ClearOne (NASDAQ:CLRO) provides audio and visual communication solutions. Professional audio communications products have provided approximately 70% of revenues, with the remaining coming from what the company calls unified communications endpoints and visual communication products. For example in professional audio conferencing the company has nearly 50% market share globally. (Source 10K 2013) The awards that they have won give some indication of product quality and innovativeness, the latest recognition coming from TMCnet.
The company doesn't manufacture any of the products which means that the business is essentially very capital-light in nature. Using the latest Q2 figures they have $4.3 million in net working capital after backing out $26 million of marketable securities (corporate and municipal bonds), $2.2 million in net PPE and $13.8 million in intangible assets. Putting these altogether the invested operating capital comes to $20.3 million. In the past ClearOne's unadjusted invested capital has fluctuated quite a bit, mostly due to fluctuations in marketable securities. In 2012 the company received $38.5 million in litigation proceeds from UBS which put the outstanding cash in 2012 to $55.5 million with no marketable securities. In 2013 the company decided to invest much of the proceeds in bonds, putting marketable securities in 2013 at $25.5 million. After trying to back out all the non-operating numbers one comes up with a fairly stable $20 to $30 million in invested capital along the years. Regarding cash and debt, currently ClearOne has no debt (hasn't had since 2010) and a cash balance of $6.3 million plus the $26 million in marketable securities. With the current market cap of $87 million we arrive at an enterprise value of roughly $55 million.
Lately the company has seen some nice increases in revenues, but at the same time operating expenses have ramped up significantly as well. This was addressed in the Q2 conference call where management said that since their professional audio segment is growing, the sales commissions paid for their independent sales reps increase too. These sales commissions are the reason why it's probably not reasonable to expect operating expenses to materially decrease in the future, unless sales decline which would cause the commissions (a major part of OPEX) to decline. On gross margins, ClearOne expects to have them around 60%, plus minus 2-3%. From 2008 to 2013 that's exactly the range where the gross margins have loyally been, averaging 59% for the 6-year period. In H1 2014 gross margin was 58.8%, inside the anticipated range.
To arrive at EBIT from gross profit one needs to take out operating expenses. For ClearOne operating expenses are comprised of sales and marketing (mostly commissions to independent sales reps), R&D and general & administrative expenses. Sales and marketing expenses have in the past increased quite uniformly with revenues. From 2008 to 2013 they've shown annual growth of 5% compared to 4% in revenues. R&D has been around $7 to $8 million, although in H1 the full year run-rate was about $9 million. In Q1 and Q2 2014 management explained the R&D expenses will at least slowdown in the second half as some projects were completed. Having said this, it should be reasonable to expect R&D being $8 million per year for the next few years. G&A expenses have been varying between $5.5 and $7 million, to be conservative and take $7 million run-rate for the next few years should be prudent.
In the growth front ClearOne has seen 4% annual growth in sales from 2008 to 2013. In H1 2014, revenue growth was strong at 16% year-over-year (in Q2 alone the growth was 20% year-over-year). After some years of more modest growth, things might be picking up again if the recent result are indicative of future. The revenue growth has also had a significant impact on profits. EBIT (cleaned from litigation proceeds) has increased 38% annually from $1.1 million to $7.6 million in 2013. In H1 2014 EBIT declined 26% year-over-year as expenses increased more than revenue.
Capital allocation and acquisitions
ClearOne has made several acquisitions in the past years, and will continue to make in the future as well. In total from 2008 they have used $21.95 million to acquire five businesses: NetStreams for $1.4 million (November 2009), MagicBox for $1 million (September 2011), VCON for $4.6 million (February 2012), Spontania for $5 million (January 2014) and Sabine for $9.95 million (March 2014). The successfulness of these purchases is difficult to assess as the company's disclosures don't give that much information. Currently they have $21.5 million in intangibles on their books, meaning that the acquisitions haven't at least been done at book value (not a big surprise considering these are tech companies).
