Qualstar (QBAK) looks like an interesting play on a possible merger/acquisition. Recent events seem to point to the likelihood of a value unlocking opportunity in the near future, and given a scenario in which no opportunity presents itself the company looks well protected against a stock price collapse.
Qualstar began in 1984 and has a quaint history. The company was founded by William Gervais and Richard Nelson, both of whom held meaningful positions at the firm since its inception. Both founders seem to be engineers by heart and by trade, and both graduated from California State Polytechnic University. Additionally, each founder has refrained from the damaging practices of granting dilutive options or accepting very large compensations.
Currently Qualstar operates in two main areas, automated tape libraries and open-frame switching power supplies; in both areas the company is involved in much of the lifecycle process, i.e. design, development, manufacture, and sell.
In the tape segment, the company offers tape libraries utilizing the LTO tape drive technology. Tape libraries are used to store, retrieve, and manage electronic data. LTO is an acronym for Linear Tape Open, a technology originally developed in the 1990s as an “open standard” alternative to proprietary magnetic tape formats. LTO technology is widely used with small and large computer systems, often for back-up and storage purposes.
In the power supplies segment, Qualstar offers a range of AC-DC and DC-DC ultra small open frame power supplies in 125, 160, 275, 280, and 375 watt models. These devices are sold under the N2Power brand and are used in telecommunications equipment, servers, routers, switches, RAIDs, high-efficiency lighting and similar applications.
From a balance sheet perspective, the company looks good. According to the most recent 10Q, Qualstar had $2,903 of liabilities compared with $32, 938 of assets, giving a book value of roughly $2.45 per share; book value is calculated using 12,253 shares. 62% of current assets are made of cash and equivalents and marketable securities, and 97% of long term assets are made of marketable securities. With a current market price of $1.8, downside seems protected given the quality of the assets and the fact that the company is already selling for less than book.
From a P&L basis, the company is nothing to boast about. In fact, throughout the past five years Qualstar has reported an operating loss each year. Interestingly though, the most recent quarter results do not resemble those of many prior quarters. For the QE 9/30/2010 a substantial shift to profitability seems to have occurred. Gross margin increased by 54%. Operating expenses as a percent of revenues were cut from 54.8% to 38% (R&D dropped from 21.8% to 13.5% and general and admin went from 18.2% to 12.4%). This allowed the company to go from net income representing a negative 25.8% of revenues to a positive 3.2%.
Management claims that the increase in gross profit was due to a change in product mix and a reduction of inventory reserves. Inventory reserve went from $945 in QE 9/30/2009 to $480 in QE 9/30/2010, adding 465 to gross. Considering that this additional reduction of reserves represented 48% of 2009 QE gross and 22% of 2010 QE gross, this decision by management to lower reserves had a large impact on gross profit. The trimming of R&D, according to the company, was related to a lower head count which in turn caused a decrease in compensation expense. We question the level of compensation for R&D to be cut by almost half, on a percentage of revenues basis. Finally, the change in G&A was not elaborated on; management only said it was comparable to 2009. The bottom line is that a lot of cost cutting seems to be going on in addition to changes in management’s thoughts on items such as inventory reserves. By itself, this change in financial performance looks nice. But there are other interesting activities that lead us to wonder whether a significant transaction will soon occur.
Founder Richard Nelson sold all his shares in a series of transactions starting around 4/30/2010. On 12/29/2010, he sold a block of 1,500,000 shares for $1.525. On the same filing date, BKF Capital Group filed a 13D disclosing a direct ownership stake of 1,500,000 shares. Mr. Steven Bronson, owner of BKF Capital filed a form 3 disclosing an indirect ownership stake of 1,557,700 shares. BKF now owns roughly 12% of Qualstar. Who is Mr. Bronson, and what is the significance of BKF Capital?
Mr. Bronson is president of Catalyst Financial and BKF Capital. Catalyst is an investment banking firm that focuses on small cap companies; the firm is located in Florida. In the past, the firm has participated in M&A purchases and sales and acquired control transactions. BKF Capital is currently a shell company looking for an acquisition or merger. As can be seen on the company’s website and the most recent 10Q, BKF Capital ceased operations in late 2006 and currently the company is seeking to consummate an acquisition, merger or other business combination with an operating entity to enhance revenues and increase shareholder value.
With Mr. Nelson out and BKF in, 28% of ownership is now controlled by three asset managers. The second largest percentage ownership stands at 26%, and is controlled by founder William Gervais. Given the lower trending stock price and history of operating losses, we would not be surprised to see fund managers press for some kind of corporate changes.
- Dimensional Fund Advisors LP- 961,187 Common or 7.8%
- Porter Orlin, LLC- 1,016,851 Common or 8.3%
- BKF Capital- 1,557,700 Common or 12%
- William Gervais- 3,150,000 Common or 26%
The shift to profitability, coupled with a founder selling out completely to a shell company looking for an acquisition, strikes our interest. Obviously this is purely a speculative play. We welcome any insight or comments. Some unanswered questions we currently are working on include the following. If an event is to take place, why would one of the founders sell out before the transaction? Why did one of the founders decide to sell all his stock? BKF used to be an asset management company, so what is it doing trying to get into the tape library business? Also, for a company with no operations, we are intrigued by BKF’s renewal of a share repurchase plan; this plan allows the company to purchase 1 million shares (about 1/8 of outstanding shares), of which 500K have already been repurchased.
A few other things to note:
BKF Capital is a little over a third the size of Qualstar. Thus, to complete a transaction the company will need to issue debt or equity. If the company cannot do this we don’t see how a deal will go through. It is possible that BKF has no intention to complete a transaction and Mr. Bronson just found this situation to be an undervalued opportunity. Considering that Mr. Bronson purchased shares around $1.55, his company has already made roughly 16% on the investment.