iPass has a very strong business model. For example, the company has never lost a customer, and it continues to generate recurring revenue, even years after the initial sale. In addition, the products iPass have to offer address a growing need in the enterprise connectivity market.
But a good business model does mean solid operating performance and share price increases. As a result of excessive spending and poor use of capital, margins (operating, gross, ROIC, etc.) have fallen and the company has wasted shareholder capital. For example, operating income has fallen despite the company's purchases of GoRemote ($78 million), Mobile Automation ($20 million), and Safewww.com ($8.5 million).
Despite the weak operating results, there is an activist in the stock who could, in my opinion, turn the company around due to iPass's solid business characteristics. The activist, Shamrock Activist Value Fund, has previously been covered here on this blog. Shamrock has been involved in iPass since May 23, 2005, when fund filed a 13D declaring a 7.2% position in the company as they acquired shares in the $6 range. Since then Shamrock has filed eight 13D amendments (13D/As), most recently on September 28th, and increased their ownership to over 14% of the company. Many of these filings are very interesting and well worth the time it takes to read them.
On August 14th, Shamrock sent a letter to the company which is available in this 13D/A filing. The letter was written to iPass's lead director, John Beletic, and it explained Shamrock's initial rationale for purchasing the stock more than one year prior and the current problems facing the company. According to Shamrock, the firm first purchased shares because iPass had an impressive enterprise customer base, leading products and services, high gross margins, and "virtually every expense item variable and controllable." In addition, Shamrock referred to a meeting with management that occurred on June 16, 2006, when Shamrock outlined concerns in four critical areas: corporate performance, capital allocation, compensation, and governance. Shamrock went on to say the company has failed to acknowledge the fund's concerns as the company is focusing on revenue growth through 2008 rather than profitability, thus further misaligning management's goals and shareholder interests.
In order to turn the company around, Shamrock mentioned their action plan's key points. First, the company should return $60-70 million to shareholders in the form of a special dividend or a share buyback (Note: There is more than this amount sitting in cash on the balance sheet.) Next, Shamrock wants the company to initiate an aggressive cost-cutting plan. In addition, Shamrock demanded a board seat. Lastly, Shamrock would like the company to begin their search for a new CEO once Shamrock has obtained their board seat.
In this more recent filing, Shamrock demanded the company allows Shamrock to inspect and copy the following:
- All reports, memoranda and other materials prepared by the Company or for the benefit of the Company by outside investment banking, consulting or accounting firms in connection with the Company's merger with GoRemote Internet Communications covering the period from January 1, 2004 through February 14, 2006.
- All minutes, notes or other records of meetings of the Company's Board of Directors or any meeting of any other Company subcommittee or ad hoc committee comprising any directors of the Company relating to the Company's merger with GoRemote Internet Communications.
- All materials prepared for any meeting (or for any participant in any such meeting) described in paragraph (2) hereof of the Board of Directors, a subcommittee or adhoc committee.
- All materials prepared by the Company detailing management's proposed integration plan for the Company's merger with GoRemote Internet Communications covering the period from October 1, 2004 through September 15, 2006.
Shamrock has made these demands, "to investigate possible mismanagement, misrepresentation by management of cost savings associated with the merger with GoRemote, misrepresentation by management of an integration plan with respect to the merger with GoRemote, waste of corporate assets, and lack of due care and appropriate due diligence by the Company's Directors and senior management when evaluating the proposed merger with GoRemote."
Shamrock has based their demands and suspicions on several issues. First, the CEO of iPass, Ken Denman, claimed there would be immediate cost savings synergies as a result of the proposed merger with GoRemote during a December 15, 2005 presentation to a Credit Suisse Software Conference; the company's costs for the first six months after the merger roughly equaled the costs of operations for the companies when they operated as standalone companies. Also, the company indicated the merger would be accretive during the first quarter as merged companies; this did not occur. Lastly, shortly after the merger closed, the head of integration, John Thuma, left the company.
iPass's stock is extremely cheap at current levels. I believe the current stock price represents less than 50% of the intrinsic value of the company. My estimate of intrinsic value is, however, rather dependant on Shamrock's ability to make changes at the company. First off, Shamrock wants the company to stop making acquisitions until ROIC and operating margins are back above 20%. Current operating margins have recently turned negative so if the company follows this demand the company will stop making acquisitions for the next several years. In doing so, the company will be forced to focus on its current business and, in doing so, cut and monitor costs and expenses. Cutting costs would be rather easy. To start, the company would put a ceiling on research and development increases, which clearly hasn't occurred yet -- R&D for 2005 was $17.6 million, up from $13.8 million and $9.95 million in 2004 and 2003, respectively.
I believe the company could see operating margins return to 6-10% during 2007, possibly early 2008, if they actually listen to Shamrock. While this may seem hard to believe, because the company's current operating margins are negative, this is because the company has allowed spending to go out of control. Remember operating margins were 19.4% and 18.8% in 2003 and 2004, respectively -- the company should very easily do roughly $15 million in EBIT. Assuming the company doesn't buyback shares or declare a dividend, this would represent a current EV/EBIT of roughly 13x. While this may not seem very cheap at first, one must remember two things: companies similar to IPAS often boast EV/EBIT multiples greater than 20 and iPass has much more potential operating margin expansion upside than their competitors if they were to continue cutting costs, watching advertising and sales expenses, and resist making nonsensical acquisitions, as Shamrock believes is necessary.
iPass looks very interesting for investors with medium-to-long term investing horizons who like to bet on turnarounds, especially with a well established activist value fund involved.