Communications Systems Inc. - Operational Volatility Clouds Future Outlook

| About: Communications Systems, (JCS)
This article is now exclusive for PRO subscribers.

Summary

This company, focused on telecommunication products, is currently sporting an interesting valuation as it is trading around NCAV and issues a small dividend of 3% per annum.

While this might be attractive, I believe the company is facing several fundamental challenges. Most importantly, it is the revenue volatility which prevents stable cash flow generation.

The operations are also unlikely to be efficient as costs are growing regardless of the top line. The company is trying to counter this, but I believe that not enough.

These issues are not something new and I believe that they have been left unanswered due to a possible status quo of management (unchanged board, low equity participation etc.).

Due to all this, I believe it is challenging to answer whether the recent share price downturn was overdone, especially when the upside likely relies on sale of new products.

Company Introduction

Communication Systems Inc. (NASDAQ:JCS) is a company operating three connected businesses. The biggest subsidiary in terms of revenue is Suttle which focuses on a variety of basic connectivity products such as wall plates, jacks and others. The other hardware subsidiary is Transition Networks which is focused more on networking solutions such as media converters or switches. The last subsidiary is JDL Technologies which is a service-based company that aims to support computer networks for other companies. Their customers are predominantly schools under the e-rate program. They also recently launched a new venture Net2Edge which is similar to Transition Networks but operates in the UK.

They segment their revenue on the basis of these subsidiaries as can be seen below.

Suttle and Transition Networks also sell their products abroad. The international sales have accounted for 15% of Suttle's sales and 27.1% of Transition Networks' sales.

The revenue stream is also fairly concentrated in each subsidiary as they are usually dependent on several larger custom. Last year, top ten customers accounted for 67% of the net sales, of which the largest one (from Suttle) accounted for 16%. These are usually the large telecom companies such as Verizon (NYSE:VZ), AT&T (NYSE:T) or CenturyLink (NYSE:CTL).

Investment Thesis

I got interested in the stock because of the fact that it is now trading near its NCAV value with a dividend yield of roughly 3% and ability to create free cash flow. While these might be appealing, I believe that due to the following points, it is hard to understand whether the recent share price downturn was overdone or not.

  • The company's revenue stream is extremely volatile and the management does not seem to be able to do much about it. All of the three subsidiaries are dependent on new contracts in order to break even, and the company does not seem to be consistent in achieving these. I believe that the company might be too large to be niche and too small to be able to hit these larger contracts on a regular basis. This means that one can't be sure whether they are going to create cash or not in the near future which is, for now, crucial.
  • JCS's operations are not likely to be efficient. While the revenue is volatile, their cost basis is unchanged and actually growing which could mean that they are unable to cut cost. While the cash flow can be strong, the fact there is a room for significant operational improvement is not ideal. They did close down part of their operations in Costa Rica recently, but the likely cost savings might be less than 4% of total operating costs per annum.
  • These fundamental challenges are present for some time now, and the management does not seem to be pushing for sufficiently large changes. I believe that this is due to the stale status quo present in the board of directors and likely incentives of the top management. The founder of the company owns 12.1%, while the current CEO and other board members have little to no equity. As the founder has been with the company for over 40 years, he might be reluctant to change things around. He also got his son on the board who might support the existing structure. The company also has a poison pill, thus it is not the easiest activist target either. All this then creates incentives that are not ideal given the state of the operations. That being said, GAMCO owns 12.42% of the company and might be trying to pressure the board (a significant amount of shares are being cast in opposition to the incumbent board members already).

In the end, the management issues would not be such a problem if the company's revenue was not as volatile. It makes it hard to be able to say whether the company will create cash or not. Investors will know only when the company signs a new contract or reports its results as disclosure is scarce.

It might be that the relatively safe dividend yield and the current valuation is providing enough margin of safety for investors, but that really depends on how are they going to fix the fundamental issues and if they are able to grow the new products which is not clear as of now. If they are unable to do so, their NCAV value could shrink due to the negative cash flow in the past few quarters.

Revenue Volatility

As mentioned, the main issue is the fact that the company is unable to stabilize their top line which invariably affects the operations. This issue is present in all subsidiaries as seen below.

  • Suttle

This hardware subsidiary has been particularly hit by the revenue instability, as in 2015 the revenue was lower by roughly 21%.

suttle.png

This was mainly due to the fact that a specific customer curtailed its orders of Suttle's FTTx products. They also mentioned that the overall decline was also partially due to trouble in sales of legacy products. In the beginning of last year, the management has said that they continue to aggressively invest in R&D in order to be able to widen their market reach, but I am not sure how much of an effect will this have, as in the past nine months the revenue from the subsidiary is even lower than in 2015.

