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Liquidity Services, Inc. (NASDAQ:LSI), an online auction marketplace for wholesale, surplus and salvage assets, plans on offering 7.7 million shares (2.7 million from insiders) at a range of $9-$11. The ticker symbol will be LQDT. Friedman Billings and RBC Capital Markets are lead managing the deal. Post-offering LQDT will have 27.3 million shares outstanding for a market cap mid-range of $273 million. 10% of IPO proceeds are going to repay all debt, the other 90% for general corporate purposes. Chairman and CEO William P. Angrick, III will own 34% of LQDT post-offering.

Company description from the S-1:

"We are a leading online auction marketplace for wholesale, surplus and salvage assets. Our online auction marketplaces are www.liquidation.com, www.govliquidation.com and www.uksurplus.com."

LQDT focuses on the reverse supply chain: Online auctions are 'business to business' selling of bulk goods including military surplus, consumer returned merchandise, and scrap metals. Traditionally disposal of these goods have been via live auction or negotiated sale, offering limited geographic visibility and high fragmentation. Companies looking to unload bulk goods were never quite certain they were finding the best prices for those goods. LQDT formed 6 years ago with the plan of consolidating reverse supply chain goods into an online marketplace, creating a much larger pool of sellers/ buyers for particular bulk, wholesale, surplus or scrap items.

Essentially a start-up revenue-wise [as recently as 2002], LQDT currently has 415,000 registered buyers in 116 countries and has completed 500,000 online auctions. Of their online auctions 90% have been converted into cash sales. Goods are sold 'as is/ where is' with very limited rights of return. LQDT lists all pertinent information including pictures and estimated shipping of products, as well as handling all transactions. Products are categorized across major industry verticals such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware, and specialty equipment and products are sold in lot sizes ranging from full truck loads to pallets, packages and large individual items.

Currently LQDT's revenue driver has been the US Department of Defense(DoD). In June 2001, LQDT was awarded a contract to sell all DoD surplus property in the US and in 2005 LQDT was awarded another contract to sell all DoD scrap property, including metals, building materials etc.... These contracts expire in 2008 and 2012 respectively. The result of these contracts is that the DoD has accounted for 85%+ of all LQDT's annual revenue in 2003, 2004, 2005 and the 3 months ending 12/31/05. Note too that in 2005 LQDT was awarded contracts to sell all DoD surplus property located in the United Kingdom and in 1/06 a similar contract covering Germany. It appears the DoD is quite satisfied with their arrangement with LQDT.

LQDT is contractually bound to purchase all surplus/ bulk items from the DoD. Surplus items are purchased on a varying % of acquired costs while scrap items are purchased on a per pound basis. LQDT and the DoD than split the gross profits when sales are completed. The DoD takes 80% while LQDT retains 20% of profits after costs are factored in. This is really a 'no-lose' for the DoD and I can see why they are quite happy with LQDT. They've a guaranteed minimum price for all of their surplus/ scrap plus LQDT has created an online marketplace which has maximized the selling price of these surplus/ scrap items. The DoD benefits on the back end as well, a nice deal for them. For LQDT this can be a good deal as well, depending on the margins which we will look at below. For this to work for LQDT, they must maximize the prices sold in the DoD related auctions. When taking into account this business model it is easy to understand why LQDT has completed 90% of their auctions with a sale: They've already purchased many of their auction items from the DoD!

LQDT's business currently than is reselling via online auctions US Department of Defense surplus and scrap goods.

For non DoD accounts LQDT has a consignment model in which LQDT acts in a more traditional facilitator fashion. LQDT lists for sellers and takes a % of the final sale. This model makes up only 5% of LQDT's revenues.

Financials

$2 a share in cash post-offering, no debt.

Top-line has been growing steadily, up 25% in FY '04 and 19% more in FY '05 to $89.5 million. LQDT's fiscal year ends 9/30. With the addition of the scrap metals contract it appears revenue is set to grow more quickly in FY '06. 12/31/05 Q was LQDT's best yet at $32.2 million, a 60% increase over the 12/04 quarter.

Due to the nature of their DoD contracts, the largest expense line for LQDT is profit sharing at roughly 55% of revenues. The structure of their DoD contracts will prevent LQDT from ever having strong operating margins or economies of scale. Revenues will tend to filter down to the bottom line at similar rate even as those revenues grow - assuming prices paid at auction remain stable of course.

