ModusLink: An Operational Turnaround, A Big Hidden Asset, An Activist, And A Low Valuation

| About: Steel Connect (STCN)
This article is now exclusive for PRO subscribers.

Though shares of ModusLink (MLNK) have performed well since releasing a strong set of earnings on October 15, the stock remains off the radar screens of most investors. While the company has nearly completed an operational turnaround, this isn't apparent from by looking at the ModusLink's income statement over the past couple of years which has been marred by restructuring charges. Similarly, its most significant asset, a deferred tax asset, is not included in the company's financial statements as there is a valuation allowance set against it - keeping it 'hidden.' These factors, coupled with an ugly history (discussed below) and a free float of only $135 million, make it unlikely investors have even heard of ModusLink. As we all know, the less followed something is, the more likely it is to be significantly undervalued. As hockey great Wayne Gretzky said "I don't skate where the puck is, I skate where it's going to be." Given ModusLink's operational restructuring and its large net cash balance (which its largest shareholder said will be used for acquisitions to make use of the tax assets), we can reasonably deduce that ModusLink will be in a very different place in a couple of years. In this article, I walk through what I expect the company will look like in the future and why I see the potential for 200% upside in the shares looking out 2-3 years.

There are four main reasons which I believe make ModusLink a great investment:

Operational turnaround - After some very difficult years (losing money on core operations, an accounting restatement, etc.), ModusLink made some key changes. It brought in a new head of operations in 2011 and hired a new CEO, John Boucher, at the beginning of 2013. The company has made significant cuts to headcount -reducing staff by 18% YoY while growing revenue 6%. Additionally, the company has diversified outside of its core customer base of tech customers which not only helped ModusLink increase revenue but it also expanded gross margins. While the reported results are messy, ModusLink actually earned an operating profit once you add back all of the charges:

For year ended July 31, 2013

Operating loss

-28.2

Add back:

Restructuring charge

14.5

Severance payment

1.4

Professional Fees

1.3

Costs of SEC inquiry

10.8

Non-cash Amortization

1.1

Adjusted Operating Profit

0.9

This was a significant improvement versus an adjusted operating loss of nearly $7 million in the year prior. Given that the new CEO has been with the company just 10 months, I expect we will see further improvement going forward.

Hidden Asset - ModusLink has $900 million in net operating loss carry-forwards. Prior to renaming itself ModusLink and focusing on logistics, the company was internet incubator CMGI. During the dotcom bubble, the company at one point had a market capitalization of over $45 billion! While the company was a terrific failure, managing to squander billions of shareholder capital, it generated significant taxable losses. These losses can be used to defer taxable income going forward. Because ModusLink has not been profitable in recent history, the auditors force the company to record a valuation allowance against its $800 million in deferred tax assets (which would allow it to shield ~$2.1 billion or so in taxable income). While it is prudent to keep a reserve against some of these assets, now that operations have been turned around, the company is expected to generate a profit starting with the current year and begin making use of these tax assets.

Activist Investor - Warren Lichtenstein's Steel Partners took a 27% stake in ModusLink back in February 2013. For those who don't know Steel Partners, it is an activist fund founded by Warren Lichtenstein which is focused on small and midsize companies with large net operating loss carry-forwards (NOLs). Steel is basically a specialist when it comes to extracting the value of these loss carry-forwards and as mentioned above, ModusLink has a ton of them. The form of the deal is instructive as Steel Partners acquired its stake in a transaction whereby ModusLink issued $30 million worth of shares to Steel Partners at a price of $4/share, a 45% premium to where the stock had been trading. In addition, Steel received 2 million warrants which are exercisable at $5/share. Steel Partners placed two directors, Warren Lichtenstein and Glen Kassan on ModusLink's Board of Directors. ModusLink already had a healthy net cash position at the time with $52 million in cash and no debt at January 31, 2013. By now you are probably wondering what Steel Partners is planning to do with ModusLink. Why did it inject cash into an already cash-rich entity? How is it going to extract value from the NOLs?

