Hedge Fund Goes All In With Overland Storage

| About: Overland Storage, (OVRL)

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Overland Storage (NASDAQ:OVRL) announced on 11/1/13 that it entered into a Definitive Agreement to acquire Tandberg Data Holdings, a company owned by private equity firm Cyrus Capital. The deal is scheduled to close by the end of 2013. Based upon information in the preliminary proxy statement, the combined companies should generate approximately $110 million of revenue in 2014, and be EBITDA positive net of charges related to integrating the two companies. Shareholders of each company will initially have 50% of the equity, however, upon voluntary conversion by Cyrus of its $1.30 convertible bond, Cyrus will own 63% of the combined entity, and have 2 Board seats. This is great news because we surmise that Cyrus wanted a public entity to begin its aggressive acquisition grab. Our discussions with Cyrus lead us to believe that it regards the new Overland as a platform to scale up via acquiring additional companies, eliminating duplicative costs to leverage profitability, and growing the company into a much larger company which will be sold. We are confident that Cyrus will succeed.

There is excellent synergy between the two companies in both products and customers, and the combined entity will have a truly global presence. Overland's strengths in clustered NAS storage, scale-out NAS storage and tape automation complement Tandberg's strengths in RDX removable disk cartridge, tape drives and media, and RDX licensing business. Where Overland's business is concentrated in the U.S. SMB market, Tandberg has a strong presence in

Europe and a cost-effective manufacturing base in China. In addition, the partnership with Sphere 3D has the potential to significantly increase revenue and profits.

The new $7 million convertible loan from Cyrus should more than cover integration related costs including closing facilities and severance packages. The company had about $7 million of working capital on the most recent balance sheet, and about $4.5 million available under its line of credit with Silicon Valley Bank. Tandberg itself is debt free. Therefore, we believe the company is more than adequately capitalized to support anticipated growth, and that no new equity needs to be issued. Cyrus would not invest so heavily in this deal unless the funding was in place to see it through.


If we compare the valuation to similar public storage companies, in our opinion Overland is currently 50% undervalued. After the integration is complete and the income statement shows a significant profit the company at this price is 66% undervalued. Price to Sales valuation is just 0.75 based on previous 2014 revenue guidance; and 0.50 based on the our expected 2014 revenue $120 million . Compare this to Qualstar Corp (NASDAQ:QBAK), with Price to Sales valuation of 1.27. Compare to Imation's (IMN) recent acquisition of Nexsan at 1.5 x Sales ($120 million). Compare to HGST's [a subsidiary of Western Digital Corp (NYSE:WDC)] recent acquisition of STEC at 1.4 x Sales.

In addition, the Tandberg/Overland combination has assets that competitors are sorely lacking. The investment in Sphere 3D is worth $3 million alone. Roth Capital recently doubled their price target for Overland from $1 to $2 based on this deal. They clearly see the opportunity here.

But consider this. Cyrus had $12 million of convertible notes in Overland paying 8% annually and convertible to common stock at $1.30. As part of this deal, they agreed to convert the notes immediately at $1.30 (subject to limitation as described below). The stock is trading at $0.90. Why would they agree to convert at $1.30 now (and foregoing future interest payments as well) unless they saw tremendous value here?

Cyrus (and partners) invested $15 million in Overland less than 1 year ago and are investing $7 million now for a total of $22 million (in addition to its investment in Tandberg). Overland's market cap is only $29 million. Why would they do this if they felt Overland wasn't worth at least double the current market cap?

Catalyst #1 - Cost saves

So what future events move the stock price up from $1 to $3? First, there are the cost saves from the deal. We have been told by management that the cost saves in 2014 will be huge. Operational efficiency and cheaper manufacturing are the keys. Materials costs will come down significantly through consolidation of suppliers. Annualized savings will run $10-$13 million in cost of goods sold, increasing the gross profit margin and gross profit dollars. The new facility in China should reduce manufacturing costs by more than 40%. The rest of the cost saves are from efficiencies in streamlining operations. The cost saves alone turn this company profitable, without even considering the growth opportunity.

Our model generates $20 million profit in FY 2016 (7/1/2015 - 6/30/2016). On a fully diluted and all-notes-converted basis, that's $.29/share.

Catalyst #2 - Products

There is excellent synergy between Overland and Tandberg in both products and customer base. The combined company has a broad product portfolio, ranging from early-stage growth initiatives such as enterprise/cloud mobility and storage/virtualization platforms with the Sphere3D partnership (see below) and scale-out NAS storage platforms to high-volume revenue drivers such as clustered NAS storage and removable RDX disk cartridge products to mature product lines such as tape automation platforms, tape drives, media, and virtual tape libraries. Overland's SnapScale clustered NAS solution recently won the Editor's Choice Award for Hardware Product of the Year at The Storage Awards 2013 in London.