I would also say that their products are partially commoditized, and therefore they are unlikely to gain an edge through their offering, but rather they should focus on operational efficiency, which as we will see, they seem to struggle with as well.

That being said, the company does stress the importance of the future product releases as an important milestone that should offset the decline in legacy products.

  • Transition Networks

The other hardware subsidiary is similar to Suttle, in that the revenue was driven by large one-off contracts and that the products are not easily differentiated in the market.

The largest such contract occurred in 2011 when a 'Fortune 500' company did a significant network upgrade. Since then, the revenue kept on falling, which the company credited mostly to fall in government spending. This might continue underneath Trump administration as suggested here. Apart from investing into new products, the management failed to mention any new developments that should show that the current revenue trend is going to change. The only thing they pointed out in their 2016 presentation was that the macro environment might be favourable, as there is a push to cater to higher bandwidth needs etc.

The subsidiary is also likely to show another decline in revenue for the last year as the past nine months have been lower.

  • JDL technologies

This subsidiary is the only one that has not been suffering from its revenue composition. This networking service provider is enjoying a slight run-up in revenues, and while it is also volatile, the next three years should not be an issue due to the subsidiary's long-term contract.

JDL is currently predominantly servicing school districts in Florida under the e-rate program. The main contract is with the Broward County where JDL won a re-bid proposal with $83 million slated to be gradually awarded up until 2020. This means that this subsidiary is not going to struggle in the near future, but the impact on the whole of the company is minor as the subsidiary's gross profits account only for 15% of the total.

Although they could be able to scale this business as the e-rate program was recently expanded by the FCC. That being said, I found one strange bid proposal for Brevard County where JCS had the highest price of all. They bid $286 million against the winning bid of $4.2 million. The company also has been present in the sector since at least early 2000s and failed to gain meaningful traction apart from the few contracts, and therefore it might be troublesome for them to grow the business.

Unable to adjust operational costs

The revenue issue would not be such a challenge should the company be able to curtail its operational costs, but this is not the case as SG&A have been growing despite the slowdown in revenue.

This is mainly tied to new product development for each subsidiary, especially in the case of Suttle. While this might be necessary it shows that the company might struggle to regain their margins for a while now should they continue their R&D efforts (as it seems that they will as mentioned in the 2016 shareholder presentation).

The company though does seem to start to cut costs as it announced that it will shut the operations in Costa Rica which were tied to Suttle. This also shows that the company could still probably outsource more as a significant part of the products is manufactured in the US. While the step to shut Costa Rica is reasonable the impact is likely to be insignificant as the company mentioned that costs associated with the shutdown will be around $1.6 million which should be regained in under one year. Savings of around $1.6 million per annum would then be only 4% of total company's operational costs.

The gross margins are also slightly impacted (mainly in Suttle) but this can be credited to product mix as legacy products and R&D efforts weigh on the profitability.

These operational challenges then can also impact the employee experience as can be seen in these largely negative reviews of Transition Networks. While these can be of normal occurrence during a restructuring it should not be taken lightly, especially when one can find quotes like these;

Upper Sales Management levels lacks future company vision and strategy. Executive level management lacks strong leadership and vision for future product releases.

The bread and butter of this company has always been media conversion; unfortunately they are late to the market on all other product lines. {March 2016}

The media conversion technology has been dramatically declining for many years now. It's not Transition's fault, it's the natural product cycle. Transition's (CSI's) fault here is the inability to convert (no pun intended) to the new reality.

Some spikes in federal revenue from some legacy products cloud the picture. Transition is a dead dog that CSI wants to squeeze the last buck from. {November 2014}

Similar reviews, albeit less explanatory, are underneath Suttle and JCS as a whole as well. All this then shows that the management might not be able to act swiftly to counter the fundamental challenges.

Management Incentives & Stale Status Quo

This inaction might be due to the composition of the board and the stale status quo that might be present inside.

The company's founder Curtis A. Sampson has been with the company since 1969 and thus might not be well positioned to see things from outside perspective. The other board members might be suffering from the same as two of them are present since 1997, the son of Mr. Sampson, Randall Sampson is present since 1999. The other two members are present since 2008 and 2013. Mr. Curtis Sampson also seems to be active within the company as he was the interim CEO in 2013 after the company decided to minimize the administrative oversight of the central staff over the three subsidiaries.

