|Shares Out. (in M):||21||P/E||22.6x||10.8x|
|Market Cap (in $M):||111||P/FCF||22.6x||10.8x|
|Net Debt (in $M):||-23||EBIT||0||0|
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I am posting my two best ideas. This is idea #2.
CUI Global, Inc. (NASDAQ: CUI)
We believe CUI Global, Inc. (“CUI”), an industrials company headquartered in Tualatin, Oregon, represents a compelling risk vs. reward. The story is complicated with many moving pieces. That said, we think the up/down here makes it worth the effort to try and understand.
The full history and investment thesis is laid out below, but it might be helpful to begin with a short summary.
CUI shares closed at $5.42 on Friday. We believe that CUI’s two core businesses are gems – they are asset-light and knowledge-intensive, with low cap-ex/working capital requirements, high free cash flow, and solid double-digit percentage growth profiles. Similarly-positioned companies today trade at 15-20x multiples; we think CUI generates ~$0.50 per share in FCF in 2014. Assuming the bottom-end of this range, this would value the core business at ~$7.50 per share. Adding on $1.00 per share in net cash and the value of the company’s net operating loss carry-forwards, we get to an underlying valuation of ~$9.00 per share.
That provides us with a margin of safety. The real story here, however, is the launch of two major new product lines that we believe could be transformative for the company and lead to substantial upside for shareholders. One product, an industrial metering device for natural gas infrastructure, has already launched and is rapidly rolling out to its global end-markets. The other product, a digital power module business, is set to launch in mid-2014. We think that as these two product lines gain traction, the potential upside is multiples of the current share price.
When Numbers Lie
At first glance, CUI hardly appears a good candidate for investment. Past financial data is messy, with numerous one-off items and expenses that obscure the results of the underlying business. Even worse, CUI’s sales and earnings figures on an as-reported basis paint a bleak picture of little growth and negative profits (see Exhibit A).
CUI Global, Inc.
Profit Per Share:
Source: Company Filings
What the numbers don’t show is how radically different the company is today as compared to its past. Pre-revenue product lines are coming into production. A major new distributor is poised to accelerate growth in one business segment. A transformative acquisition is set to dramatically boost profits in another. And the expenses that complicate trailing figures – such as up-listing costs to join the NASDAQ Stock Exchange, fees incurred to clean up the company’s balance sheet, and non-cash write-offs of non-core legacy assets – should not repeat.
Backward-looking, CUI is a low-growth, unprofitable business with substantial debt. Forward-looking, CUI is a fast-growing, profitable business with a strong balance sheet and net cash. As CUI unmasks itself as a prince and not a frog, we believe CUI shares will re-rate to reflect the firm’s much-improved positioning and prospects.
A Brief Company History
The corporation that would become CUI was formed in April 1998 as an early-stage LED display business. Originally called New Millennium Media International, Inc., CUI would change names frequently over the ensuing years to OnScreen Technologies, Inc. (2004), Waytronx, Inc. (2007), and finally to CUI Global, Inc. (2011).
Our story picks up in late-2007 when Bill Clough, one of the company’s Directors, stepped into the CEO role. A prior CEO – an ex-Fortune 500 executive – had pushed the company to the edge of bankruptcy by building out substantial infrastructure and overhead that may have worked for a bigger firm but made little sense for a small, largely pre-revenue business. As the cash bleed grew to alarming levels, the Board turned to Bill to right the ship.
Bill’s background was unusual for the job. An ex-cop who commanded a 75-person SWAT unit in the US before spending time in Europe and the Middle East as a Federal Air Marshal, Bill moved back to California in the late-1980’s to attend law school and be closer to his wife and two young children. After graduating, he joined a partner to launch a legal practice that eventually grew into a 50-person operation with twenty lawyers on staff. Bill retired by selling his ownership in the firm to his partners in 2006.
Bill’s involvement stemmed from a $2M personal investment he had made in the company a few years prior to taking the reins. Not wanting to see his investment lost – and needing something to do in “retirement” – Bill jumped in with both feet. By the end of 2007, the perennially loss-making LED display business had been shut down, the company’s cost structure right-sized, and the company’s efforts refocused around a promising early-stage thermal management technology for cooling microprocessor-based electronics. Bill and his team settled in for the lengthy process of research, development, and eventual commercialization of the technology.
