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(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

GSE Systems, Inc. (NYSEMKT:GVP) is a provider of engineering and training software to the energy industry. Heading into 2013, the company had a backlog of $51.9 million. Of that backlog, $36.2 million is expected to be converted into revenue during 2013.

Just over 40% of the company's revenues are denominated in currencies other than the U.S. dollar. Thus, a stronger dollar would weigh on revenue, operating income, net income and cash flow from operations (results from operations). The impact could be material in some cases. But I'm expecting the dollar to weaken as Europe emerges from recession.

The firm has strategic alliances with several firms including Samsung Electronics (OTC:SSNGY) and Westinghouse Electric Company. Its key competitors include Honeywell (NYSE:HON) and L-3 Communications (NYSE:LLL). For more than 40 years, the company has been developing next-generation, custom training simulation technologies. Since it built the first commercial full-scope nuclear power plant simulator in 1971, the company has completed more than 1,100 installations in 50 countries and has built more full-scope power plant simulators than all of its competitors combined. In 2012, approximately 70% of the company's revenue was generated from end users outside the United States.

As described later, the company is set to benefit from the increased use of nuclear power in several countries around the world. Also, the firm should benefit from the need to train new workers in the energy industry as a substantial portion of the current labor force is set to retire. Both of those reasons should provide a growth catalyst for a company that could increase 200%, based on valuations.

I arrive at 200% upside by using the 5-year average valuations, which are 3 times larger than the twelve trailing months valuations. The forecast financial performance should act as a tailwind for valuations.

Additionally, it seem as though this stock is undervalued because of the nuclear incident in Japan. Investors feared the worst: regulations would limit the use of nuclear power moving forward. That isn't the case. Instead, regulators have explored options to make the nuclear industry safer. GSE, through its simulation software, helps companies engineer safer nuclear power plants and train employees on safety procedures. Thus, GSE should see an increase in business as companies modify plants to meet new regulatory requirements.

In other words, investors feared regulators would throw the baby out with the bath water, but only the bath water went down the drain. Consequently, GSE should converge towards fair value.

From $1.59, the trailing stop loss would start in the $1.00 to $1.10 range. Fair value is at $4.77.

Risks

  • The company's valuation may not revert to its 5-year mean valuations.
  • The company competes in some areas with larger engineering firms that have competitive advantages.
  • The company may not benefit as much as expected from the increase in use of nuclear power plants.
  • The company may not benefit as much as expected from the need to train a new workforce.
  • Improved financial performance may not be reflected in the valuations.
  • GSE Systems is a micro-cap stock; the company isn't well covered by major research firms and, as a consequence, the market for shares is less efficient and liquid. The current market capitalization is about $29 million.

Business Profile

GSE Systems is a world leader in real-time, high fidelity simulation; the company provides simulation, educational, and engineering solutions and services to the nuclear and fossil fuel electric utility industry and the chemical and petrochemical industries.

GSE Systems' customers purchase products from the company because of its expertise in the industry, bandwidth of resources and the value driven by its high fidelity solutions. To be successful with a differentiation strategy, the price premiums must be above the cost of differentiation and the differentiation must be appealing to customers and sustainable over time. Companies pursuing this strategy should have a strong market research team. This strategy puts a premium on employing creative and inventive people. Based on the company's statements and researching the company's employees, the firm does have a strong market research team and high-quality personnel with substantial industry experience.

During the last two years, GSE made two key, strategic acquisitions. The company acquired EnVision Systems and TAS Automation. EnVision provided a broader portfolio of computer-based training and generic simulation products. TAS provided expanded capability in engineering services.

According to a report entitled "European Nuclear Power Sector: Trends and Opportunities", "nuclear energy shows potential to reduce emissions and dependence on fossil fuels, and therefore, will be a major contributor to the European energy mix in 2020." Further, nuclear provides a solution to reducing emissions in many countries around the world, including the U.S.

Next, not only does the company benefit from plans to reduce carbon emissions, it also benefits from new regulatory requirements mandating improved safety measures in the wake of the incident in Japan. On March 9, 2012, the U.S. Nuclear Regulatory Commission [NRC] approved the first three new regulatory requirements to deal with safety issues based on eight changes identified by the NRC's Fukushima task force, with implementation required by the end of 2016.

Further, GSE should benefit from the declining workforce and the need to train new workers. Per the Nuclear Energy Institute [NEI], as of 2008 nearly 38% of the U.S. nuclear power industry will be eligible to retire by 2013. According to the Center for Energy Workforce Development (CEWD), an estimated 46% of the current energy industry workforce may need to be replaced by 2015 due to attrition and retirement. GSE recognized this growing need for energy industry training several years ago and began developing various training solutions leveraging the use of its simulation technology.

GSE provides both turn-key solutions, including simulated hardware and proprietary software, to match a specific plant, and discrete simulation technology for specific uses throughout a plant. Its substantial investment in simulation technology has led to the development of proprietary software tools. These tools significantly reduce the cost and time to implement simulation solutions and support long-term maintenance. The company's high fidelity, real-time simulation technology for power plant fluid, logic and control, electrical systems and associated real-time support software, JADE, is available for use primarily on UNIX, Linux and Windows computer platforms. The company's Xtreme tools were designed for the Windows environment. Both technologies were specifically designed to provide user friendly graphic interfaces to the company's high fidelity simulator.

Forecasted Financial Performance and Valuations

The financial performance of GSE Systems is relatively predictable; there isn't much variance of the annual revenues. For 2013, I am forecasting revenues in the $48 million to $54 million range. Operating income and net income should be in the negative $2 million to $2 million range. The operating margin and net income margin suggest GSE Systems does not have a wide moat. Revenues during 2012 totaled $52 million.

GVPGVP 5Y Avg*
Price/Book0.72.2
Price/Sales0.61.7
Price/Cash Flow7.120.9

*Price/Cash Flow uses 3-year average

From a valuation perspective, GSE Systems is substantially undervalued. On a time series basis, GSE is undervalued. On an absolute basis and relative to its 5-year average valuations, GSE is undervalued. Based on the 5-year average valuations, GSE has a fair value of $4.77; the stock is currently trading at $1.59. Thus, GSE could increase in price 200%. The twelve trailing months valuations are about 33% of the 5-year averages; thus, fair value would be 200% higher than the current valuation.

Return on Equity and Cost of Equity

In terms of return on equity, the company has a return on equity in the low single digits and a cost of equity in the low single digits. The return on equity may be just below the cost of equity, but not by more than a few basis points.

Source: GSE Systems: An Energy Play With Solid Catalysts And 200% Upside