Acquisitions as a catalyst - At the top of page 3 of its April 8, 2013 letter to shareholders, Steel Partners tells you how it plans to monetize ModusLink's NOLs: "we are looking to grow Moduslink through acquisitions." Ok, now we know why it issued equity - to make acquisitions, make use of the NOLs and maximize shareholder value.

So what might ModusLink be worth taking into account the operational restructuring of its logistics business and knowing that it will be making acquisitions over time?

Let's first consider what type of profitability the logistics business will earn going forward. Last year the business was basically break-even after adding back restructuring charges. However, it didn't have the full-year benefit of its operating expense reductions. Also, the company has been both growing the business and expanding gross margins - we are likely to see some additional growth in gross margins going forward. Further, I expect that management will continue to find more efficient ways of doing business and think we might see a second wave of cost-cutting which could further boost operating margins. That said, logistics is a tough, competitive business. Overall, I think it is reasonable for the business to earn between a 2.5 and 4% operating margin. For the purpose of our analysis, I'm going to use a 3% operating margin assumption.

Second, what type of incremental earnings can we expect from acquisitions? Let's assume that as the business turns profitable, it is able to borrow debt in the amount of 3x EBITDA. This could prove conservative given that debt markets are pretty generous today and that the company will benefit from Steel/Warren Lichtenstein's connections. Further, when the company sits down with its lenders, it will be showing them an EBITDA which includes a pro-forma adjustment for the acquired business. I'll expand on this more later. Anyway, using our 3% operating margin assumption and adding back $14 million in depreciation, I get an EBITDA figure of $37 million which at 3x is $111 million in borrowing capacity. Let's add to this the company's cash pile of $77 million. Also, I'm assuming that the company can sell its venture capital portfolio for book value which gives us another $8 million. This produces a total war chest of $196 million.

Given that Steel Partners will play an active role in the acquisition process and that Steel has a strong track record of buying assets on the cheap, I'm assuming that ModusLink will get a pretty good deal on what it buys. Assuming ModusLink can buy a business (or more likely a couple of businesses) for 7x operating profit, this produces an additional $28 million in operating profit. Here's a look at the pro-forma ModusLink below:

Revenue

777

+3% vs. 2013 results

Operating Profit - Existing business

23

3% operating margin

+Acquired Operating Profit

28

Spend $196 million; pay 7x Operating Profit

Pro-Forma Operating Profit

51

-Interest Expense

-7.8

-Taxes

0

No Taxes to be paid; Huge NOL position

Net Income

44

Shares outstanding

51.5

+Warrants

2

$5 strike price

Total shares outstanding

53.5

EPS

0.81

Multiple

12

9.76

13

10.62

14

11.40

15

12.25

16

13.04

I've awarded the company a multiple of 14x earnings. On the surface this seems high - ModusLink is a low margin business in a competitive business with high levels of customer concentration (Hewlett-Packard is nearly 30% of revenue). However, I believe the high multiple is warranted by growth - specifically, ModusLink will continue to make acquisitions going forward. Taking the model above, simplistically the company would have an additional $44 million to invest (assumes net profit = free cash flow). Actually, it is even better than that. After spending $196 million on acquisitions, ModusLink has EBITDA of $58 million (=44 million in operating profit + 14 million in depreciation) which would give it $174 million in debt capacity (vs. the $111 assumed pre-acquisition; still using 3x net debt to EBITDA). Taking this additional $63 million and adding in the $44 million of cash generated would give the company the ability to spend another $107 million on an acquisition. If we assume that it pays 7x operating profit again, ModusLink would add another $15 million in operating profit (~30% growth). We could then reasonably expect the company to do this again the following year. This is the strategy I expect the company will pursue in an effort to make use of its tax assets and maximize shareholder value.

With a strong balance sheet, an activist investor, and a business that is now earning at least modest profitability, I don't see much downside in the shares. This is a highly asymmetric investment from my perspective.

Disclosure: I am long MLNK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.