Upside Is Substantial: So Why Did TeleCommunication Systems Sell Off?

Includes: SY, TSYS
by: Marty Chilberg

Last week TeleCommunication Systems (NASDAQ:TSYS) announced that they had been awarded a delivery order to provide the US Marine Corps with its Wireless Point-To-Point Link-Delta Solutions (WPPL-D) and associated field services (see here). The award, with a potential 12 month value of $269m, has initial funding of $12.3m. This announcement helped produce a move in the share price from $3.82 to $5.17, for a tidy one week gain of 35%. After following this company for last past two years, I'm convinced that this move is not the end of the story for current or potential investors.

Even after this significant gain, the market cap for the company is only around $275m, or less than .7x, the low end of management's C10 current revenue guidance. I guess it's not surprising that most investors I chat with about TSYS have never heard of them. This stock had sold off almost 70% from its close at December 31, 2009, with average trading volume reaching such anemic levels that it truly was a market afterthought. The most frequent questions I've encountered from fellow investors are: What do they do? Why did the stock sell off? Where is their growth opportunity going forward?

First, let me try to provide some perspective about the sell off.

TeleCommunication Systems is a company that wears many hats. During the C09 calendar year, 58% of their revenues came from the government sector and 42% from commercial. Revenue growth history has been stellar, with growth in CY08 of 53% and in a tough economic environment in CY09 they were still able to organically grow 36%. During 2009 they seemed to click on all cylinders in a bad economy: earnings were solid, operating and free cash flow were better than earnings and they were even able to settle a patent infringement claim with Sybase (SY) that yielded a hefty one time payment. Even more importantly, the decided to strategically remake their company for the future by acquiring four different companies: Location Logic, Solvern Innovations, Sidereal Solutions and Networks in Motion.

Strategically these acquisitions seemed to make perfect sense. The two most significant were Location Logic and Networks in Motion, which were both in the rapidly evolving Location Based Services (LBS) market. These added substantial run rate revenues to the commercial segment while the other two were smaller and in government. Importantly, all of these acquired companies generated most of their revenues as recurring service revenues. The initial market reaction to these announcements was very positive. In the week following the May 19,2009 announcement of Location Logic, the stock price appreciated around 6%. On November 3rd, the Solvern Innovation acquisition was announced and 5 trading days later the stock was up 2%. On November 16th, the Sidereal Solutions acquisition was announced and 5 days later the stock was up 8%. Finally, on December 15th, the largest and most significant of these acquisitions, Networks in Motion, was announced and again, 5 days later, the stock price had appreciated by 4%. Clearly investors liked the acquisitions despite the risks associated with such a significant integration challenge and the amount of debt (converts) raised, cash used and shares issued to pay for them.

Life was good as an investor until it wasn't. The start of the decline was triggered by the December 2009 earnings conference call. Earnings for the quarter looked fine on release but after a little analysis it was clear that there was a large cash payment received from Sybase for settling a patent infringement case. Eliminating this one time benefit indicated that the company missed street consensus by a penny. Not a big deal with so much going on, but the driver of this appeared to be a year end management bonus payment that resulted from a profit accelerator built into the plan. Remember the Sybase settlement? Unfortunately, the plan didn't anticipate this type of event and had no carve out provision. Sentiment turned bearish almost immediately and has stayed that way until recently. During the March 2010 quarter, the stock dropped almost 25%.

Next up came the April release of March 2010 quarterly earnings and the related conference call. Expectations were pretty high despite the fact that the company only provided guidance on an annual basis and had encouraged investors to load the second half of the year more heavily. What happened was a minor disappointment and uncertainty. The earnings met consensus expectations but the revenues were light. On the call and for some time thereafter, there really was no explanation for the shortfall. Most investors took the run rate revenues disclosed in each acquisition press release and added it to the projected legacy company revenues. It made sense so naturally the concern was that the acquired products were less than advertised. The company remained upbeat and maintained guidance, cautioning investors to weight the second half of the year even more aggressively. The timing of this "miss" couldn't have been worse as the term double dip was mentioned so often Dairy Queen should have taken advantage. BP was spewing oil into gulf and euro contagion was a daily discussion. The end result was the stock declined another 56% percent during the quarter.

The final step down appeared to have been triggered by the June 2010 earnings announcement. The company missed on both top and bottom lines and brought down total C10 guidance to a range of $410-420m. Describing the drop in guidance of $10m, the company identified two culprits. First was an unexpected drop for the year in SMS revenues on the commercial side. SMS stands for Short Message Service (i.e. text messages). This business for TSYS has been around for many years, and despite growth in actual messages, the revenues were projected to decline to $40m from $54m in C09. The second issue was that government systems orders in backlog had the potential to slip out of this calendar year due to deficit spending concerns. So naturally we saw the bottom drop out once again from the stock. It eventually hit the 52 week low of $2.92.

In summary, the decline of value in the share price was over 70%. The drop in revenue guidance from the company was from an initial range of $420-430m to a current range of $410-420m, or a little over a 2% drop. The net income drop was more significant. The initial guidance was for GAAP income of $23-$27m. The current guidance is $16-20m or a drop of about 30%. The reason for the disproportionate drop in guidance comes from the SMS revenue decline of $10m, as it was very high margin software licenses.

That's the end of part 1, where I tried to answer the question of why the company's stock sold off so much this year. Next I'll try to paint the picture of why I am so optimistic about this company going forward.

Disclosure: Author is long TSYS