|Shares Out. (in M):||12||P/E||n/a||35.0x|
|Market Cap (in $M):||21||P/FCF||n/a||22.0x|
|Net Debt (in $M):||-23||EBIT||-1||1|
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Qualstar Corporation (QBAK) is unique in the current market environment; it trades for approximately its net-net cash position of $1.71 per share and significantly below its net current assets (conservative liquidation value) of about $2.36 per share. At this valuation the market is emphatically stating that the "company is better off dead than alive." But, if the market is correct, as we Efficient Market Theorist believe faithfully, why is the CEO consistently buying the shares? Its CEO, Bill Gervais, expresses great optimism in the prospects for the business and most importantly has consistently put his money where his mouth is. For example, he has bought almost 40,000 shares in the past month bringing his holdings to 3.1 million shares or over 25% of shares outstanding. Is the CEO irrational or, perhaps sacrilegiously, can we suggest that the market is inefficient?
Qualstar, we believe, is the company the market forgot. As we have witnessed the powerful small cap recovery from the depths of the 2008 Great Recession, Qualstar shares have simply been ignored and have languished around current levels. Revenues stagnated after the recession to about $4 million per quarter, down from about $5 to $6 million per quarter prior to the recession. Why haven't revenues recovered? The simple answer is that the company is in the middle of a product cycle transition and the current revenue stagnation is not reflective of the fundamentals of the business. We conjecture that as legacy products have entered the end of their natural product cycles, sales have rapidly declined. In contrast, the new product ramp ups have developed more slowly as they have experienced an extended sales cycle. Thus, the decrease in legacy product sales has not been fully offset by the increase in new product sales. Let's dig in to the company's products to see if this is a reasonable hypothesis.
Qualstar is in two main businesses: the design, development, manufacture and sale of tape drive libraries and high efficiency open-frame switching power supplies. Tape libraries are extremely familiar to all of us and remarkably, even with the great advances in disk technology, remain the most efficient and inexpensive medium for data storage for many applications. Tape libraries are used to store, retrieve and manage electronic data primarily in network computing environments. They consist of cartridge tape drives, tape cartridges and the mechanical automation and software needed to move the cartridges from their storage locations to the tape drives. These tape library units provide data storage solutions for organizations requiring backup, recovery and archival storage of critical data. These libraries are customized and sold worldwide, primarily to value added resellers. These customers typically integrate Qualstar's tape libraries with software from third party vendors and related hardware such as servers and network components to provide complete storage solutions, which are then sold to end users. Revenues from the tape library segment represented approximately 57% of revenues for the first nine months of fiscal 2011, 62% of revenues for fiscal 2010, and 69% of revenues for fiscal 2009.
The company's second major product line, the growth driver and jewel of the company's portfolio, is the design, development, manufacture and sale of high efficiency open-frame switching power supplies. Qualstar's power supplies are used to convert common alternating current (AC) line voltages found in buildings to direct current (DC) voltages that are needed internally to operate most electronic equipment. The company entered the power supply business in 2002, when it purchased the assets of N2Power, Incorporated. Power supplies provided by the N2Power division are utilized within some of Qualstar's tape library products as well as sold to original equipment manufacturers and contract manufacturers for incorporation into their products. Revenues from the power supply segment represented approximately 43% of revenues for the first nine months of fiscal 2011, 38% of revenues for fiscal 2010, and 31% of revenues for fiscal 2009. Clearly the power supply business is becoming a much bigger proportion of the company's revenues.
Is the tape data storage business a dying business? First, one has to live deep in Siberia not to recognize the astronomical explosion in the volume of data that has occurred over the past decade and will continue to grow in the future with the growth of the internet. Unambiguously, these data must be stored, but why use archaic tape? Isn't disk technology so advanced that tape will soon be obsolete?
Let me quote from the company's 10-K to get an authoritative and accurate resolution to the above question: "Current non-volatile storage solutions are based primarily on two technologies: magnetic disk and magnetic tape. These technologies represent a compromise among a variety of competing factors including capacity, cost, speed, portability and data reliability. Magnetic tapes are removable, which allows them to be transported easily to an off-site location for security or protection from physical harm. Magnetic disks provide faster access to stored data and generally are used when speed is important. Less frequently used data is often migrated from magnetic disks to tape storage. Tape libraries provide an online solution, where less frequently used data files are stored on tape at substantially lower cost compared to disk while still providing automated access. (Data stored on tape requires considerably less electrical energy as compared to data stored on rotating disks. As energy costs increase, it's clear that electrical efficiency will become a more important factor in the selection of storage methods.)" So, clearly tape libraries continue to serve an important part of the storage market and will continue to grow as the volume of data required to be stored grows.
