Research Frontiers (NASDAQ:REFR), currently trading at $5.90 a share with a market cap of $136 million, is substantially overvalued with an overstated addressable market, a history of diluting shareholders, and a sky-high valuation. Under certain circumstances shares could fall 75% to 90%.
Research Frontiers is not a new company. The technology is not new. The company was incorporated in New York in 1965 that makes this company nearly 50 years old. Age of a company is not usually a red flag unless a company has been selling the same story, and failing to deliver, for nearly that entire time. The company's roots go back even further than that, as it was "incorporated (...) to continue early work the Dr. Edwin Land, founder of Polaroid Corporation, and others had done in the work of light-control beginning in the 1930s." Bulls would like to have you think that this is some new technology, that major adoption is right around the corner. That has been the story for ages now and that adoption has never come. Research Frontiers licenses something called SPD or "suspended particle devices." SPD is essentially particles which are suspended between two sheets of glass, when an electric current passes through the glass, can be dimmed to control how much light can pass through the glass.
Over the years Research Frontiers has said that this technology will be used in car sunroofs, side mirrors, commercial and residential buildings, aircraft windows, goggles, and even sunglasses. So far none of these claims have played out, and the company generates only nominal revenue from licensing this technology to other companies. This is a very long story of a company that has never lived up to what it has claimed to have. The story of shareholders being diluted while management gets rich. Despite this history, there are still vocal supporters of Research Frontiers. I suspect that they will be burned yet again.
Research Frontiers generates minimal revenue by licensing the SPD product for various uses, mainly in automobiles and for use in aircraft. If you would like to learn more about the bull case, there was an interview with Research Frontiers' CEO published on Seeking Alpha. In an interview on Seeking Alpha, CEO Joseph Harary responded to a question about what his company did by saying:
"(...) Research Frontiers has invented and licenses Suspended Particle Device technology, which is a film based nano technology that allows you to control the tint of glass or plastic. The technology is used in four main industries. The largest is the automotive industry, the aircraft industry, the architectural industry and the marine industry. In addition, this year we launched our VariGuard division, which seeks to protect light sensitive artifacts from damage."
The company also has an IR presentation on its website which is useful for a quick overview. Bulls seem to believe that the company has finally turned the corner and that profitability is around the corner. They highlight the joint ventures with Mercedes and Daimler, defending their views by suggesting that Mercedes would never do business with a company with an inferior product, which may be true. Given the company's history however, investors should remain highly skeptical that any turning point has been reached.
The stock has floundered for much of the past 10 years after getting caught up in the tech bubble of the late 1990's. This article, which appeared around the time of Research Frontier's IPO in 1989 in the New York Times should put things in perspective for investors. The article reads:
Research Frontiers Inc. says it has successfully tested ''electrically controllable variable light transmission sunglasses'' that filter out 44 to 88 percent of the light, at the wearer's option. By comparison, ordinary window glass filters out 20 percent of the light, and dark sunglasses filter out 85 percent, said Robert L. Saxe, the company's president.
The technology may be adapted to ski goggles, helmet visors, and automobile sunroofs and side windows. Mr. Saxe said it also shows promise for windows in offices and homes, where it could be used to keep out sunlight on hot summer afternoons and allow it in during the winter. If equipped with an electric eye, the window -or sunglasses - could be set to maintain a constant light level no matter what the level of sunlight.
At that time it appears the company was focusing on sunglasses although it clearly had its sights set on bigger things. How long did it take to get there? Well in 2003 Research Frontiers announced that Daimler AG was using its technology in a bus, but that did not lead to any meaningful revenue for Research Fronties. Then in 2011 Research Frontiers announced that Mercedes had licensed its technology for the SLK.
As I will show, Research Frontiers has a history of similar deals with companies that failed to reward Research Frontiers shareholders. To finance this continued non-delivering of promises Research Frontiers has continually issued shares, diluting shareholders along the way. As you can see between 2000 and 2014 there was not a single year when the number of Research Frontiers Shares outstanding did not increase from the previous year. The pace of these increases appears to be increasing over the last several years as well.
For a brutally obvious example of how Research Frontiers has failed to deliver on its numerous promises, we can simply look to the first few sentences of annual reports and compare that to operating results.