If the first part of the story is about business stabilization, then the second is about relationships.
In early-2008, Jim McKenzie faced a dilemma. Jim was the founder and owner of CUI, Inc., a small Oregon-based electronics business he had formed in 1989 to import high-end oscilloscope probes from Japan. Pleased with the product, Jim’s customers asked him to supply other electronic components and power modules as well. Twenty years on, he had built CUI, Inc. into a high-quality supplier with a sterling industry reputation, double-digit millions in sales, and almost fifty employees, including Jim’s son, daughter, and daughter-in-law.
Nearing age seventy, Jim had recently been approached by General Electric (NYSE: GE, “GE”) with an offer to buy his company. Jim knew that if he sold to GE, the business would likely be dismantled as it was integrated into the larger firm. Not wanting to see his life’s work taken apart – nor his son, daughter, and daughter-in-law lose their jobs – he confided his frustrations in Bill Clough, a customer and close friend. Jim preferred not to sell to GE. He wished to leave his business to someone who would care for it, grow it, and preserve its culture. He wished to leave it to someone he trusted. Someone like Bill. They shook hands on a deal the same day.
Waytronx, Inc. purchased CUI, Inc. in May 2008 for $37.5M, financed entirely by debt (a $6M bank note and $31.5M in seller financing) with the intention of reducing the debt via a fall 2008 IPO. The bankruptcy of Lehman Brothers put that plan on ice. Bill and his team lowered their heads and focused on building the business and paying down debt. From revenues of $17M in 2008, sales grew to $40M+ in 2012. And via a combination of cash flow, debt-for-equity swaps, and equity raises, CUI finally achieved a net cash position in early-2013.
The combination of Waytronx, Inc. and CUI, Inc. gave the company a corps of talented engineers with specific expertise in the commercialization of new technologies. To capitalize on this strength, Bill set about searching for additional products to purchase or license that could be plugged into the CUI pipeline.
One technology would eventually lead to the second transformational acquisition of Bill’s tenure. The CUI, Inc. purchase included a stake in a test and measurement company called Test Products International, Inc. (“TPI”). In the aftermath of the financial crisis, TPI was approached by GL Noble Denton – the former R&D arm of British Gas in the UK – which was looking for a partner to commercialize a technology for measuring the energy content of natural gas. TPI didn’t have the bandwidth to undertake the project, but suggested CUI as a good alternative.
In 2009, CUI acquired the exclusive, perpetual, worldwide license to GL Noble Denton’s GasPT2 technology, with all patents/IP transferring to CUI upon the sale of the 3,100th unit incorporating the technology. It was soon evident that CUI had something special, and the company rapidly accelerated its commercialization efforts.
As CUI worked to bring GasPT2 to market, the firm linked up with UK-based Orbital Gas Systems Ltd. (“Orbital”). Orbital, a highly-respected engineering firm, operated as the outsourced service engine for British utilities dealing with natural gas-related projects including installation, maintenance, repairs, and general problem-solving. Orbital was an ideal partner for CUI in two respects. First, with close ties to the British utility industry, it was the dream platform to distribute GasPT2 into the UK. Second, Orbital had independently developed an advanced probe technology to efficiently and safely draw natural gas samples from pipelines for testing. Orbital and CUI combined their technologies into a single, comprehensive unit for sale to end-users.
The two sides soon realized that a deeper connection might be in order. The situation was eerily similar to Jim McKenzie’s some five years earlier. Andy Clews, the sole owner of Orbital, had stepped away from the business and was ready to retire. Not wanting to sell to a corporate giant like Siemens AG (DAX: SIE) which would likely strip apart the operation – especially since Andy now had children working at Orbital – Andy struck up a conversation with Bill. Bill asked for a price he could afford. Andy suggested £17M with £3M of cash left in the company on the date of purchase (approx. 1x sales). Bill said yes. For a second time, CUI had a transformational deal in place catalyzed by personal relationships.
Two Good Businesses
To pay for Orbital, CUI successfully raised equity capital in April 2013. The transaction closed on April 18.