Operating margins have been in the 8% range, showing strength in the most recent 12/05 quarter closing in on 9%.

Net margins (after removing debt servicing and normalizing tax rate) in FY '05 were 4%, the 3 months ending 12/31/05 closer to 6%. Net income for FY '05 was 14-15 cents. LQDT at mid range will be trading 66 X's trailing earnings.

Looking into 2006, the key for LQDT is the new US DoD scrap contract. This really boosted the 12/05 quarter and should lead to increased top-line growth in FY '06. If the most recent quarter is an indication (and I believe it to be), than I think LQDT can increase revenues by 50%+ in FY '06 to $140- $145. Scrap metals accounted for just 1% of revenue in the 9/30/05 quarter, 22% in 12/31/05 quarter. I would expect slightly increased operating and net margins in FY '06, but nothing similar to the top-line revenue increase. The terms of the scrap contracts with the DoD are similar meaning much of the selling prices are expensed back to the DoD in profit-sharing.

At 6% net margins for FY '06, I think LQDT can earn 30- 35 cents a share. At a mid-range pricing than LQDT would be trading at 30 X's 2006 earnings.

Risks

The big risk here is obviously the huge dependence on the DoD. I'm not really too concerned here though. Why? 1) The earliest LQDT would lose any DoD revenues would be at the end of the original contract in 2008. 2) This by all accounts appears to be a very good deal for the DoD and 3) LQDT in the past year has been awarded three additional DoD contracts, including the scrap metals contract which will be a revenue driver. Yes it is possible that if/ when the DoD contracts are put up for rebid, that the risk in holding LQDT would accelerate. However that is at the earliest 2 years from now and based on the current relationship, it appears to me that there is minimal risk of LQDT losing the DoD business. Another risk of course is LQDT's ability to resell purchased items. As mentioned above much of LQDT's business model is actually that of a reseller rather than facilitator.If unable to resell merchandise LQDT must in effect 'eat it.' Thus far this has occurred in less than 2% of auction items in which LQDT was the actual seller. If the economic landscape changes drastically this could be a much larger risk, however currently LQDT appears to be doing a solid job of reselling at a strong enough price to sustain net margins.

A big chunk than of LQDT's business is protected for a couple more years at minimum. The larger issue however is LQDT's ability to garner non DoD revenues. The online auction space is a tough one with Ebay/ Overstock and even Amazon participating as well as countless niche players. All three have much stronger traffic and are also to some extent involved in the bulk/ surplus and reverse supply chain auction. Other government agencies as well as private companies have their own government goods related online auction sites as well. There is an awful lot of competition in this space overall meaning going forward operating margins will most likely shrink for the entire group as competition continues to grow. LQDT has very nice DoD contracts to fall back on as they attempt to grow in other areas, but to sustain and grow their market cap over time they will certainly need to bring in additional reverse supply chain business. They've really not yet proven they can do so. My thoughts here are they've everything in place to make this happen, including the strong backbone DoD contracts. What remains than is for LQDT to execute.

Conclusion - In my opinion the new scrap contract with the DoD is what makes this deal work.Without it, LQDT is yet another internet IPO coming at an aggressive valuation. With though, it will allow LQDT to increase revenues faster in FY '06 than in either FY '04 or FY '05. It will also put them one good size contract or so away from actually being cheaply valued at $9-$11. There is a lot of longer term risk here of course, as alluded to above. But over the next 2 years LQDT has their DoD contracts as a base in which to build. They've one very good relationship with a large customer and the platforms and infrastructure in place to handle a great deal more volume. Just as importantly the DoD auctions have brought a large number of buyers to LQDT's sites.

With the solid DoD contract base if anything goes right over the next 1-2 years, than LQDT could easily trade much higher. I do like the risk reward set-up here at pricing range or even $1- $2 or so above as I feel an awful lot more here could go right than wrong here over the next 1-2 years. LQDT has built a nice base here, one in which they've managed to carve out a profit. They will now need to leverage that base to bring in more sellers and greater revenues. If they are able to do so, LQDT is definitely a buy at $9- $11. Good risk/ reward in that area in my opinion. Factor in a top notch underwriter in Friedman Billings and I think this deal works.

Source: Analysis of Online Retailer Liquidity Services IPO (LQDT)