PCTEL: Index Fund Selling Creates Opportunity

| About: PCTEL, Inc. (PCTI)
This article is now exclusive for PRO subscribers.

Summary

PCTI offers an extremely favorable risk/reward opportunity following massive selling by index funds after the stock was removed from the S&P 600 Index.

We strongly urge the Board to conduct a tender offer for 20% of the shares outstanding at $8 per share.

Severe winter weather negatively impacted Q1 results; however, our primary research indicates that business has rebounded in Q2.

We expect Q2 results will serve as a catalyst to revalue the stock as investors become more comfortable that FY 2014 guidance is attainable.

PCTI pays a dividend of 2.2% which compensates investors while they wait for investor sentiment to improve.

PCTEL (NASDAQ:PCTI) is a compelling investment following the massive selling by index funds after the stock was removed from the S&P 600 Index on May 30th. Severe winter weather negatively impacted Q1 results; however, our primary research indicates that business has rebounded strongly in Q2. The Street clearly does not believe management's guidance for FY 2014 but our research suggests the guidance is attainable. We expect Q2 results will serve as a catalyst for the stock to revalue higher as investors become more comfortable that FY 2014 guidance is indeed realistic.

PCTI operates in a space with attractive fundamentals such as high gross margins, stable competition, and secular growth opportunities.

Following the purge by the index funds, PCTI trades at an unsustainably low valuation relative to comparable companies and recent M&A transactions. The company has an overcapitalized balance sheet with zero debt and over $3 per share in cash. We think the Board should conduct a tender offer for 20% of the shares outstanding at $8 per share. We believe the intrinsic value of PCTI is $11 per share, which equates to +50% upside. Our suggested tender offer would add an additional $1 of upside for shareholders. The stock pays a solid dividend of 2.2% which compensates investors while they wait for investor sentiment to improve.

Company Overview:

PCTEL designs and develops high-value antenna, scanning receiver, and engineered site solutions and services for public and private networks. The Connected Solutions segment (68% of revenue) simplifies network and site deployment for wireless data and communications applications for private and public networks, public safety, and government customers. It develops and sells high-value antennas, specialized towers, enclosures, and cable assemblies for custom engineered site solutions.

The RF Solutions segment (32% of revenue) develops and supports network test equipment to measure and analyze wireless signals for efficient cellular network planning, deployment, and optimization. The RF Solutions segment also includes a services business that specializes in the design, testing, and optimization of in-building, small cell, and traditional wireless networks, which enables superior utilization of wireless spectrum for cellular and WiFi networks.

Index Selling Creates Attractive Entry Point

The fundamental investor's best friend is the non-economic market participant. An economic buyer is motivated by profit; a non-economic buyer has a different agenda that is not necessarily profit maximizing. Index funds are classic examples of non-economic market participants; their goal is simply to replicate a given index. This mindless buying and selling can create temporary distortions in stock prices of companies entering and exiting indexes. This phenomenon is particularly powerful in small cap companies where trading liquidity is less plentiful.

On May 22nd, S&P Dow Jones Indices announced that PCTI was being removed from the S&P Small Cap 600 Index to make room for General Cable (NYSE:BGC) which was being dropped down from the S&P MidCap 400. The chart below shows the incredible selling that resulted from the index funds' rebalancing.

PCTI has normal trading volume of ~45k shares per day but on May 30th (the last day before the S&P 600 change was official) the stock traded over 2.4m shares. In the eight days following the S&P announcement, the stock has traded an average of 488k shares per day or 10x its normal amount. Predictably, there was not a natural buyer to soak up of all of this supply and the stock price declined meaningfully. We posit the index selling was entirely responsible for the stock's move from $8 per share to $7. With the index rebalancing behind us, we expect the stock price will steadily move back towards its prior range of $8 -$8.50 within the next few weeks.

Q2 Earnings Should Be Catalyst For The Stock

We think PCTI is a similar situation to our last Seeking Alpha write-up, VASCO Data Security (NASDAQ:VDSI), going into its Q1 earnings report. We thought Street expectations were too low for VDSI and our primary research suggested strong Q1 results and meaningful improvement in future guidance. VDSI played out just like we predicted and the stock revalued +50% higher within a few days.

We see a similar opportunity in PCTI as the Street clearly does not believe management's FY 2014 guidance is attainable.

PCTI's Q1 2014 financial results disappointed investors as revenue fell -5.6% yr/yr. Management attributed the poor performance to the severe winter weather. Given the operating leverage in the business model, the revenue shortfall evaporated operating income and EPS.

Despite the revenue shortfall, PCTI kept FY 2014 guidance (revenue of $112-114m) intact and actually communicated a slight directional increase in revenue expectations.

"Core antenna sales were soft for seasonal reasons but we expect a strong rebound this quarter in that product area. That coupled with new business makes us comfortable with the high end of our previous revenue guidance of $112 - $114m for our full year 2014."