This alone would not be such an issue if the incentives of the board members and the top management would be clearer. Since the top management owns less than 11% (excluding Mr. Curtis Sampson who owns 12.1%) and no single person apart from the son of Mr. Sampson owns more than 1% they might not care much about what happens to the company's shareholders. Their main benefit is derived from compensation which might not be facing the same threat as the overall fundamentals.

On the other hand, I would also say that while compensation is not the same as shareholder ownership, the management might be incentivized to try to hit good numbers if they are well compensated. The trouble here is though that they are not necessarily. In past several years the management bonuses were not reflective (in absolute terms) of the company's operational results. For example in 2011 Transition Networks hit an all-time high in revenue as it landed a major contract. The compensation was the following;

The salary of the head of the subsidiary remained quite low and while it did increase by 66% the absolute value is only a fraction of what the company actually got that year in operating profit. This might be reasonable if the circumstances of landing of the contract were not necessarily results of the management's efforts but it shows that the bonus plan is conservative. This would be a good thing if the management would own enough stock. This could then mean that they lack clear incentives to continue to run the company as best they can.

All this being said Mr. Gabelli's GAMCO is a significant shareholder that might try to influence the board should the situation continue for too long. They are already likely voting against the incumbent board as seen during the latest annual meeting.

The company though has a poison pill and change of control provisions for several managers and thus even despite the low ownership by the founder and the management it might be challenging to launch an activist campaign.

Cash Flow & Dividends

While the outlook for revenue, costs and the management might not be overly optimistic, the cash flow from the operations has been strong until recently mainly due to the one-off contracts that enabled significant profitability as can be seen below.

The CapEx is currently around $2.5 million per annum and the dividends were accounting for roughly $5 million prior to the cut in Q3 of this year, therefore the amount of cash that the company created was substantial. The buildup though was partially burnt in 2015 and 2016 as the company continued to pay dividends but did not have a significant operational cash flow to back it up.

cashflow1.png

I also believe that it might be unlikely for the cash flow to recover in Q4. This could be due to the fact that one of the major cash flow factors in the past have been account receivables which usually increased quarter or two prior to being liquidated as seen below.

cashflow.png

ARs seem to be flat now therefore it might be that the cash flow is going to stay slightly negative in the near future.

The inventories also do not seem to be in an unusual spot and therefore it might be that the loss from the income statement might impact the cash flow more than in the past.

inv.png

Thinking about cash flow beyond the next few quarters is again challenging due to the uncertainty regarding new products and the fact that cash flow was connected to large orders in past which might not happen again.

That being said should the company be successful in increasing top line or getting new contracts they could easily return to cash flow seen prior to 2015, which would create significant upside in the stock.

With regards to the dividend policy, I believe that it is good to see that the management is open to returning money to shareholders, but the company might be better off without a consistent dividend and issue special dividends only if they are able to land large contracts. Consistency in paying out dividends without having operational consistency might not be the most useful way to go about it.

Valuation

While the fundamentals are uncertain, one could say that the downside is limited for now. As you can see below, the stock is currently trading near NCAV.

ncav.png

Although one could also account for their real estate, as they own substantial amounts that might further constitute margin of safety. The company actually lists its property in Minnetonka (used by corporate and Transition Networks) on Loopnet with a price of $7.2 million, but the advert was created in 2004 (although the listing was updated just a week ago), and thus it is not clear if a sale can occur sometime in the near future.

The company also owns 109,000 SF in Hector, Minnesota, which is a warehouse and assembly point for Suttle. Unfortunately, there is not enough information that could be used to value the property, but one can take a conservative estimate of $55 per SF (slightly lower than Minnetonka due to location and nature of the building). This could then mean additional $5.9 million in value.

The current valuation then might even look unreasonable given the amount of cash flow that the company was able to do generate in the past, but I believe that should the company struggle to complete the restructuring, they could burn through some of the cash on the balance sheet, and therefore decrease the NCAV value. Thus the margin of safety here is not as strong as one would think given the reliance on future operational results.

Conclusion

I believe that the thesis comes down to this question; will the company be able to execute its restructuring, stabilize the revenue and grow new products? I would say that right now it seems that they are just beginning to take serious steps to ensure that they will able to do that and thus it would be better to wait and see if these efforts are going to impact the results.

I would be less skeptical if the restructuring would mainly be focused on operational cost as this is inherently less challenging to perform, but as they also need to sell new products one would need to make a forecast about sales and that I believe is not prudent given the past performance and the possible management incentives.

Finally, the company would maybe be easier to analyze should they disclose more or initiate conference calls.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.