Telecommunication Systems, Inc (TSYS) is a technology company operating in the commercial and government segments. During 2009, TSYS agreed to acquire five separate businesses, providing a compelling yet challenging transformative opportunity. Two acquisitions, Networks In Motion (NIM) and LocationLogic, are commercial location-based services (LBS). The other three enhanced the company’s government segment in Defense and Space with cyber security, wireless communications, and satellite communications (SatCom) offerings. Each was positioned as accretive to forward earnings. My perspective is that the management of TSYS has failed to take advantage of these opportunities. Management has also failed to appreciate a long held standard: Their primary responsibility is to maximize long term shareholder value. The simple truth is the market cap of TSYS was about $510 million by the end of 2009 and today is less than $150 million, despite growing revenues from $300 million in 2009 to a projected $425 million this year.
Before prescribing my action plan for change, let me clarify: I’m invested in the company, believe it is dramatically undervalued, and appreciate that no outsider can have the requisite knowledge to craft a better strategic plan than that of an inside executive management team. I also recognize that factors outside the company’s control have contributed to this value collapse. These headwinds include the movement toward reduced defense spending, free navigation from Google(GOOG), Intel’s (INTC) acquisition of Telmap, and even the tsunami in Japan. Looking at valuation or how these events have impacted the share price may be interesting, but don’t contribute to the theme of this article. Also note that the rest of the article will refer to my proforma earnings for TSYS. I have stripped out certain components of the income statement to better illustrate performance. For the purposes of this article, the proforma earnings statement eliminates capitalized software development costs, $3 million in fees associated with the NIM acquisition (2009), $2 million estimated bonus expense related to the patent sale (2009) all noncash stock compensation expense, and amortization of all intangibles.
To the officers and directors of TSYS:
1) Write off a significant portion of intangible assets. The carrying value of intangible assets is currently $243m. The biggest piece, goodwill, is $176 million. The remaining purchased and capitalized costs total $67 million. You should listen to the stock market and recognize that the carrying values of these intangibles are overstated. The process of determining a write-down due to impairment or net realizable value is comprehensive and requires substantial judgment. However the evidence is unavoidable. During 2009 roughly 20% of all companies in the S&P 500 wrote down intangible assets. Not surprising given the collapse of the equity markets at the end of 2008. The company expects total amortization this year of over $16m, representing 4% of revenue. If this analysis led to a 70% write-off, operating income in 2012 would improve by 300 basis points.
2) Clean up the rest of the balance sheet. The write down of intangible assets is a good starting point, but don’t stop there. You should also tackle the rest of balance sheet. The biggest issue is the debt level of the company. The total debt of TSYS is about the same as the market cap at $148 million. Given this valuation, raising equity in the short term isn’t shareholder friendly. While restructuring should be evaluated, maximizing cash flow to pay it down as aggressively as possible needs to be a priority. Avoid future acquisitions until predetermined debt/equity ratios are achieved. Consider a sale of less productive assets. Capital expenditures (capex) should be reduced to more affordable levels. Prior to the 2009 acquisitions, average capex at TSYS ran under $3 million annually, and property and equipment (PPE) totaled $12.8 million. As of September 2011, PPE was $50 million after spending $19 million in 2010 and $16 million through September 2011. This increase in annual capex, as a percentage of operating cash flow, from 5% in 2009 to 26% in 2010, isn’t sustainable. Yet guidance suggests a similar level for 2012.
3) Take a hard look at the mobile navigation business. Intel shifted the mobile navigation market recently with their purchase of Telmap. Details of the transaction have not been disclosed. The New York Times reported Israeli media stating that Intel was paying $300 million to $350 million. The Times also wrote that Telmap was profitable and expected to post $33 million in revenues for 2011. This deal and price point makes sense as Intel is playing catch-up in the mobile platform processor market. Their AppUp initiative is making it easier for developers to integrate LBS in new applications. Simple math suggests your NIM business could be valued at double the Telmap valuation based upon your stated revenue of around $70 million. The market isn’t giving this valuation for various reasons, probably including your identity as a defense company and fear of losing share to a better capitalized and positioned Intel. Turn this shift to your advantage. Look at the mobile processor market place and approach competitors to Intel aggressively. Take advantage of your position before you lose it. An outright sale to a company like Qualcomm (QCOM), Broadcom (BRCM) or Nvidia (NVDA) would be a home run. It could easily triple your market cap and provide a capital infusion to pay off debt and invest in your other LBS and telematics initiatives, setting the table for future growth. Alternatively, approach these companies and many others, including Skyworks, Marvell, AMD, and Texas Instruments with an aggressively priced, embedded strategy allowing them to respond to Intel, protecting their market share while growing yours.
