Relm Wireless RWC
September 07, 2007 - 12:01pm EST by
vandelay278
2007 2008
Price: 4.55 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 63 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Thesis

 

RELM Wireless Corporation (Ticker: RWC) represents a compelling and asymmetrical risk / reward opportunity.  The stock is currently trading at approximately $4.55.  We think that the stock could be a double or more in a year or two with limited downside.

 

Company Description (mostly from the latest 10-K)

 

The company designs, manufactures and markets wireless communications products consisting of two-way land mobile radios (LMR), repeaters, base stations, and related components and subsystems.  Land mobile radios are basically very high tech / high power walkie-talkies.  Two-way land mobile radios can be units that are hand-held (portable) or installed in vehicles (mobile). Repeaters expand the range of two-way land mobile radios, enabling them to operate over a wider area. Base station components and subsystems are installed at radio transmitter sites to improve performance by enhancing the signal and reducing or eliminating signal interference and enabling the use of one antenna for both transmission and reception.  The company’s manufacturing operation is limited to the assembly of components that are sourced from Asia and thus capex requirements are minimal.  The company’s largest customer is the US Government at approximately 50% of total sales.

 
The Opportunity

 
The upside opportunity here lies in the migration from analog LMR to digital LMR and specifically APCO Project 25, or simply P25, compliant digital LMR.  Up until the mid-1990s, LMR systems were based around APCO 16; an analog standard which was established in 1979.  APCO 16 permitted the development of proprietary LMR systems which resulted not only in severely reduced interoperability as one manufacturer’s system would not communicate with another manufacturer’s system, but also effectively eliminated competition and market choice by requiring additional infrastructure (base stations, repeaters, etc…) and subscriber units (handsets) to be purchased from the same manufacturer of the original system.  This is how Motorola became the 800-pound gorilla in the LMR market.  In addition, as a result of these systems being analog-based, available spectrum was disappearing rapidly.  In 1989, APCO established Project 25 to develop a new set of common standards for LMR systems to address some of the shortcomings of APCO 16.  In August of 1995, the final documents establishing the APCO 25 standard were approved.  The new standard provided a migration path to digital (and thus spectrum efficient) technologies and also required that P25-compliant systems be interoperable.  Adoption of the new standard was slow until the 9/11 attacks which not only spurred a renewed sense of urgency to solve the problems of interoperability but also resulted in the formation of the Department of Homeland Security (DHS) which now effectively mandates that DHS communications equipment grants allocated to its sub-agencies be used to purchase only P25-compatible equipment unless there are compelling reasons why P25 standards should not be followed.  In addition, both the Department of the Interior (DOI) and the Department of Agriculture (USDA) have adopted the P25 standard which effectively mandates that all of their sub-agencies purchase P25 equipment in most cases.  While P25 adoption has accelerated over the last few years there is still a massive installed base of analog radios that will eventually have to be converted to digital.  Given that the P25 standard requires interoperability, purchasers can now choose to use one manufacturer’s handsets with another’s infrastructure thereby significantly weakening Motorola’s stranglehold on the market and thus providing RWC, whose P25 radios are priced at approximately $1,150 for the DPH model and $1,500 for the next generation KNG model versus $2,500-$5,000 for Motorola’s, with a much more level playing field.

 

Why will LMR Users Convert from Analog to Digital

 

We think that conversion to digital will continue to accelerate over the coming years for a few reasons:

 

1)      Funding.  For the most part, if a Federal or State, local or tribal agency wants to use Federal funds to purchase LMR equipment, the equipment, in most cases, must be P25 compliant.  Federal “cabinet-level” agencies such as the Department of Homeland Security and the Department of the Interior effectively mandate that their sub-agencies purchase P25 radios.  Federal communications-related funding for State, local, and tribal public safety agencies must be used for P25 compliant equipment unless compelling reasons for not using such equipment exist.  It is clear that spectrum efficient interoperable communications is the direction that the Federal Government wants to go and that means P25 LMR for the most part.