In addition to tape libraries, Qualstar designs and sells high efficiency, open frame switching power supplies. Again, the company's 10-K does an excellent job of describing this business. "These power supplies are used to convert AC line voltage to DC as well as DC to DC for use in a wide variety of electronic equipment such as telecommunications equipment, servers, routers, switches, lighting and gaming devices. Qualstar's power supplies are sold under the N2Power brand. The company has specialized in units that are less than 1.5 inches high and that are optimized for high efficiency operation. The high efficiency allows the units to be operated in confined spaces without over-heating. These products are manufactured for the company in China and sold to original equipment manufacturers (OEM) and contract manufacturers as well as to distributors. The Company believes that as worldwide energy concerns and energy costs rise, their high efficiency approach will become more important. Additionally, these power supplies are utilized within some of the company's tape library products. The company has developed a line of power supply products that deliver up to twice the power in half the space relative to competitors' products. Manufacturers of servers, routers, switches, telecom gear, and other process-based equipment continuously pursue smaller, more powerful, and more efficient power sources for their equipment to remain competitive. Additionally, new lighting devices are coming to market that are sealed because they are used outdoors. Sealed units require high efficiency power supplies to help reduce the detrimental effects of internal heat buildup."
Revenue (In Thousands of Dollars)
2011 (9 Mo's) 2010 2009
Tape Libraries 7,806 9,487 12,341
Power Supplies 5,789 5,783 5,551
Total 13,595 15,270 17,892
Tape Libraries (1,250) (3,219) (2,636)
Power Supplies 607 98 80
Total (643) (3,121) (2,536)
As described above, in the tape product the company is experiencing a transition from their legacy product line to their significantly more efficient and improved XLS product line. It simply takes time for the company's OEM's to design the new product into their lines and begin production. The decline in tape library revenues during the period was due primarily to lower sales of the legacy tape library products in the TLS and RLS product lines, partially offset by increased revenues from the XLS product line, in conjunction with decreased sales of tape media and miscellaneous products. The company expects sales from the XLS product line to increase in fiscal 2011 and beyond as this new generation of the tape library product gains market acceptance. The power supply business is expected to continue to grow as the company takes advantage of its significant competitive advantages. In fact, the company expects the power supply business to generate $7 to $8 million in sales in fiscal 2011, substantially greater than the $5.8 million in 2010.
Third quarter (March 31, 2011) results came in within management expectations. Revenues increased 6% from last year's comparable quarter and 3% from the previous quarter. Weaker tape sales were offset by strong power supply sales. Tape library revenues were $2.0 million versus $2.1 million last year and $2.6 million during the previous quarter. XLS library sales were strong in the first half, but moderated in the second half. The company believes this is a temporary slowdown in XLS sales. Power supply sales came in at $2.2 million, an 18% increase from the prior quarter and at an all-time record.
For the fourth quarter the company is forecasting $4 to $5 million in sales with a gross margin of 32% to 36% with continued strength in the N2Power business. In fact the company is projecting $10 to $11 million in N2Power sales in 2012.
How about profitability? For the quarter the company lost about $.5 million, marginally lower than last year, but never the less a loss. The key to profitability, management believes, will be growth in sales. In the second quarter of fiscal 2011 the company was profitable with strong XLS sales and a gross margin of over 40%. Realistically, we should expect gross margins to be more moderate, probably in the mid-thirties. At this level we should expect operations to be profitable at about $6 million in quarterly sales. We expect this to be achievable by the end of fiscal 2012 with the continued strong growth in N2Power sales and moderate contribution from XLS sales.
The company's balance sheet remains pristine with $23.2 million of cash ($1.89 per share), almost $21 million of cash net of all liabilities ($1.71 per share), $29 million of net current assets ($2.36 per share), a current ratio of almost 14 to 1 and absolutely no debt.
Management appears to be very shareholder friendly with their focus on building shareholder value and not "lining their own pockets." Bill Gervais, the CEO, owns about 26% of the outstanding shares and has been a consistent open-market buyer of shares over the past year. His base salary was $157,500 in fiscal 2011, a ten percent reduction from 2010. Just in case you thought he was paying himself with undervalued options, his total compensation for 2010 was $161,300. His reward will be derived from growing the business to profitability and increasing the value of the shares and not from his low salary.
I am always impressed with the detailed and meticulous valuation analyses prepared by my colleagues. Enamored with the beauty of simplicity, I try to focus on less intricate opportunities. What is a fair valuation for QBAK shares? Clearly, it's irrefutably greater than the $1.71 per share net-net cash position. How about the receivables and inventory? They probably have some value. Can we argue that the company is worth more than its net current asset value of $2.36 per share? Probably, if you believe the losses will end or will remain under control.
How about the two operating businesses? Are they both worthless? Clearly the N2Power business is profitable, growing rapidly and would have definite value to an external buyer. With about $10.5 million of power sales expected next year and with twenty percent annual growth, is it a stretch to say that someone would pay $10 million or one times sales for this business ($.80 per share)? We certainly do not think so! The storage business is a different story. It has some value but it is losing money and some faith is required to conclude that XLS sales will continue to grow. Let's be unreasonably conservative and completely discount my attempt to demonstrate that this business has value. Let's assume that the storage business is worthless!
So let's add up the pieces. Add net current assets per share of $2.36, $.80 per share for the power business and zero for the storage business. This gives a sum of $3.16 per share, 83% greater than the current share price. Wait, you may argue that the receivables and inventories should be excluded. What's the value using the sum of net-net cash of $1.71 and $.80 for the N2 power business? That's $2.51 per share and still 45% above the current share price. You pick your scenario, but the conclusion is unambiguous these shares are cheap and the market is inefficient!
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