Description
At the risk of being typecast as a "pinksheet specialist", I'm following my first VIC write-up on HLSH.PK with another compelling pink sheet opportunity- CLRO.PK. I tend to steer well clear of pink sheet stocks, except in those rare cases in which I feel the value is too compelling to ignore. As with HLSH.PK, I believe such is the case with CLRO. And the catalysts for CLRO are right around the corner.
ClearOne is a communications solutions company that provides audio, video and web conferencing products for organizations of all sizes. The company also used to have a conferencing services division prior to a sale of this segment a few months ago (more on that later).
CLRO was listed on the Nasdaq before the SEC brought a lawsuit against the company in January 2003 for some “alleged” funny business in the books (mainly related to revenue recognition and product channel stuffing). As a result, trading on the naz was halted early in 2003 and the company has been in recovery mode ever since. I read the SEC suit when it was first announced and the problems certainly didn't appear serious enough to justify the stock selling off as it did (to roughly $.60 when it first hit the pink sheets, after trading in the teens just a year earlier). Mainly, the SEC was after the company for product channel stuffing, and the amounts in question seemed immaterial. Then, low and behold, in early 2004 the SEC settled with CLRO for ZERO in penalties and at the same time the company quickly settled the resulting shareholder class action suit for a small cash payment of $5 million and a disbursement of 1.2 million shares. Half of the cash payment has been made and the other half will be paid in January 2005. I believe they may have been able to settle the shareholder class action for much less. However, they likely just wanted to get the ordeal behind them in a timely fashion.
Considering that the SEC settled for no penalty, that the amounts in question seemed immaterial, and the bullishness of executives in interviews during 2004, I believe that any adjustments to previously filed financials will be minimal and that the company is likely operating in a very successful environment today, as they have in the past. Should you want to really dig into the details of the SEC’s suit, please see the case at:
http://www.sec.gov/litigation/complaints/comp17934.htm
I’m not so bold as to say that there was absolutely no funny business involved, especially since in early 2004 the SEC did levy some small personal civil penalties against former executives Flood and Strohm:
http://www.sec.gov/litigation/litreleases/lr18592.htm
I imagine that there were ultimately some small write-offs to accounts receivable either because of aggressive channel pushing or aggressive sales to less than totally credit worthy companies like MCSI. However, considering amounts involved, I think a charge of no more than $5 million to A/R is warranted to clean the balance sheet.
While we have not seen financial statements since the end of 2002, all circumstantial evidence suggests that the company has been growing product revenues and is currently trading at a small multiple to earnings and free cash flow. Current financials are expected to be released by the end of September (assuming they meet the timetable set forth a few months ago).
Here are some highlights of the last few reported fiscal years (ending June 30th):
* Revenues (in millions):
2002 - $54.5
2001 - $39.9
2000 - $28.1
* Gross margins ranged from 57.8% to 60.8% each year. It’s good to know that, while some product mixes and divisional revenue contributions were changing over this span, margins remained similar.
Excluding one time charges, this company has never lost money on a GAAP basis in any publicly released quarterly report in the last 4 years.
* Diluted EPS
2002 - $0.74
2001 - $0.61
2000 - $0.49
* Free cash flow, excluding working capital changes (I believe working capital changes are irrelevant in a proper FCF analysis):
2002 - $7.3 million (or $.65 per share)
2001 - $6.5 million
2000 - $4.9 million
As for the balance sheet, it was extremely strong in 2002 and is even stronger today as the company is and always has been basically debt free. The company divested its conferencing services division a few months ago, and netted a nice sum of roughly $20 million in the sale. I applauded the sale of this business, as competition in conferencing services is becoming stifling and the company can now focus exclusively on its core competency of quality audio and video products. CLRO's services revenue was around $17 million in the fiscal year 2002, and this part of the business did $15.6 million in calendar year 2003 according to the PR when the sale was announced. So sales in this division appear to be flat at best. It appears that they kept the growing part of the business and dumped the flat part of the business. $20 million sounds fair, and now CLRO boasts an even stronger balance sheet and more attractive enterprise value.
As for book value, total shareholder equity as of 9-30-02 was just north of $70 million, or $6.27 per share as of that date. Tangible book (a more relative figure), while about $3.23 per share back in 2002, is likely substantially higher today after the sale of the conferencing services division. As a guesstimate, let’s say there are $10 million in cash and non-cash charges relating to the shareholder class action settlement, $5 million in A/R and other write-offs, add $20 million in cash from the sale, and add roughly $10 million in income from fiscal 2003 and 2004 (EPS of around $.50 per year). Considering the fair sales price received for the conferencing services division and that the products division has likely been consistently profitable, I believe that there will not only be no write-offs of intangible assets in the last couple of years, but that there will also be a small gain on sale of the services division. So I’m going on the assumption that CLRO has a book value today of around $5.66 per share and a tangible book value of roughly $4.13 per share.
Now back in September 2002 (the most recent available financial statement date), CLRO had $5 million in cash and no debt. And I believe they have been generating profits and cash since then. Let's add at least another $5 million in cash from free cash flow in the last 2 years (this is likely a very conservative estimate). Adding the $20 million received for the conferencing services division and subtracting the $2.5 million already paid out in the shareholder settlement, we have a company that is likely sitting on at least $27.5 million in cash today (or $2.22 per share in cash, based on 12.4 million shares outstanding).