2)      Spectral Efficiency.  In the interest of conserving scarce spectrum, the FCC has mandated that all private LMR systems (which includes State, local and tribal LMR systems) migrate to 12.5 kHz channels from 25 kHz by Jan 1, 2013 (no new 25 kHz applications after Jan 1, 2011) and the NTIA (a sub-agency of the Dept. of Commerce that manages the Federal government’s use of spectrum) has mandated that all Federal agencies migrate to 12.5 kHz channels by Jan 1, 2008.  While this doesn’t require the use of digital equipment, most analog equipment already in the field operates with 25 kHz channel bands.  This equipment will eventually have to be upgraded at which point the user will have to decide whether they want an analog 12.5 kHz solution or a digital one.  Given that most Federal funding is being allocated to P25 digital purchases and that the general direction is towards digital, we feel that P25 will have the edge.  In addition, the 12.5 kHz channel band requirement is only phase 1 of the FCC narrowband requirement.  Phase 2 requirements are for 6.25 kHz channel bands which will all but require digital radios.

3)      The 700 MHz Reallocation.  The upcoming 700 MHz spectrum reallocation from TV broadcasters (which must vacate the spectrum by Feb 17, 2009) to public safety agencies will likely create new demand for LMR that operates in the new public safety bands.  In addition, $1.0 billion of the estimated $10.0 billion in spectrum auction proceeds (auctions scheduled to commence in Jan 2008) will be used to fund a grant programs for interoperable communications for state, local and tribal public safety agencies.  While RWC does not currently have a 700 MHz product, they will be starting development of one next year and expect to have a product in the market by 2009 to coincide with the reallocation.

4)      Integrated Wireless Network (IWN).  IWN is the joint effort of the DOJ, DHS and Treasury Department to provide a secure and interoperable wireless communications network using the P25 standard at a total program projected cost of $5.0-$10.0 billion.  While IWN represents a significant potential opportunity for RWC, the Office of the Inspector General (OIG) recently concluded in a March 2007 audit of the program that it is at a "high risk of failure" for various reasons including disparate departmental funding mechanisms as well as apparent fracturing of the partnership.  Our view is regardless of whether or not IWN moves forward as a joint program or as a collection of individual agency programs, the need to upgrade systems still exists and thus opportunity is still there.  For example, according to the OIG, 73% of the DOJs 4,163 radio system sites are so old they are no longer supported by the manufacturer.  The reason this is still the case is simply because the DOJ was planning to upgrade its system based on IWN which hasn’t moved forward and thus the DOJ’s upgrade has been delayed.  Well, the bottom line is that the DOJ must upgrade its system one way or another and if IWN doesn’t happen then the DOJ will develop their own wireless network.

5)      Aging Installed Base.  If the example regarding the DOJ given above is any indication, the current installed base of analog radios being used by public safety agencies across the United States is aging which means that the current LMR installed based will have to be replaced at some point in the near future.  Given the limitations on funding and the FCC / NTIA’s narrowbanding requirements, we feel that upgrading to P25 compliant digital radios is only a matter of time.

 
Why RWC?

 