The combined entity has the scale, product diversity, software/hardware platforms, and global support/service capabilities to realize the vision of emerging as a key provider of storage platforms and distributed cloud/mobility solutions. Going forward, their strategy will provide a complete suite of products to meet the needs of their channel partners and their target market, the hyper-growth SMB market. Eventually they will compete upstream for additional market share.

Catalyst #3 - Partnership with Sphere 3D

We expect the partnership with Sphere 3D to significantly boost revenues and profits. This is a game changer! Watch this 3 minute video and tell me that this is not one of the most impressive technologies you have recently seen. The combination of Overland's flagship SnapScale data storage, and Sphere 3D's Glassware 2.0 virtualization, will enable incompatible mobile device users the full functionality of any software program or application on any device, anywhere over the cloud, without sacrificing performance or security . This eliminates the application limitations, data management and security problems for enterprises created by the BYOD (Bring Your Own Device) phenomenon.

CEO Eric Kelly joined the Sphere 3D Board as Chairman. Overland plans to introduce a new product line during FY2014 designed to enable enterprises and individuals to securely access applications with full functionality from their mobile devices. The solutions will be delivered as a storage/software appliance or as a cloud offering. Watch the video - it's truly astounding

Catalyst #4 - Lawsuits

A couple of years ago, Overland Storage launched litigation against IBM (NYSE:IBM), DELL Inc. (NASDAQ:DELL), and BDT. The complaint broadly claimed infringement by BDT's products and it specifically identified BDT's FlexStor II product line as infringing on Overland's Storage patents.

BDT is the largest tape provider in the world (60-80% of the market). Overland claimed that BDT infringed on its patents and started selling equipment to Hewlett Packard (NYSE:HPQ). BDT won the contract with Hewlett Packard approximately 7 years ago by giving a discount with an identical product. The HP business represented 70% of Overland's revenue at the time (approximately $150 million per year).

Overland is represented by DLA Piper (the largest law firm in the world), with the case taken on contingency. John Allcock (lead counsel) had previously never lost a case in his career, with 71 infringement cases won. The Overland-BDT suit was filed with the ITC (International Trade Commission) and lost. The only reason that Overland was not victorious in the ITC court was due to the importation issue. BDT could not be proved to be the importer of record for the infringing products. However, in federal court that is not an issue. The case is still being fought by DLA Piper on contingency. It's our opinion that the firm has $5 - $7 million in billable time invested in a positive outcome. They clearly believe in the merits of Overland's case. We expect several settlements in 2014 and a positive result in federal court.

Lawsuits against other companies potentially infringing on Overland's patents are tee'd up in federal court for 2014.

Catalyst #5 - Hedge Fund Ownership

Everyone knows what eventually happens when a hedge fund becomes a majority owner of a public company. They have return hurdles to meet, partners to answer too, and deal makers in their rolodex. While we expect to see a strong new storage player in the long term, we foresee an even better outcome for investors in the short term. We expect to see a transaction that rewards stockholders within 12 to 18 months. Cyrus will own about 63% of OVRL post conversion of all debt to equity, so private equity is strongly incented to make additional acquisitions, scale up the revenue to $200 million+, and then sell the company. We expect that this company grows organically through the product offerings discussed above, and non-organically through acquisition. Only 22% of revenues come from the flat to declining tape storage business. We target revenues of $150 million in 2015 and an eventual merge into a bigger player at 1.4 times sales. During that time we believe we will see additional revenue come in through settlements and wins in federal court. We expect a transaction to occur in 2015 or sooner at $3 or more per share.

Some Deal Points Worth Highlighting

Pursuant to the Note Purchase Agreement (NPA), Cyrus and the other note holders agreed that all of currently outstanding convertible notes will automatically convert into shares of Common Stock at their existing conversion price of $1.30 per share, subject to a limitation prohibiting any such holder from holding more than 19.99% of the Company's outstanding common stock (81% will convert due to the limitation). Total debt drops from $21 million at the June fiscal year end to $6 million when the $1.30 notes convert into equity. There will be about 70 million common shares out post deal. The 9.7 million warrants are well out of the money at $1.76 average strike and have about 16 months left before they expire.

Outstanding principal under the Notes will bear interest at 8.0% simple interest per annum. The new $7 million convertible is very light on covenants and appears to be almost impossible to default on. The Company has the option to pay accrued and outstanding interest either entirely in cash or shares of Common Stock; provided that the Company may not pay interest in stock at a price per share lower than $0.90 (as adjusted for stock splits, stock dividends, etc.) and in the event of a share price lower than such amount, the Company shall have the option to pay interest in a combination of stock and cash subject to limitation on stock payment so the stock will not be diluted further.

The IP Portfolio

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The combined Overland/Tandberg entity has all of the elements investors want in an equity. Not only is it a tremendous value, it has excellent growth potential. It has a deal-making hedge fund majority owner which has recently invested amounts close to the entire current market cap of the company. It has near-term and long term potential catalysts in cost efficiencies, profitability, new products, internal synergies, lawsuits, further acquisitions and ultimately, a sale.

Disclosure: I am long OVRL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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