Westell wstl
July 03, 2006 - 12:31am EST by
2006 2007
Price: 2.19 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 153 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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If a microcap value investor got a chance to name a Holy Day it would probably be June 30th, but of course we would want the market to be open on that holiday. And we would NOT take the day off.

June 30th of course is the day of Russell rebalancing. The market and Russell have gotten better at the rebalancing since 1998 and 1999 when it was really easy to take advantage of. But anytime an index is forced to buy and sell hundreds of illiquid stocks on the same day, something is going to wind up mispriced. It is an amazing testimonial to the efficiency of even microcaps today that there weren’t more $20 bills lying on the sidewalk last Friday - if you found a bunch of them you’re better at this than we are. We’ve found we can usually find one or two.

They’re easier to spot on July 1st than June 29th. The telltale sign is huge volume at the close on the 30th following a drop for unexplained reasons. Its usually not necessary to act June 30th unless you’re of the size where you need to get a big part of that closing print, but the window to act after that is days or weeks, not months. What is hard about doing this is that it really has to be a no-brainer because you don’t have a lot of time to do your homework when you find something in free fall on June 29th.

Westell traded almost 10% of shares outstanding after the close on Friday, and those last block trades were up from the price we were buying at all day. That volume looks like the exclamation mark ending a drop in the stock from 3 to 2 for what we judge to be technical selling, not fundamental selling. That technical selling ended on Friday.

2.19 back to 3 is almost 40%. WSTL was a lot higher than 3 not that long ago, and we are not convinced the drop from 4 to 3 made sense either. Later in this writeup we will suggest there might be a big catalyst to this business, though that was not why we bought it. For now we are just looking to take it from 2.07 to 3 on a “$20 bill found on the sidewalk” trade, but we can see how we could get greedier here as we learn more.

Valuation looks very attractive. The market cap is about $150 million. There is about $40 million of excess cash sitting on the balance sheet. Our estimate of last three years free cash flow is about $17 million per annum. The stock is trading at a low 3s multiple on trailing EV/EBITDA.

We do not claim to be experts on this business. For now it looks like just a very opportunistic trade, after spending most of the day Friday getting intimate with the 10-K as we were buying shares.

Westell is not a great business by any means, though they have made decent money the last few years and have a superb balance sheet. They sell DSL modems and related equipment almost exclusively to domestic RBOCs. Verizon is 50% of their business. It is pretty easy to see the risk here. If Verizon were to cut them off they don’t have a business. There are low cost Asian competitors and Cisco in their business. We don’t think that is why the stock is down though. We would not be buying this if it were down because of Verizon looking to cut them off.

The business has been quite profitable and it is run by grownups. They have a big NOL so they don’t pay taxes, though their earnings estimates are fully taxed. Cash flow is very strong.

What took the stock down from 4 to 3 in May was a reduction of earnings guidance because they are increasing R&D and sales and marketing expenditures. If you believe management, they are investing in new product launches to capitalize on VOIP and IP Television, and you can see these new product launches in their 10-K.

Their biggest customer has just spent a fortune digging up my neighborhood and probably yours too if you write a check to Verizon every month, so their optimism makes sense. Their biggest customer has invested many billions of dollars to grow in the space WSTL’s new products are targeted toward. We don’t know whether or not Verizon will continue with WSTL’s products in this new space – there are a lot of competitors. But there is clearly a pre-existing relationship here and management sounds pretty confident they’re going to grow with Verizon.

Once again, the disappointment that took the stock down from 4 to 3 was an earnings disappointment due to spending on future growth. And given who their customer is and that customer’s strategy, this could turn out to be good spending.

That is something we will reevaluate when the stock gets back to 3. Maybe at that point growth will be evident and we will see 4 or 5 or 6. Or maybe it won’t and we’ll take the easy money in the stock The reason we purchased a position is not because we love the business. It just looks oversold to a level where there is interesting low-risk upside, we think we know why, and that reason ended on Friday. We do like the kicker of optionality on something going right with their new investment though, which looks very well timed.

The stock is reasonably liquid for a $2 microcap.

Sometimes a cigar butt is just a cigar butt. Was that Freud or Graham? Did they know each other? For now this is just a cigar butt, but one with a 40 or 50% puff which was created by a visible market inefficiency. And we see some chance that this cigar butt is more than just a cigar butt.


Index selling pressure ends.
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