With the preceding as a backdrop, we see RWC as a cheap call option on the migration from analog LMR to digital P25 LMR.  The current size of the global LMR market is $8.0 billion.  According to management, the company’s current addressable market is approximately $2.0 billion.  At approximately $32 million in sales, RWC’s current market share is only about 0.4% of the global market and 1.6% of its addressable market.  Management’s goal is to have 10% of the global market in ten years.  While that would be fantastic, it is probably a bit optimistic.  However, a goal of 10% of the $2.0 billion addressable market is not out of the question.  Regardless, for the stock to work as well as we think it will, RWC only needs to capture a fraction of management’s market share goal primarily because the gross margins on their digital products range from 70%-75% for their current digital product line and even higher for their new digital product which will be released over the next few months (versus current company gross margins of 50%-55%) and that is where we believe the bulk of the growth in RWC’s top line will come from over the next few years.  RWC’s digital gross margins are so high because the company uses the same core (which is contract manufactured in China using fairly common components) for both its high-spec analog and digital radios but charges twice as much for the digital version.  The primary difference between a high-spec analog and a digital radio lies in the software and in the vocoder which is basically the digital circuit board that converts analog signals to digital.  In addition to the favorable impact from digital gross margins, as top line grows there will be SG&A expense leverage as well as the product development and sales teams have, for the most part, already been built out and G&A should grow slightly from 2006 levels.  The only true variable component of SG&A is commissions expense which averages 6.2% for manufacturers reps and ranges from 0-3% for internal salespeople and to a much lesser extent selling expense which we have growing at a CAGR of 13.5% over the next few years.  In 2006, RWC had total sales of $32.4 million.  Approximately 50% of sales were from analog products, at 35% gross margins, and 50% were from digital products, at 73% gross margins, (we think 2007 sales will likely be comparable to 2006 both in total amount and composition).  Assuming analog sales stay flat while total sales increases $8mln per year from 2007 to 2009 for total top line growth of 50% to $48.5 million from 2007 to 2009 (which represents a top line CAGR of only 14.3% from 2006 to 2009 versus an 18% CAGR from 2003 to 2006) we project that fully-taxed earnings could more than double from $0.26 (2007 estimate) to $0.68.  That means that if RWC goes from only 1.6% of their current addressable market to a still meager 2.4% market share (0.4% of the global market to 0.6%), which is only an additional $16mln of sales over the next two years, fully-taxed earnings could more than double.  The stock is currently trading at 17.5x our $0.26 estimate for 2007.  If you simply apply this PE to our $0.68 2009 estimate, the stock should be trading at $12.44 in a year; a return of 173%.  We think that a multiple in the mid-20s range is much more appropriate for this sort of estimated growth given that we expect similar growth beyond 2009 and also factoring in the lumpiness of sales as an offset.  A 25 PE would put the stock at $17 in a year.

 

If our top line growth estimates are proven wrong, then we see very limited downside.  RWC is currently trading at about $4.55 per share.  The company currently has approximately $1.00 per share in net cash on the balance sheet.  Excluding this cash balance, the operating business is being valued by the market at about $3.55 per share.  Excluding interest income and the effects of changes in working capital, we think that the operating business will generate approximately $0.46 in free cash flow per share in 2007 (the company generated an amount slightly higher than this in 2006).  This is based on a flat top line of approximately $32.4 million, similar gross margin and marginally higher SG&A expenses.  In addition, please note that the company is not currently a tax payer as they have approximately $14mln of NOLs ($16mln as of year-end 2006).  The NOL’s should last through 2008 and for some portion of 2009 based on our assumptions for growth.  Based on these numbers, the market is currently valuing RWC’s operating business at 7.8x our estimate of free cash flow.  Another way to look at this is that the company’s cash balance will be approaching $1.50 per share by the end of 2007 which implies that the operating business will be trading at 6.7x (or a 14.8% free cash flow yield) assuming no growth in 2008 operating earnings.  Even taking a multiple of fully-taxed 2008 operating earnings (assuming no growth and excluding interest income) factoring in the present value of the NOL, the stock less estimated year-end 2007 net cash is trading at about 12.1x.  We think that such low multiples provide investors with a decent margin of safety and are based on conservative estimates which do not reflect the growth potential of this company.

 

 

 

 

 

 

Est 2007

Est 2008

Est 2009

Addressable Market

 

 

 

 $  2,000.0

 $  2,000.0

 $  2,000.0

RWC's Share of Addressable Market

 

1.6%

2.0%

2.4%

 

 

 

 

 

 

 

 

Analog Sales

 

 

 

 $      16.2

 $      16.2

 $      16.2

Digital Sales

 

 

 

 $      16.2

 $      24.2

 $      32.2

Total Sales

 

 

 

 $      32.4

 $      40.4

 $      48.4

  Total Sales Growth

 

 

 

--

24.7%

19.8%

 

 

 

 

 

 

 

 

COGS

 

 

 

 

 $      15.0

 $      17.1

 $      19.2

Gross Profit*

 

 

 

 $      17.5

 $      23.4

 $      29.2

  Gross Margin

 

 

 

53.9%

57.8%

60.3%

 

 

 

 

 

 

 

 

Total SG&A

 

 

