Tollgrade Communications, Inc. (NASDAQ:TLGD) designs, engineers, markets and supports test system, status monitoring hardware, software, and green products for the telecommunications and power utility markets.
Step 1 - We first search for companies with pristine balance sheets.
Tollgrade ended July 2010 with $66.6 million in cash and no debt, giving shareholders $5.23 cash per share. They have an enterprise value, with $50 million in annual sales, of only $18 million, or just $1.45 per share. This is an outstandingly strong balance sheet.
Step 2 - We like extremely low values.
Tollgrade is one of the low value companies we have identified. The enterprise value per share is only $1.45 and last quarter's profits were $.10 per share giving them an annual earning potential of around $.40 per share. The projected earnings provide a future P/E of about 16. If you take the cash out, as some buyouts do, it's only about 3.6 times enterprise profits.
Tollgrade's trailing annual sales were $46.5 million, which gives an enterprise sales value of about $.50 per share. The last quarter sales of $11.5 million is about half the entire enterprise value of $20 million keeping in mind that this is after subtracting the cash.
Their last quarter return on the enterprise value after taxes was 27% annualised. With the potential of reducing marketing and overhead expense, a company could purchase Tollgrade’s enterprise with realized synergistic savings more than double the 27% existing rate of return.
Step 3 - Is the operation or enterprise driving value to their shareholders?
For the second quarter ended June 2010, they reported their first positive quarterly net income since the third quarter of 2008. During the quarter, they took a one time charge of approximately $1.7 million. Those charges would have increased operational income over $.09 cents.
The gross profit in the second quarter of 2010 was $7.0 million compared to $5.2 million in the second quarter of 2009, or a 35% increase. As a percentage of sales, the gross profit margin for the second quarter of 2010 was 61% versus 49% for the second quarter of 2009. The increase in the gross profit margin was achieved by management's aggressive cost reduction tactics and higher sales. The reductions were initially implemented last quarter but we believe further financial execution will develop an even larger margin.
This work force reduction was completed by the end of the second quarter 2010, and together with attrition, they project annualized savings in excess of $6 million.
Step 4 - Is this a good business?
Very much so, yes.
Key infrastructure is a very good and profitable business; because of the many barriers to entry, including technology and knowledge, this industry often has less competition. We have watched many companies use this key resource as a strategy to launch companies into great wealth and size. The single best example, I could think of is Hewlett Packard (NYSE:HPQ), even though they are vastly different companies.
The high barriers allowed Tollgrade to provide very good gross margin in the 60% range, even knowing the last few years they have been outperformed by most of their peers. Making high profit margins during a slow time is a sign of low direct competition.
Key Infrastructure such as test and measurement systems have been doing good businesses. While the smart grid is still not materializing as fast as many predicted, the push for a greener and more efficient national electronic grid illustrates robust growth prospects for the company, and possibly a higher P/E ratio.
Step 5 - Is the Train Wreck and then the fog from the Wreck clearing?
When finding companies with a negative enterprise, or in this case, extremely low enterprise values, often a "Train Wreck" is needed to drive value close to cash. We have identified some major issues that have kept the value so low:
1. Past management.
2. Share holder activist
Even though many thought that the management as a whole was under-performing, we believe the weakness was focused in both operations and cost control. With Tolllgrade’s outstanding financial and operational execution, it appears that their management has outperformed most, if not all, of their peers making management a strength, not a weakness. The past Chairman, President and CEO Joseph Ferrara has been completely removed and has no known direct involvement. It appears that Ferrara simply lacked the skill, control and foresight to grow the value of the enterprise. As Ferrara relinquished control, Tollgrade brought in established leadership in Edward H Kennedy.
Kennedy was co-founder and CEO of a company named Ocular Networks Inc, being the chief steward that helped grow and then sold Tellabs Inc. in 2002 for $355 million. Since selling, Kennedy was President and CEO of another start up company named Rivulet Communications which was sold in April 2010 to NDS. Here is the official announcement on the sale of Rivulet.
Kennedy has surrounded himself with the same managerial support staff that he had at both Ocular Networks Inc and Rivule with Greg Nulty. He was hired as the new Vice President of Marketing for a second stint at Tollgrade. The new management team has an outstanding record of success. One of his first moves was to reduce two new major technology projects that appear to have a low probability of success. He did this while increasing sales, and lowering their reliance on concentrated clients. We believe Kennedy has the potential of being a diamond in the the ruff.
Ramius Capital, (also filed under RCG Holding and Cowen group with the SEC click here),
claimed “Tollgrade...lacked experience in the technology and telecoms industry.” It also asserts that operating performance issues had not been addressed and that the business had suffered despite “excessive” spending on research and development and “poorly executed” acquisitions.
This caused an epic proxy battle for control of the board of directors. A house divided has little opportunity to grow let alone stay afloat. Thus, the infighting helped the investment community believe Tollgrade was on the wrong track. When the board appointed outside leadership with no connections to the company or to Ramius, the internal fighting appeared to have come to a complete end.
Since Kennedy and Nulty have taken leadership roles, the Ramius group, reportedly holding 16.55% or over 2 million shares, has not tried to publicly intervene. It seems that the new leadership has strengthened corporate governance and shareholders, management and the board are on the same path.
We enjoy companies that can provide outstanding short term execution -- turning weaknesses into real strengths, while at the same time bringing down the costs causing the the cash flow to increase substantially. They are attempting to greatly enhance both their growth prospects and value added position with many new solutions for a diversified clientele that is driving their future success.
We believe Tollgrade Technologies has value, execution and a balance sheet like past technology companies that fit our model---e.g. Tessera Technologies Inc.(TRSA), O2Mirco International Limited (OIIM), Sonus Nerworks (SONS), Silicon Graphics International (SGI), and DivX (DIVX). We're optimistic that Tollgrade will have a similar outcome knowing other technology companies that fit this model have performed well. They have completed excellent quarters and have already attained growth of assets.
We have provided some ratios to help value Tollgrade Technologies:
|Price to Enterprise Sales||.48||4.45||3.68||2.32|
1. Revenue Based.
When valuing the enterprise, knowing Tollgrade's stock price is based with over 70% cash, the underlying enterprise value disparity greatly increases. If you want to compare TLGD to its peers in sales values, assuming $46 million in revenues times the lower “sector” multiple you get an enterprise value per share of 13.35 per share plus the $5.23 of cash; you get a combined value of $23.81 per share.
|Valuation||Tollgrade Technologies||Industry||Sector||S&P 500|
|P/E Ratio to enterprise.||3.6||21.89||20.50||17.99|
2. Earnings Based.
Using the "sector" as a benchmark P/E for comparison, with a run rate of $.40 cents per share, times the $20.50 sector peer P/E, this gives a value of $8.2 a share -- plus the $5.23 cash, this places earnings at $13.43.
We believe that Tollgrade is trading at about a 50% discount to many of its peers and well below most small companies in their field. We find Tollgrade Technologies' valuation low, with the belief that they have both a very solid franchise and that their strong improvement in cash flow makes them an excellent buyout candidate. The earnings have been outstanding with a new corporate leader that has proven success of leadership in growing and selling companies.
Disclosure: Durig Capital owns TLGD for itself, clients and related client accounts. When we published this article the stock was $6.72 per share.