Since our letter to you in last year's Annual Report, there have been some dramatic and exciting changes at Research Frontiers and in the various industries that our SPD light-control technology serves. In 2001 the Company's most important long-term goal-commercialization of SPD technology-was successfully accomplished! The supply infrastructure that we have been building over the years continues to grow and now consists of 15 companies licensed to make SPD emulsions, ﬁlms and end products. And now that SPD Inc.'s factory in Incheon, South Korea is in production, SPD-Smart™ products are beginning to be sold for a variety of applications worldwide. (Source)
"Mass production of products utilizing the Company's SPD (suspended particle device) light control technology started in 2002 to meet the growing need for light, glare and heat control in buildings and vehicles. The ﬁrst SPD ﬁlm production facility came online at the Incheon, South Korea, factory of SPD Inc. (SPDI), a majority-owned subsidiary of our licensee, Hankuk Glass Industries Inc., Korea's largest glass company. Our licensees have introduced a variety of SPD-Smart™ end-products using SPD ﬁlm produced by SPDI, including architectural, automotive, aircraft, marine, and appliance windows." (Source)
Last year at our annual meeting we spoke about "Building and Industry." Since then, all three of the world's largest glass groups have either licensed or sublicensed our SPD-Smart™ light-control technology. These companies include Japan's largest glass company, Asahi Glass Company, Ltd., which has acquired a sublicense from its affiliate, AGC Automotive Americas (formerly called APTechnoglass) for using SPD technology for automotive sunroofs. Saint-Gobain France SA, a subsidiary of Europe's largest glass company, Compagnie de Saint-Gobain, was granted a broad non-exclusive license to make various SPD-Smart™ products. And, most recently, Pilkington plc, inventors of the world-renowned float glass process for producing flat glass, has been granted a worldwide non-exclusive license to work with SPD Smart-light control technology and to provide lamination services to Research Frontiers' licensees."
"DaimlerChrysler's introduction in September outfits new Setra 415 HD luxury touring bus with a panoramic glass roof using SPD-Smart light control technology (pictured above). SPD-Smart glass is also being used in the Jeep Rescue concept vehicle which so far this year has been featured at the Detroit, Chicago and New York Auto Shows. In addition to DaimlerChrysler, other automobile manufacturers are working with our licensees to introduce a variety of SPD-Smart automotive products into their vehicles." (source)
This past year, ﬁve new companies became licensed to use SPD technology, and our 34 licensees now include some of the world's largest chemical, ﬁlm and glass companies. The customers that these licensees have been working with to introduce SPD-Smart™ products also include some of the world's largest aerospace and automotive companies. This past year, ﬁve new companies became licensed to use SPD technology, and our 34 licensees now include some of the world's largest chemical, ﬁlm and glass companies. The customers that these licensees have been working with to introduce SPD-Smart™ products also include some of the world's largest aerospace and automotive companies. (source)
There is a Haitian proverb: "Beyond the mountains are more mountains." This proverb applies to most companies involved in bringing a new technology to market. In R&D, after one issue is solved, others sometimes arise. It is appropriate to note that Haiti is an island nation, so that eventually, with perseverance and hard work, the mountains end, the goal is reached, and smooth sailing across the ocean of opportunity can begin. We are happy to report that we can see the ocean and some very large companies are preparing to bring SPD-Smart™ products to the world. While we have always focused intensely on the development of our SPD light-control technology, this past year in particular, the Company has been working with extreme dedication and has made several very important new inventions to enable our ﬁlm licensees to begin to successfully produce very attractive second generation SPD-Smart light-controlling ﬁlm. A key part of our R&D strategy is to anticipate and find solutions for any potential problem or weakness relating to SPD emulsions, ﬁlms or products. As discussed at our June 2005 Annual Meeting, part of this strategy is to gain further direct experience with commercially coating SPD emulsions into ﬁlm, and the Company has now completed our own coating trials using the facilities of an outside toll coater. (source)
Shareholders have often asked when a large manufacturer would begin selling or using SPD-Smart windows or other products. This question was decisively answered on February 9, 2007 when the Raytheon Aircraft Company announced in a press release that it is now offering electronic aircraft window shades using Research Frontiers' SPD-Smart light-control technology for retrofitting and upgrading all models of its Beechcraft® King Air aircraft. Now that SPD light-control film is available from Hitachi Chemical's production facilities in Japan, and additional sources of SPD film are expected to enter production, and with customer adoption now gaining traction and becoming known worldwide, we expect that the SPD industry will begin to grow and flourish. SPD Smart-technology also continues to receive worldwide attention at major trade shows, conferences and as the recipient of prestigious awards. (...) We believe that the future now looks very bright for Research Frontiers and we expect our licensees to achieve substantial business with SPD-Smart products for many applications. (source)
Here are what I consider to be the important highlights from each of these statements from 2001 to 2006. Note that after 2007 Research Frontiers changed the format of its annual letter into more of a brochure. While there is nothing wrong with this, it is simply a different format with easier to digest information. If there are more traditional shareholder letter from this time on I could not find them.
So now let's review the operating results.
Since Research Frontiers shareholders finally got their answer to "When will a large manufacturer begin selling SPD Smart-Glass." Research Frontiers has:
- Generated $8.6 million in fee income.
- Spent $44.3 million in total expenses.