 

 $      12.0

 $      13.2

 $      15.1

Operating Income

 

 

 

 $        5.4

 $      10.2

 $      14.1

 

 

 

 

 

 

 

 

Interest Income

 

 

 

 $        0.6

 $        0.8

 $        1.2

EBT

 

 

 

 

 $        6.0

 $      11.0

 $      15.3

 

 

 

 

 

 

 

 

Taxes

 

 

 

 

 $        2.4

 $        4.4

 $        5.8

  Tax Rate**

 

 

 

40.0%

40.0%

37.6%

 

 

 

 

 

 

 

 

Net Income

 

 

 

 $        3.6

 $        6.6

 $        9.6

FD Shares Out

 

 

 

      14.039

      14.039

      14.039

FD EPS

 

 

 

 

 $      0.26

 $      0.47

 $      0.68

 

 

 

 

 

 

 

 

Free Cash Flow Calc

 

 

 

 

 

 

Net Income

 

 

 

 $        3.6

 $        6.6

 $        9.6

Less Interest Income

 

 

 

 $       (0.6)

 $       (0.8)

 $       (1.2)

Plus Non-Cash Comp

 

 

 $        0.8

 $        0.8

 $        0.8

Plus D&A

 

 

 

 

 $        0.4

 $        0.4

 $        0.4

Plus Taxes Shielded with NOL

 

 

 $        2.4

 $        4.0

 $          -  

Less CapEx

 

 

 

 $       (0.2)

 $       (0.2)

 $       (0.2)

Operating FCF

 

 

 

 $        6.4

 $      10.8

 $        9.3

FD Shares Out

 

 

 

      14.039

      14.039

      14.039

Op FCF per Share (excl Int Inc)

 

 $      0.46

 $      0.77

 $      0.67

 

 

 

 

 

 

 

 

PV of Annual NOL Tax Shield***

 

 

 $        2.3

 $        3.8

 $          -  

Total PV of NOL Tax Shields

 

 

 $        6.1

 $        3.8

 

Total PV of NOL Tax Shields per FD Share

 

 $      0.43

 $      0.27

 

 

 

 

 

 

 

 

 

Multiple of Fully-Taxed 2008 EPS (Excl Int Inc)

 

 

 

Current Share Price

 

 

 

 $      4.55

 $      4.55

 

Less Est Beg of Year Net Cash per Share

 

 $     (0.95)

 $     (1.45)

 

Market Value of Operating Business

 

 $      3.60

 $      3.10

 

Less PV of NOL

 

 

 

 $     (0.43)

 $     (0.27)

 

Net Mkt Val of Operating Business less PV of NOL

 $      3.17

 $      2.83

 

Est EPS (excl Int Inc, assume no growth)

 

 $      0.23

 $      0.23

 

Multiple

 

 

 

 

         13.6

         12.1

 

 

 

 

 

 

 

 

 

*Analog GM 35%, Digital GM 73%

 

 

 

 

**Tax rate drops to 37.6% in '09 due to no AMT

 

 

 

***Year-End 2007 and 2008; discount rate 6%

 

 

 

Potential Near-Term Drivers of Top Line Growth

 