We'll take a closer look at the most recent, and the largest, acquisition of Sabine. In essence it was a strategic purchase as Sabine has supplied microphone systems sold under the ClearOne brand. What they hope to achieve via the acquisition is strengthening the already well-performing microphone segment. They paid about $10 million for the business of which $1.5 million was paid in ClearOne shares. In the 1st half of 2014 the revenues from Sabine were $1.3 million. Since Sabine's run-rate revenue before the acquisition was $5 to $6 million and ClearOne was their largest customer (they've partnered with Sabine since 2012), it's probably fair to say they paid about 3-4 times sales, clearly quite a bit. Paying $10 million for a company with $5 million in revenues (and breaking even) of which most has been from the acquiring company, does indeed sound a little odd. Management explained that the acquisition was strategically important, something that needed to be done sooner or later. Sabine has developed some essential technology that ClearOne uses in its professional products, technology that they weren't able to develop in-house. It's easy to judge management and say that the acquisition was simply ridiculous at that price. Actually management even acknowledges that the price was higher than they wanted, but that they had to do it now or later when the price might have been easily a lot higher. So was it a good acquisition? Certainly not cheap, but the author doesn't see it as a bad move to take and bury a few million dollars now instead of potentially (much) more later. In terms of increasing EBIT the company should be able to get at least $0.3 million.
ClearOne has generated free cash flow (after total capex and excluding changes in working capital and litigation proceeds) of $28.1 million from 2009 to H1 2014. As said, $22 million has gone into acquisitions. $2 million went into debt repayment in 2010 and about $8 million has been returned to shareholders (calculated as dividends + share buybacks - share issuance/option exercises). In order to get an idea of how the acquisitions have played out we can look at return on invested capital. As has been mentioned, simply looking at the numbers given in the reports will give a very distorted picture, mostly because of the large litigation proceeds. Accounting for these, the 6-year average ROIC comes at 15% with most years being around 6% to 9% and then once in a while above 20% like in 2013. In general the ROICs aren't magnificent but do signal that the company is generating reasonable returns on invested capital.
Looking 2.5 years out into the potential results of FY2016 we can see some interesting things. Management has communicated lately that they're seeing some good things happening in the business, meaning new products and increasing interest towards them from customers. What this actually quantifies into is impossible to say but a reasonable expectation would be that they'll grow at least at the historical rate. As mentioned, in H1 2014 they have shown increasing growth compared to 2013. With the favorable tailwinds we'll put FY2014 revenues at $55 million (assumes $28.2 million for H2). From this, with the 4% historical growth rate we get to about $60 million in sales for FY2016. 60% gross margin would put gross profit at $36 million. Taking out $8 million for R&D, $7 million for G&A and $11 million for sales and marketing (assuming it continues to increase slightly faster than sales) leaves us $10 million in operating profit. Lastly, taking taxes of 30% leaves us with a net profit of $7 million.
During the couple years, the company has more than likely generated some cash as well. In the past their FCF (excluding working capital changes and the litigation proceeds) has averaged 11% of revenues. Using 10% FCF margin would mean approximately $17 million in additional cash generated after capex. To err on the conservative side of things, we'll assume the company will need to use this $17 million in acquisitions in order to get to $60 million in sales in 2016. This would leave us with a net profit of $7 million and net cash of $32 million. A company that has been steadily growing in the past deserves a p/e multiple of 10-12. With the midpoint, 11, the company would be valued at $77 million. However, with basically $32 million in excess cash and equivalents, it's fair to say that the market cap would be $77 million plus $32 million, equaling $109 million. This is up 27% from the current market cap, which could be called a base case.
One can make all sorts of cases by turning the variables around differently. The base case definitely has more than a few (very) conservative assumptions. One of the different ways of looking at it is by assuming more organic growth and therefore that less money is used in acquisitions. From the $49 million (17+32) in net cash at FY2016, let's say they use just $4 million in acquisitions and leave the rest in the company (or pay some dividends, which fundamentally don't change the value of the company although market perception might become more positive and that way increase market value). Instead of looking at net profit and p/e, we can also try valuing the company via FCF. Assuming FY2016 FCF is $7 million and that a fair multiple would be 12, we arrive at a value of $84 million. Adding the $45 million in cash to this we get $129 million, upside of 50%.
