTI at a price of at least $6.50 to $6.80 per share.

We think that as ACTI continues to demonstrate double-digit top-line growth and increasing cash-flow over the coming quarters, that it’s share price will rise to our target price. At the same time, with a pristine balance sheet and low relative valuation to other security software stocks, there does not seem to be much downside risk in the company´s shares.

Please Note: We first recommended ActivIdentity (ACTI) at $4.37, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are
committed at your own risk, financial or otherwise.

Network Engines (NENG): Slowly Making Progress

February 7th, 2007 by Yehuda Fruchter   |   1 Comment

About a year ago, we picked Network Engines (NENG) as a potentially solid turnaround candidate in the technology sector. Back then, the stock was trading at $1.88 per share and the company was losing money. Fast forward one year, and the company is now trading at about $2.25 per share, up nearly 20%, and reported $6 million in free cash-flow for the most recent fiscal quarter.

Overall, given the above statistics, we can´t complain much about our investment in the company. In any turnaround situation, stabilization of cash-flow is the first priority, and management has clearly been very successful on that front.

However, renewed revenue growth, the second important aspect of any turnaround, still remains a concern at Network Engines. With 82% of revenue coming from EMC, the company is in dire need of new revenue streams. On that front, even though the company has been successful in attracting new partners, there has yet to be any meaningful financial impact from these deals. Generating new revenue is, of course, far harder to achieve than cutting costs and we therefore plan to have some more patience to wait for top-line growth.

Furthermore, we think that patience makes sense here, because with $39 million in cash, no debt, and no cash burn, the company has plenty of resources and time to establish new revenue streams, especially considering the booming nature of the appliance industry.

Additionally, with about 40 million shares outstanding, the company´s enterprise value is around $50 million, or less than 0.5X EV/TTM Sales. Though this low relative valuation is somewhat warranted given the reliance on EMC, it should be clear that “The Market” is not pricing in any meaningful sales growth potential for Network Engines.

Therefore, as we mentioned over a year ago, in the event that the company is successful is developing new non-EMC business, the shares could appreciate significantly. In the meantime, as mentioned above, we see little downside risk given the strong balance sheet and already depressed valuation.

Disclosure: We hold shares in NENG. This report includes market analysis. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets or in any particular stock. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise. We maintain no legal responsibility to update this report or his holdings in the stock mentioned in this report