4) Deliver on your promise to monetize intellectual property. You recently announced the results of an independent valuation, which pegged the value of the patent portfolio at between $117 million to 171 million. You also hired a certified licensing professional to lead a monetization effort. Good start, but you have claimed that you are serious about monetization for several years. Aside from the new hire, the only real change seen by shareholders is the appraisal and the public relations associated with it. The market normally views IP as either a moat protecting market share, or part of the “sum of the parts” valuation if a company is for sale. Investing in the valuation makes little sense unless IP is for sale and you are setting a price point. Focus on licensing or selling any noncritical IP. Once you do the market will respond by bidding up your value.
5) Provide better and more frequent guidance. You have missed consensus revenue expectations 6 times of the past 7 quarters, which is even more astounding given real progress made over the past three years. In 2008, the mix of systems versus service revenues was around 55/45. In 2011, you expect over 70% recurring service revenues. Good job! Even more compelling is your build of backlog relative to guidance. I analyzed the impact of this trend here and found that over the past year, funded backlog recognizable in the next 12 months grew as a percentage of projected revenues from 46% to 68%. For companies in the defense space, anything over 60% is considered solid. Kudos again! Given these trends there is no reason that you should be consistently unable to meet street expectations. Setting and managing realistic expectations that are consistently met or beaten needs to be the standard. Compare yourself to the NFL. Game plans change every Sunday responding to the competitive situation. So provide quarterly guidance. You know better than anyone what’s happening internally and in the market place. Build an atmosphere of winning in the face adversity. Look at a team like the Detroit Lions. They haven’t been to the playoffs for 12 years in a league that promotes parity. Now they are seeing improvement after a complete shakeup in coaching and the general manager positions. Hold the management responsible for success and make changes where the constancy of failure is apparent.
6) Develop a business model that strives for best in class metrics. All good executives know that scale is required to achieve efficiency. The best ones consistently achieve it. They also take advantage of every acquisition to deliver synergies. You grew revenues from $300 million in 2009 to a projected $425 million for 2011. In 2009, proforma operating costs were 24.5%. Integrating the acquired companies in 2010 could have made that year’s increase to 26.4% misleading. However, this should be the payoff year, and your proforma spending is projected to be 29%. That has driven your operating income down from 16% in 2009 to an anticipated 11% this year. This is a 30% drop in relative performance when high performance teams would deliver improvement. The most glaring example is G&A, where spending has increased from 9.4% last year to approximately 10.5% this year, despite a 10% increase in revenues. Set a goal of getting G&A spending to 5% and create a roadmap to achieve it. Determine the appropriate level of R&D spending to drive innovation and success, and commit to it regardless of economic conditions. Adopt a comprehensive annual product line review similar to that of Intel, designed to measure managers on continual business improvement. Measure product managers on a series of metrics including: contribution margin, return on invested capital, market share, growth, book-to-bill ratio, capex, revenue per headcount, etc. There is no reason this company can’t achieve a minimum of 15% operating profit next year with a goal of achieving 18-20% by 2013-2014.
7) Turn off the stock option ATM. Technology companies traditionally promote equity ownership by employees through outright awards or stock option plans. Stock compensation expense recorded by TSYS has increased from $3.8 million (1.7% of revenue) to $10.2 million (2.6% of revenue) in 2008 and 2010 respectively. The estimated amount to be expensed in 2011 is around $9.5 million. Some of this increase is likely attributed to initial grants to acquired employees, though this arguably should have been part of the cost of acquisition if done concurrent with the deals. Shareholders biggest beef, though, should be the recurring re-granting given to the executive team. I’ll use the activity of the CEO as an example to make the point. As Founder TSYS, Mr. Tose owns Class B shares, which has super voting rights. His total ownership position is about 10.5% of the company, which provides about 25% voting control. In addition, he has 2.4 million options to buy more shares. This year Mr. Tose has sold 666 thousand shares. The company has granted him additional restricted stock and stock options totaling almost 350 thousand shares. This is not a unique situation. He was also granted 200 thousand options in both 2009 and 2010. In each of these years, he sold around 600 thousand shares. Selling shares to diversify a concentrated wealth position is prudent. Awarding new shares annually to replenish those sold, however, is a different matter. The company appears to be using equity grants to conserve cash, ignoring the negative pressure on the share price by his continual selling. And Mr. Tose is not alone. The rest of the officer group has followed a very similar pattern of repeated annual inside selling, which is replenished with annual option or stock awards. Let’s remember the reason equity programs make sense. This is intended to create a long-term alignment of management and shareholders, so that they mutually benefit from value creation. This misuse of equity compensation is contrary to shareholders interests and should be discontinued.
I hope the preceding suggestions trigger a reconsideration of management’s role representing the interests of shareholders. I, for one, believe much can be done to unlock the significant value that has been created by this team, but is yet unrealized in the share price. Hopefully this letter serves investors and potential investors, as well as management, by provoking thought or action that benefits us all.