  • One of the company’s major competitors won an $80 million order from the army for P25 compliant radios last December.  RWC was competing for this order and lost it to this competitor.  Apparently, this competitor’s radios are failing at very high rates and are taking many weeks to repair.  This situation could provide RWC with an opportunity to grab a potential follow-on order that could result in as much as $30 million in sales.  According to the company, this follow-on order would be for analog radios which have gross margins in the 30-35% range.  Regardless of the lower gross margin potential of this order, earnings will still rise substantially because of the size of the order and the leveraging of SG&A expenses.  In addition, the company is attempting to attach another $30 million digital order to the above mentioned analog order which would have margins in the high 60% range (due to the discounts being offered in order to secure the order).
  • There are numerous other large potential orders that RWC is in the running for including a $10-$12 million Coast Guard order, a $15 million Customs and Border Patrol order, and a potential $8 million order from the National Interagency Fire Center.  These orders alone, which are all P25 (70%+ gross margin) business could double RWC’s revenue alone.
  • RWC has recently received some small “seed” orders from the TSA and the FBI which indicates that those agencies are testing the company’s products.
  • RWC is introducing a number of new products between now and 2009 including their next generation digital radio, the KNG or “King” radio.  We think that this radio could be a “game-changer” for RWC as it is the smallest and lightest Class A spec P25 compliant digital radio currently available.  The company plans to start selling the VHF version of this product later this year and the UHF version in 2008.  In addition, the company will be selling a trunking version of the King radio in both VHF and UHF in 2008 (trunking is a technology that uses available spectrum more efficiently).  Finally, the company will begin development in of its 700 / 800 MHz products in 2008 with a planned release in 2009.  This new line of products will give the company exposure to the 700 MHz reallocation as well as more metropolitan public safety agencies many of which use the 800 MHz band.
  • The UHF King radio mentioned above is not only important because of its small size and low weight but also because it will be RWC’s first P25 compliant UHF radio.  This is important because there are many Federal agencies that operate on UHF frequencies that RWC will now be able to sell P25 compliant product to including the DHS and the DoD which has been buying RWC’s analog UHF product but has been inquiring about the new P25 UHF product.
  • Potential orders from the myriad other federal, state, local and tribal public safety agencies across the US driven by the migration to P25 compliant products.
  • RWC recently hired two high-level sales executives from a major competitor.  These two executives were responsible for a large part of that competitor’s sales growth with the Department of Defense over the last few years.
  • RWC’s radios are priced well below the competition for similar if not better specs and thus represent an excellent value.  RWC’s P25 compliant radios are priced at approximately $1,150 versus $4,000 for a Motorola P25 radio with comparable specs.  EF Johnson, another competitor, prices its comparable radios in the $1,500-$1,800 range.  Ma/Com (a division of Tyco) is a competitor that focuses mainly on LMR infrastructure/systems so RWC doesn’t compete with them all that much.  In any event, Ma/Com’s P25 radios are priced in the $2,000-$2,200 range.  Finally, Icom and Kenwood, both Japanese competitors do price their radios in line with RWC’s however, their radios are not Class A spec and have reliability, quality and durability deficiencies relative to RWC’s product.
  • Since RWC assembles its radios in the US, they are considered “Made in the USA” which is important for federal government customers as well as many State, local and tribal customers.

Other Items

 

  • A stock buyback could be in the company’s near future.  While we are not always fans of stock buybacks, in this case it does make sense given the limited capital requirements of this business and the favorable industry dynamics.  The negative of a stock buyback will be the reduction in liquidity of an already illiquid stock.
  • The stock has very little sell-side coverage.

Issues / Risks

 
There are three primary issues with RWC.  First, the stock is fairly illiquid.  Second, the company’s sales are somewhat unpredictable and thus have the potential to be lumpy which causes earnings and the stock price to be volatile.  In other words, it is very difficult to predict with any accuracy the company’s earnings in any given quarter.  The third issue is that Congress hasn’t agreed on a 2007 budget which has meant that the government’s funding needs for the 2007 fiscal year were being met by continuing resolution which basically means that funding is at best frozen at the prior year’s level.  This has resulted in orders for new LMR being delayed.  Given that 2008 is an election year there is a good chance that the same thing will happen next year which could translate into a relatively flat top line for RWC.  While we view the budgetary situation as temporary, it could delay any meaningful rise in the company’s earnings for another year.

 

Catalysts

 

  • New orders for P25 radios.
  • Potential large order from the Army discussed above.
  • Improvement in earnings and free cash flow due to higher gross margins from switch to digital product and leveraging of SG&A.
  • Ability to start selling products to customers who were previously trapped into buying Motorola product due to previous infrastructure purchases.
  • Potential stock buyback.

Catalyst

• New orders for P25 radios.
• Potential large order from the Army discussed above.
• Improvement in earnings and free cash flow due to higher gross margins from switch to digital product and leveraging of SG&A.
• Ability to start selling products to customers who were previously trapped into buying Motorola product due to previous infrastructure purchases.
• Potential stock buyback.
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