The average forward industry PE in the communications equipment sector is over 30. Considering that this company made $.74 per share in 2002, it seems reasonable to assume at least $.50 EPS for fiscal 2004 (excluding one-time charges, and assuming no share buyback). Applying a more conservative multiple of 15 gives us a fair value of $7.50.
However, a more aggressive multiple is probably appropriate, especially if CLRO's top line AND bottom line growth are as impressive as I suspect. Encouragingly, PLCM- CLRO's main publicly traded competitor- reported year-over-year revenue growth of 35% last quarter, and is expected to show year-over-year earnings growth of 32% from 2004 to 2005. And here are some comments made by CLRO's former CEO Mike Keough in an interview from April 2004, which suggest that CLRO's growth has been, and will continue to be, strong:
< During my year and a half with the company I've seen significant growth in the industry. We've seen a nice ramp in our product opportunities and sales>
< A year and a half ago, only about 10% of our business was international. Today, it's over 30% and I hope it gets closer to 50%. There are really opportunities around the globe for us. At the end of the day, there's a lot of strength in terms of the people we have here, the markets we serve, the markets we are starting to serve that we didn't serve historically, and just a lot of places to take our technology as we go forward.>
< Right now our business operations are going well. We're not looking to raise additional capital, we're not looking to borrow additional capital and we're not looking to put out additional stock>
< I came to ClearOne right before a lot of the issues broke with the SEC. It was pretty clear to me, number one, that conferencing was absolutely going to be a growth market for the next five to seven years, plus. It is absolutely a compelling technology and it's a driver now inside the business world.>
< So if you believe that we've done it in the past and you think we can do it again, or that the things that we have announced in press releases are heading us in the right direction, those are a few reasons why someone might invest in us right now.>
< I think there's going to be a lot more to talk about once we are fully reporting again. We have put as much information out as we can in terms of press releases about the new management team, new channels, new products, new focus on the company and businesses that we have exited. I think that a lot of the feedback that we have received says that we are painting a pretty positive picture of the direction of the company. When the other information comes out and we can talk about how we're performing, I think that will be more fuel for the fire.>
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Finally, if one was to assume a conservative rate of sales growth of just 10% for the products division, this would lead to a current annual run rate for the products division of about $45 million in annual sales for the year ended 6-30-04 and about $49.5 million in expected product sales for fiscal 2005. Not bad for a little company with an enterprise value of only $25 million as of 9-20-04.
So today we have a company with the following estimated ratios:
EV to Revenue = 0.56
EV to Free Cash flow = 4.2 (using target of $6 million annual FCF, which may well prove to be conservative)
Enterprise valuations are probably most appropriate here considering that CLRO should now have enough cash to easily buy back nearly one third of its outstanding shares at today’s price. The company has told me that insiders are not allowed to buy stock until the release of financials, and the same probably goes for any company stock repurchase plan the BOD might approve at some point in the future.
Financials are supposed to be released and brought up to date by the end of this month (which should be a positive catalyst for the stock price). After financials are released, I expect the company to apply for a new listing on the Nasdaq. With financials to be released soon, Nasdaq relisting, solid growth prospects and the opportunity to put their large cash horde to work buying back shares or expanding the business, I believe that there is compelling value here. On the surface, this may just be a risky pink sheet stock to most and it has been left for dead after being on the pinks for nearly a year and a half, but the risk/reward proposition CLRO offers seems too good to pass up at these levels, considering the solid balance sheet and the upcoming catalysts (summarized below). A return from the pink sheet graves seems to be “in the cards”, and with it a likely gain of at least 50% to 100% for the stock in a relatively short time period. This target appreciation might even prove to be conservative, considering that CLRO has already traded slightly above $8 earlier in 2004 even without these catalysts on the immediate horizon.
Catalyst
1) Filing of financials.
2) Relisting on the Nasdaq this year, resulting in vastly increased exposure for the company (CLRO is currently very much under-the-radar, typically trading only about 20,000 shares per day over the last several months). The company appears to already be qualified for the Nasdaq SC market and will likely qualify for the Nasdaq NM after the release of financials and the stock price exceeds $5.
3) Valuation- Everything we know points toward the company currently earning at least $.50 per share annually in free cash flow, excluding extraordinary charges. Considering that the company earned over $.50 free cash flow per share in both 2001 and 2002 and the numerous bullish comments made by management regarding the company's business since that time, it is hard for me to envision ClearOne earning less than $.40 per share in free cash flow on a normalized basis. And that would be before any buyback, which seems very likely given their enormous cash horde. Even in this worst case scenario, a conservative multiple of 15 yields a fair value of $6.
4) Putting the cash stockpile to work. Assuming a share price of $6, it would seem that the company could easily afford to buy back 3 million shares. That would reduce the O/S to 9.4 million, and produce roughly a 25% increase in EPS. Alternatively, the company could use its cash horde to aggressively grow the business. Either way, technology companies with a forward PE below 15, roughly half of their market cap in cash, no debt, and trading below book value are difficult to find. That's exactly what I expect the market to see once CLRO files its financials, and the ensuing price appreciation should be impressive.