In our view, the Orbital acquisition and associated capital raise materially improved CUI’s prospects. The company’s balance sheet flipped from a net debt position to $20M+ in net cash. More importantly, the deal allowed CUI to lay a strong foundation for growth and profitability anchored by its two good businesses.
In Tualatin, Oregon, CUI, Inc. forms CUI’s electronic components business. Ably managed by Jim McKenzie’s son Matt, the electronic components division occupies a distinct industry niche. Neither pure manufacturer nor pure distributor, CUI designs and engineers its products while outsourcing manufacturing and half its distribution to third parties. To customers, CUI appears a “branded manufacturer” selling components under the respected CUI label. But from a business model perspective, CUI has shed the asset-intensive bits of the business while maintaining its own brand, patents, and a specialization in the highest-margin part of the value chain.
In Stone, UK, Orbital forms CUI’s natural gas business. Run by industry veteran Andy Ridge, the business takes a two-pronged market approach. Orbital’s 100+ total employees – including 50 engineers – primarily act as service provider to Britain’s utilities tasked with oversight of the UK natural gas grid. Orbital’s relationship with the utilities is incredibly close; National Grid plc (LSE: NG), the UK’s largest utility, keeps some 40 employees permanently on-site at Orbital’s headquarters. In addition, Orbital works to commercialize and sell the new technologies created by its engineers such as the IRIS remote telemetry unit, V-E Probe, and GasPT2 analyzer.
While CUI’s two business segments – serving different end-markets and an ocean apart – appear to have little in common, to us they make a sensible combination. Both are asset-light knowledge businesses with steady growth and strong cash flow generation. Both depend heavily on the talent of engineers. Both have roots as cherished family businesses. Both have experienced leaders in place to help drive them forward. Last but not least, both businesses own a potentially game-changing product. For the components business, that product is the Novum line of digital power supply units. For Orbital, it is the GasPT2 analyzer.
The GasPT2 Analyzer
One of today’s most powerful investment themes is the build-out of infrastructure for the natural gas industry. New extraction techniques have dramatically lowered the cost of gas production, spurring record-low prices and record-high demand. As a result, hundreds of billions of dollars have flowed into natural gas infrastructure.
For natural gas utilities seeking to measure the energy they provide to customers, two calculations are required. One is the volume of gas flowing through the pipeline. The other is the energy content of that gas. Volume is measured using a flow meter, a device that costs $10-20K and is 21st-century technology. Energy content is measured using a gas chromatograph. Gas chromatographs are 1950’s-era technology: they are big, complicated, expensive ($250,000 each), maintenance-intensive, and take 30-45 minutes to generate a reading.
Based on decades of research and protected by dozens of patents, the GasPT2 unit measures the gas’s physical properties to infer its quality characteristics, including its energy content, via a proprietary algorithm. GasPT2 units have considerable advantages over gas chromatographs. Unlike gas chromatographs, which are lab instruments adapted for field use, GasPT2 units are industrial metering devices purpose-built for field applications. They are one-fifth the price ($55,000 per unit), have minimal ongoing maintenance costs, and produce readings every three seconds. In short, GasPT2 units are 21st-century technology.
After extensive testing, the British regulator OFGEM – often considered the world’s toughest regulator – certified GasPT2 in the UK. Other regulators/utilities have followed suit. Utilities are conservative by nature, and after years of testing orders are finally arriving (approx. 50 units have been sold so far this year). However, if CUI is able to secure one or two large orders from established players, we believe adoption could quickly snowball.
Should the technology connect, the total addressable market is almost unimaginably large. There are hundreds or thousands of customer access points along the pipelines of most developed country natural gas grids. Operational gas turbines number more than 50,000. In theory, a stripped-down version could even be used in well-head applications. We think the market opportunity is potentially in the hundreds of thousands of units.
Our investment thesis is that as the company reports its first “clean” quarters with Orbital and as its product launches gain traction, CUI’s share price will re-rate to reflect its substantial underlying value.
To value CUI, we first break down the company by business unit.