- Generated a $21 million net losses.
Since Research Frontiers announced that it could "see the ocean" in 2005 Research Frontiers has:
- Generated $8.8 million in fee income.
- Spent $48.5 million in total expenses.
- Generated a $25 million net losses.
Since Daimler announced that it would have a bus using SPD Smart Glass in 2003, Research Frontiers has:
- Generated $9.28 million in fee income.
- Spent $57.9 million in total expenses.
- Generated $34.1 million in net losses.
Since Research Frontiers proudly announced that their products had reached mass production it has:
- Generated $9.5 million in revenue.
- Spent $62 million in total expenses.
- Generated $38 million in net losses.
Since Research Frontiers was "no longer a concept company" it has:
- Generated $9.64 million in revenue. Over 13 years this averages out to roughly $742k per year in revenue.
- Generated $67 million in total expenses.
- Generated $42.65 million in net losses.
Overstated Market Size, What Type Of Cars Would Use This?
Generally past actions, especially with a company that has a history of over promising and under delivering, are a good predictor of future action. In building a strong short case, one should not just rely on the past. Bulls will no doubt argue that the company has finally "turned the corner" and that the long promised fee income will now start coming in. Is that the case? Well one can never be certain, and Research Frontiers may have, finally after all these years actually made the turn. Even if it has, I believe that it is overstating the size of the potential market for its product. In the previously mentioned interview with the CEO on Seeking Alpha, CEO Harary responded to a question about the market size potential by saying:
Brett: SPD-SmartGlass is primarily used in premium vehicles. Is your company working with non-luxury automakers to put this technology in regular cars and is there a need for this high end technology in regular cars?
CEO Joesph Harary: There's certainly a need and if you look at the way technology is deployed is that many technologies are deployed in premium vehicles first before they go to regular cars. Anti-lock brakes were used only in premium vehicles. Typically the volumes in the auto industry are such that it drives the price down to the point where we can penetrate many different vehicles. Even if we just looked at premium vehicle sunroofs with an MSRP above $40,000 (sic) your talking about a $225 million. Add to that non-sunroofs and regular vehicles and you can see that the market opportunity is very large.
While technology may be deployed that way for some products, it seems ludicrous to compare a product that controls how much light comes into a car, to a product that saves lives such as anti-lock brakes. Right now the product costs $2,500 more for someone purchasing a Mercedes to get the Magic Sky system in their car. Can the cost be lowered? Perhaps but lowered enough to make it attractive to those purchasing a $40,000 car. The Mercedes S series starts at $92,900. For someone who is paying that much for a car is an extra $2500 really all that much? The answer is probably no as it is only 3% more with the Sky Magic roof than without it. As you move down the luxury car line and prices fall, however, it is a much less attractive tradeoff. For example with a $50,000 car to get the roof would cost you 5% more. At $40,000 it would cost you 6% more. At $30,000 it would cost you 8% more. At $20,000 it would cost 13% more. As you go down that line and buyers become more price conscious, they are much less likely to fork over an extra $2,500 for something that is clearly a luxury. Clearly this product is not anywhere close to being as important as anti-lock brakes.
CEO Comments On Margins, Huh?
From the same interview with the CEO on Seeking Alpha. When asked about his company's margins, CEO Harary said:
Brett: Another area that seems to stand out is your company's margins. They appear to be deep in negative territory. What is Research Frontiers doing to improve its margins?
CEO Joseph (sic) Harry: We actually have very high margins, but our products were not put into vehicles until 2011. As a licensing company we don't have inventory so we are getting a royalty of typically between 10 and 15 percent of the revenues come from royalties. As the revenues grow so will the profitability.
This is a chart of Research Frontiers' gross margins.
As you can see they are not positive, in fact they are nowhere near being positive. CEO Harary focuses in on the licensing aspect of it. A company that licenses its product does not produce anything obviously has positive margins. But for the past 13 years apparently the product was either too expensive or not good enough to generate any fee income for the company. So true margins are very negative. In 2013 they were -272%. Of course, if you ignore expenses margins might be positive, but you can't do that. In the Q&A for the 4Q13 Conference Call, Craig-Hallum analyst Steve Dyer asked:
You had talked a little bit about the royalty per S-Class that you anticipate a $150 to $250.
For a product that Mercedes sells as a $2,500 upgrade, Research Frontiers gets between $150 and $250. Assuming a 100% rate, like the company does in its presentations, then that will generate solid revenue.
Think about that for a second, Daimler's luxury vehicles represent a $94mm annual revenue opportunity IF they get a 100% take rate. That is a huge assumption to make given that most cars don't have a need for a panoramic sunroof. Mainly hardtop convertibles or sports cars, not every single luxury vehicle that Daimler produces at a 100% take rate. It would appear that Research Frontiers is setting shareholders up for a major disappointment if that's 100% take rate.