For a bad scenario to materialize the company essentially needs to destroy the existing net cash and run into big issues with sales. Is this going to happen? Destruction of the cash is in the author's opinion perhaps little bit more likely than sales dropping of the cliff (both still seem very unlikely though). Making expensive acquisitions that don't materialize in revenue and earnings growth would eventually lead to the net cash being demolished. Sales have been increasing continuously every year from 2009 but naturally things could change. Assuming for example that the company destroys $25 million of cash in acquisitions, sees sales going permanently down to $35 million (same as in 2009) and manages to do $4 million in FCF (less than in 2009) would likely put the value somewhere around $60 million, representing downside of 30%.
Glancing at the above cases it's clear that the company has much higher upside compared to the downside, even with assumptions that are more or less tilted towards conservative and negative instead of optimistic.
Usual reasons for under-appreciation are at play in ClearOne as well, referring to the small market cap, liquidity and number of analysts following the company. In short, it's out of the reach and interest of bigger players. This isn't a problem for investors who don't need to allocate a million dollars in the position. ClearOne's website indicates that there are 2 analysts covering the stock. The conference calls tend to have no more than 2-3 investors asking questions, showing that the stock is not widely-covered at all.
Valuation risk isn't on the top of the list for ClearOne as it is currently trading at 1.17 times book value (which has been growing 14% annually for past 6 years), has an EV/FCF yield of 12.5% and a p/e of 10.5 after backing out net cash. Debt risk (or balance sheet risk) is also out of the table with the company having been debt-free for the past 4-5 years and possessing a large cash position. What's left is operational risk (and managerial risk, discussed below), which is what ClearOne can't escape. The magnitude of the operational risks is difficult to estimate but as was shown in the cases above, even a decline back to 2009 levels isn't an absolute disaster for investors. The company's products aren't very easily replaced by other solutions (cheaper or free, such as Skype) as businesses will most likely have a continuing need for conferencing systems and other audio and visual systems that are developed for their needs, considering for example security issues. This is still a possible issue that they might increasingly be facing in the future, something to keep an eye on.
Biggest risk with ClearOne in the author's view is the management and their ability to allocate capital so that it provides at least adequate returns. Even though ClearOne's management might not be honored with the century's greatest capital allocator award, they still seem to have done at least fairly well in the past. Yes, the latest acquisition of Sabine was priced somewhat expensive. But at the same time, without having the knowledge that the management has, it's encouraging to hear them say that they paid a little more than they might have liked but that it still had to be done sooner or later. This could be viewed as a positive sign in a sense that management recognizes what's a decent price to pay for an acquisition. A negative point is that management's interests may not be perfectly aligned with other shareholders. CEO owns approximately 1% and the management in total owns about 3.5% according to 2013 10K. One could hope for slightly larger ownerships, although the CEO's shares are valued at $1 million which is presumably still a considerable amount.
ClearOne's ability to use the future free cash flow and the current net cash wisely is in the center of the investment thesis. If the company was able to put the free cash flow into better use (get stability into ROICs and lift them above 15%) it would deserve higher multiples than a p/e of 10-12, especially if they continue churning FCF with the past pace.
If management doesn't find investment opportunities for the $32 million in cash and marketable securities it'd be better to return at least some of it to shareholders via dividends, which would be value-neutral, or buybacks. Buying back shares at the current price would most likely be a value-enhancing move for those holding onto their shares. There's an additional requirement though, repurchasing shares and then having them back in the market via managements' option exercises won't enhance long-term value. It's unclear what the management views as a proper "war chest" to fund acquisitions and other investments in the business. Most likely $15 million should be enough when considering they do $5 to $8 million annual FCF, which leaves over $15 million (about 20% of the current market value) to return to shareholders.
Roadmap for investors
ClearOne offers a spot where downside seems relatively small even in a bad scenario compared to the upside in a scenario where things go at least alright. If it happened that the managements capital allocation decisions hit the target the shareholders can easily be seen to cash in 20% annual returns. If homeruns don't appear but the same historical pace continues it still easily gives at least 10% annual returns in the next few years, very decent for investors who prefer companies with less risks. ClearOne offers just that, a company with plenty of cash and a sound balance sheet, very decent operating business and current valuation that's neutral or cheap, depending a little on how you view things.
Investors with a portfolio that has space for a stock that has double the upside potential compared to the downside could be well-served by beginning to buy ClearOne from the current levels of $9.40 per share.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Please, do your own due diligence, there’s always a risk of losing one’s principal.