• CUI, Inc. CUI’s electronic components division is a steady, cash-flow generative business. We project the division will generate forward revenues of $50M with an EBITDA margin of 13-14% and free cash flow of $4.5M. Over the next 2-3 years, we expect top-line growth to accelerate from the single-digits to 15% per annum as a result of a new distribution agreement signed in February 2013 with Future Electronics (a top-10 global electronics distributor). The agreement complements CUI’s existing affiliation with Digi-Key (another top-10 global electronics distributor), a relationship that accounts for nearly half of CUI’s sales while reaching some 57,000 end-customers each year. Publicly-traded electronics businesses such as Amphenol Corp. (NYSE: APH), XP Power Ltd. (LSE: XPP), Molex Inc. (NASDAQ: MOLX), and ABB Ltd. (STO: ABBN) generally trade at 15-20x earnings.
• Orbital. In 2012, Orbital posted revenues of £14M and net profit of £1.8M. However, CUI has publicly disclosed that Orbital’s owner, Andy Clews, received an annual salary of £2M despite having little to do with the business the last few years. Adding back the tax-effected salary takes trailing profits to £3.5M (putting the purchase price at 4x trailing earnings). For 2013, we forecast revenues of £15-16M, in-line with Orbital’s historic double-digit top-line growth rate, and net profit approaching £4M. Asset-light/engineering-intensive peers generally trade at 15-20x earnings.
CUI has 20.5M shares outstanding. We project free cash flow of $4.5M from the electronics components business and $6M from Orbital, for a total of $10M+ of free cash flow (or $0.50 per share). Using a market multiple of 15x earnings, we believe CUI’s base businesses are worth approximately $7.50 per share. CUI’s cash balance adds another $1.00+ per share in value. Finally, CUI has substantial net operating loss carry-forwards in the US that can be used to offset future cash taxes. Adding it all together, we think CUI’s base business plus its balance sheet are worth about $9.00 per share, or roughly 70% more than where CUI shares currently trade.
In addition, we believe substantial value exists in CUI’s GasPT2 business. By our math, every one hundred GasPT2 units sold translates into roughly $0.10 in earnings per share to CUI (i.e., about $1.50 in per share value). Based on conversations with suppliers, distributors, and the company itself, we believe CUI is ramping up to eventually sell thousands of GasPT2 units per year. The magnitude of the near-term opportunity is worth highlighting: the GasPT2 device is currently being vetted by some of the world’s largest utilities, and GE is testing the product to potentially be designed into its line of gas turbines (GE’s installed turbine base numbers 7,000+). Should GasPT2 connect and 1,000+ units be sold each year, the upside is 5-10x today’s share price.
Our valuation also does not account for the potential value of the Novum line of advanced power modules in the electronic components business. Novum is on the leading edge of the technology switch from analog to digital in power supplies. While it’s difficult for us to quantify, CUI thinks the Novum line could be a $100M+ opportunity.
To sum up, we think trailing financials obscure CUI’s position as a net cash business trading at a double-digit free cash flow yield with substantial growth opportunities in front of it. In our view, this makes for an attractive and asymmetric risk/reward profile.
Turning to risks, the primary uncertainty in our investment thesis is the adoption of the GasPT2 unit. While we believe the GasPT2 unit is superior to the gas chromatograph for most field applications and that its technology is years ahead of any potential competitor, should (i) utilities decide not to adopt the technology or (ii) a superior technology emerge, our thesis could prove incorrect. Second, while we have extensively vetted CUI (we have visited CUI’s operations in both Oregon and the UK), a company inflecting from loss to profit inherently brings with it a higher degree of uncertainty with respect to the business’s true underlying earnings power.
Finally, unlike many of the companies we invest in, CUI does not have a CEO who has “been there before.” Bill is whip-smart and drives the business forward at 110MPH, but he’s made mistakes in the past – including overpromising on the timeline for GasPT2 adoption – and his perception among investors is mixed due to his colorful personality and concern he may stray into empire-building. We think Bill understands that the line between a good CEO and a great CEO is determined by his or her ability to execute. Should he deliver, we believe Bill has the potential to make that leap.
The author of this posting and related persons or entities (“Author”) currently holds a long position in this security. Author may buy additional shares, or sell some or all of Author’s shares, at any time. Author has no obligation to inform anyone of any changes to Author’s view of CUI US. Please consult your financial, legal, and/or tax advisors before making any investment decisions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in CUI US. READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE. As with all investments, caveat emptor.
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