On Expenses, It's Not Just A One Time Thing
Drawing from the same interview again, the CEO made a notable comment when asked about rising expenses.
Brett: What is your company doing to tackle its rising expenses?
CEO Joseph Harary:A lot of those were non cash expenses. These are mostly accounting treatments for equity issuances and things. Our expenses are still relatively modest. it's not anything that is a change in our business model. Many of these expenses were related to the creation of the VariGuard Division, so it's not that important. Nothing really material.
While those expenses may truly be one time expenses, they certainly seem to be at similar levels multiple times in the past 15 years. I found another quote that Mr. Harary made regarding his company's business model very interesting. After being asked about the possibility of a special dividend, Mr. Harary noted:
"One of the nice things about our business model is that we have very modest and predictable expenses."
Here is a chart of Research Frontiers' total expenses ranging back to 2000.
That do not look either predictable or modest.
An Attempt At Valuation
Given that Research Frontiers is nowhere near close to being profitable, and has not generated meaningful revenue since inception, it is somewhat difficult to value. A brief comparison to some of Research Frontier's competitors will reveal that it appears wildly overvalued.
As you can see Research Frontiers trades at 26x its nearest competitor, which is Corning (NYSE:GLW). To give readers an idea of what downside could be, here is the implied share price and multiples at decreasing P/S multiples.
I believe that Corning is the closest competitor of Research Frontier. Corning and Research Frontiers do different things but both produce a technologically advanced glass. Corning also has the highest P/S multiple in the group. If Research Frontiers traded in-line with Corning that would suggest 96% downside. Here are the P/S ratios of some popular stocks. Netflix trades at 5x P/S, Tesla trades at 13x P/S, Keurig Green Mountain trades at 5x P/S, Micron trades at 2x P/S, Facebook trades at 18x P/S, Twitter trades at 28x P/S.
The reason that it could drop so much this time after floundering for so long is the sky high expectations that are priced into it. Before it was just a bus that product was going to be in, or a smaller market. Now the expectation is that it is going to be in every luxury car, in airplanes, in museums protecting documents. Consider this, for Research Frontiers to grow into a generous 30x P/S it would have to quadruple its fee income. Can it do this? I do not believe it can. Given the overstated market in luxury cars and relatively small market in airplanes this isn't happening anytime soon. The aircraft market wouldn't have SPD Technology ready until 2015 to 2017 according to the Q4 Conference Call, so until then they will be relying on just the auto and museum markets to generate revenue. And analysts are modeling the stock like Research Frontiers is finally done building its product. The same Craig-Hallum analyst said on the Q4 call,
Last question for me, as you begin to ramp revenues more meaningfully with the S, et cetera, should we see an increase of much at all in the operating expenses, in other words R&D, I mean my guess is the R&D is pretty much done other than tweaks here and there?
If he is modeling that R&D will fall drastically soon then he, as one of the few analysts covering the name, is setting up institutional shareholders for disappointment. If you read carefully you can see that Research Frontiers is already setting itself up for other markets such as architecture and museums. This is despite what they claim is a $225mm revenue opportunity in the luxury auto market. If Research Frontiers thought that they could get a meaningful slice of that they wouldn't be announcing new groups and segments. As has happened numerous times in the past, the fee income from Mercedes will fail to impress. Institutional shareholders that got involved because of an analyst with a model that was projecting zero (or close to) R&D going forward will be angry and sell. As the market realizes this and the long history of similar actions I believe it will no longer be willing to pay such a premium for expected growth that will likely not materialize.
Noticing a trend here? Even some of the most (arguably) overvalued and high growth stocks trade at a multiple far below that of Research Frontiers. Is there a catalyst to cause this drop? Not necessarily a hard catalyst but Research Frontiers has set expectations very high this time. Do shareholders remember the past, all the unrealized expectations? If Research Frontiers can't deliver this time over the next several quarters, this will be enough of a catalyst. History rhymes and if the past is any indication, Research Frontiers shareholders are set up for another disappointment. One last thought, since 2001 Research Frontiers has issued 10.85 million shares. Over that same period it has generated $9.64 million in revenue. So just to be clear, over that time frame it has issued roughly 1.1 shares for each $1 of revenue it has generated. All the while promising shareholders that this time was finally different. Is this time different? We'll see. History would suggest that it isn't. If this time isn't different then, reasonable valuation assumptions suggest between 76% to 95% downside.
Note: These opinions are my own. As always do your own due diligence. If you believe I have made any errors in my analysis please contact me and I will address them if I am incorrect or misstated anything. I have contacted IR for Research Frontiers' with some of these questions but I have not heard back. If I do hear back I will follow up on this article with any clarifications.
Disclosure: The author is short REFR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.