Elevated R&D Spend Masks Earnings Power At Image Sensing Systems

| About: Image Sensing (ISNS)
This article is now exclusive for PRO subscribers.

Summary

Consolidated net sales down 6% year-over-year; extreme weather conditions partly to blame.

GAAP earnings down, as royalty income stream is being reinvested in R&D for growth opportunities in software solutions -- Safe Cities.

GAAP earnings pressured by continued professional services expenses with respect to an ongoing, albeit winding down, FCPA investigation and non-cash charges.

Image Sensing Systems (NASDAQ:ISNS) "develops and markets video and radar processing products for use in traffic, security, police and parking applications such as intersection control, highway, bridge and tunnel traffic management, venue security, entry control, license plate recognition and traffic data collection."

ISNS also enjoys an attractive, predictable, scalable and high-margin royalty stream from its licensing agreement with Econolite, which allows ISNS to reinvest the royalty cash flow to build a software solution it calls "Safe Cities." Safe Cities is designed to leverage ISNS' competencies in above-ground detection hardware by adding a high-margin SaaS revenue stream for law enforcement, security and traffic management professionals.

Collectively, ISNS management estimates its end-markets to be up to an $800 million opportunity annually. This, in my view, is a large opportunity for a company valued at just $20 million.

Q1 Earnings Tough, Earnings Power Masked By R&D

ISNS released a tough Q1 earnings report, which saw consolidated revenue decline 6% year-over-year. While Q1 is typically a seasonally slow time of year for ISNS, it was further affected by extreme weather conditions in the quarter. Intuitively, ISNS' product portfolio -- a suite of above-ground detection products -- needs to be installed outdoors. Therefore, end-customers tend to order and install in the warmer months in Q2 and Q3. Accordingly, I expect ISNS to pick up some additional sales due to some pent-up demand from a sluggish Q1.

Meanwhile, the Econolite royalty stream was also down slightly, likely affected by weather conditions as well. When coupled with elevated R&D spend ($1.8 million, up from $1.1 million year-over-year) and a number of non-recurring (e.g., closing Poland operations, lingering FCPA investigation costs and warranty expenses, etc.) and non-cash (e.g., amortization of purchased intangible assets), ISNS' GAAP earnings looked ugly.

That said, the market is not giving ISNS or CEO Kris Tufto any credit for the significant R&D spend over the last 2 years to build a software solution that could lead to significant recurring revenue and long lifetime customer relationships. Stated differently, ISNS is building a platform comprised of hardware and software which, in theory, should lead to sticky customer relationships due to ISNS creating higher switching costs and a defendable moat. I believe this timing mismatch in R&D and potential revenue from Safe Cities is causing "time arbitrage."

The market, however, remains focused on the short term, and numerous analysts demanded explanations on the elevated R&D spend and cash position of ISNS. While management did not indicate a near-term liquidity issue on the conference call, investors appear to be bracing for a capital raise based on recent price action. I'm fairly confident a secondary is not going to happen given ISNS can dial back R&D spend if it needs to, and because ISNS continues to improve margins on its product business, meanwhile enjoying the royalty stream of its distribution partner, Econolite. Lastly, ISNS has an untapped $5 million revolving credit facility to weather any cash issues in the near term.

ISS Picks Up A Big Private Investor

Of particular interest to the ISNS investment thesis is that a successful private investor, Norman Pessin, filed a 13D indicating he and his wife collectively own 5.7% of ISNS. Given Mr. Pessin's demonstrated track record of success investing in nanocap companies -- like Nautilus (NYSE:NLS) -- I am glad to have him on board.

I called and spoke with Mr. Pessin on May 1 to discuss our shared interest in ISNS. Like me, Mr. Pessin views the Econolite royalty stream as a valuable asset, providing downside protection. Mr. Pessin also reported that he met ISNS CEO, Kris Tufto and CFO Dale Parker before making his initial investment. Mr. Pessin indicated that he was impressed with Mr. Tufto and Mr. Parker's pedigree and track records. I agree, and view Mr. Tufto's considerable experience growing software companies a key asset in ISNS' attempt to build out a SaaS platform for its Safe Cities initiative.

At the end of the day, investors are making investment decisions both on valuation, business models and other factors such as the quality of the management team. I view Mr. Tufto and Mr. Parker as an important part of the investment narrative.

Valuation

I continue to view the Econolite royalty stream as an integral part of the ISNS value proposition, which protects downside risk, allows the company to reinvest in its growth platform and could attract a potential acquirer for its attractive economic characteristics.

Today, ISNS (at its $20 million valuation) can be purchased for about 2x the relatively stable royalty stream. Therefore, a natural buyer for ISNS becomes its licensee, Econolite, because it can relieve itself of future royalty burdens simply by buying ISNS. Yes, there is a shareholder rights plan in place preventing a takeover at fire sale prices, but my guess is that the royalty stream is a key investment consideration for Econolite or a financial player. My view is unchanged from my last report, where I indicated the royalty stream is worth $40 million, or double the current market capitalization, with the rest of the product/software businesses thrown in for less than free.

Conclusion

ISNS is an interesting investment opportunity today. However, investors should note the risks with respect to nanocap stocks in general, especially ones with a low float (less than 5 million shares outstanding). Specifically, ISNS will likely remain challenged for the rest of 2014 due to management expectations for elevated R&D spend over the next several quarters. However, if Safe Cities turns into a meaningful software platform with a growing recurring revenue stream, ISNS will be a home run. It will just take some time to get there. Until then, downside -- in the form of permanent capital impairment -- is protected by the royalty stream and shares will remain volatile due to the limited float and daily trading volume.

Disclosure: I am long ISNS. 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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.