-Marty Singer, PCTI Chairman and CEO

Source: Q1 2013 Earnings Press Release

The stock drifted down from ~$9 per share to ~$8 in the days following Q1 earnings. We interpret this decline to mean the market didn't buy the winter weather excuse and sees FY 2014 guidance being unrealistic. Our divergent viewpoint on PCTI is that winter weather was indeed the actual driver of the revenue disappointment and that business has since rebounded sharply. Our primary research indicates Q2 will surpass market expectations. We expect Q2 results will serve as a catalyst to revalue the stock as investors become more comfortable that FY 2014 guidance is indeed realistic.

Our primary research consisted of interviewing PCTI customers and distributors, and each source independently said that the severe winter weather in Q1 was responsible for the slowdown across the industry. They also said they have seen a rebound in activity as the weather has improved. We believe our research suggests the disappointment in Q1 was not a harbinger of larger problems and we expect Q2 results to be better than expectations.

Direct quotes:

"We experienced a slower start to the year, not too many people were installing antennas during the winter. Our sales have started to pick up since the weather has been warmer."

- Contact at Distributor #1

"First quarter was relatively slow but it has started to pick up again"

- Contact at Customer #1

"There was not a lot of construction going on during the winter but we have seen our business ramp up since it's warmed up."

- Contact at Distributor #2

Solid Business Model and Fundamental Trends

PCTI has a solid business model operating in a healthy and growing industry. The company is well positioned to benefit for the explosion of mobile data consumption. As more consumers assimilate smartphones and tablets into their lives, the demands on wireless networks will continue to increase. PCTI offers products and solutions that enable superior utilization of spectrum and networks; we believe PCTI's industry niche is enjoying secular growth.

PCTI primarily competes against Laird and Larsen. According to our research, PCTI offerings compare favorably to the competition and the brand is very reputable within the industry. Industry competition is not overly fierce as the three major players have found a way to coexist. Our research indicates that customers typically start with one brand and stay with it. Even though the switching costs aren't high, the industry has relatively loyal customer bases.

PCTI generates gross margins of ~40% which we find quite attractive given the growth opportunities. We expect both segments to grow throughout the remainder of FY 2014.

Extreme Discount to Comparable Companies and M&A Transactions, Overcapitalized Balance Sheet

Following the purge by the index funds, PCTI now trades at an unsustainably low valuation relative to comparable companies and recent M&A transactions. The company has an overcapitalized balance sheet with zero debt and $3.02 per share in cash. If we back out the cash hoard, the equity value of PCTI is only $4.25 per share for an enterprise value of $79m.

We think it's realistic that PCTI will be able to generate annual EPS of ~$0.40 in the near future which means the stock is trading at just over 10x PE. We believe this multiple is way too low given the company's growth potential and attractive profit margins.

The peer group currently trades at 10x EBITDA, 30x earnings, and 1.6x EV/Revenue. If we apply the peer group multiples to PCTI, fair value is $11-12 per share.

Comparable M&A transactions have been done at 11x EBITDA, 25x earnings, and 1.6x EV/Revenue. If we apply the M&A multiples to PCTI, fair value is $11-12 per share.

Source: Bloomberg

Note: Our valuation method adds back the excess cash at PCTI for the PE ratio analysis

Opportunity For Highly Accretive Tender Offer

PCTI consistently generates significant operating cash flow and it has minimal CAPEX requirements so cash tends to accumulated over time. The company currently has over $56m in cash (vs. market cap of $135m) which is way more than it needs to maintain its operations. We strongly urge the Board to conduct a tender offer for 20% of the shares outstanding at $8 per share. This action would allow investors to benefit from the depressed stock price and it would be highly accretive to shareholders longer term. Our suggested tender offer would consume $30m which would still leave the business with over $26m in cash ($1.76 per share). We believe our tender offer plan would increase shareholder value by $1.00 per share, which is significant considering the stock is trading at $7.27.

This tender offer is an easy way to create meaningful shareholder value while still preserving operational and strategic flexibility for the company. We are optimistic that our tender offer plan will get serious consideration given that insiders own 5% of the company.

Dividend Yield Compensates Investors to Wait

PCTI pays a nice dividend of 2.2% which compensates investors while they wait for investor sentiment to improve. With zero debt and ample free cash flow, we think the dividend is very secure and could even be increased in the near future.

Conclusion:

We see an extremely favorable risk/reward opportunity in PCTI. We estimate the stock has 4.6x upside potential to downside risk. The temporary effects of the extreme winter weather took the stock down from $9 to $8, and then mindless index selling took the stock down from $8 to $7. Ignoring this noise, PCTI is an attractive business in a growing industry. We think the stock is significantly mispriced and we see fair value at $11 per share or +50% upside.

Disclosure: I am long PCTI. 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.