Plantronics: Leverage Is High, And A Dividend Cut Is Very Likely

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About: Plantronics, Inc. (PLT), Includes: AAPL, CSCO
by: Value Digger
Summary

The Polycom deal was financed with debt, which has significantly weakened Plantronics' balance sheet.

Aside from the financing method, the Polycom deal was a major strategic mistake for additional reasons.

Leverage is high, and free cash flow is estimated to remain limited over the next twelve months.

We believe that a dividend cut in the next quarters is very likely.

We advised the subscribers to our research "Value Investor's Stock Club" to short PLT at $38 per share by buying specific Puts, and our subscribers made a triple-digit return from our bearish idea.

No Seeking Alpha article has been published about Plantronics (PLT) since July 2018, so we will dive into this company and its very weak balance sheet while also warning the dividend investors about the potential dividend cut in the next quarters.

Overview

According to its annual report, PLT is a designer, manufacturer, and marketer of integrated communications and collaboration solutions that span headsets, Open SIP desktop phones, audio and video conferencing, cloud management and analytics software solutions, and services.

Its major product categories are Enterprise Headsets, which includes corded and cordless communication headsets; Consumer Headsets, which includes Bluetooth and corded products for mobile device applications, personal computer, and gaming; Voice, Video, and Content Sharing Solutions, which includes Open SIP desktop phones, conference room phones, and video endpoints, including cameras, speakers, and microphones.

Its solutions are designed to work in a wide range of Unified Communications & Collaboration ("UC&C"), Unified Communication as a Service ("UCaaS"), and Video as a Service ("VaaS") environments.

Its audio and video solutions are designed to meet the needs of open offices (such as cubicles for knowledge workers and contact centers), meeting rooms (from huddle rooms to boardrooms), mobile workers (using laptops, mobile phones, and tablets in or out of the office), back-offices (for management, monitoring, and analytics of our systems), PC and gaming, residential, and other specialty applications.

PLT sells its Enterprise products through a global network of distributors and channel partners while it sells its Consumer products through both traditional and online consumer electronics retailers, consumer product retailers, office supply distributors, wireless carriers, catalog and mail order companies, and mass merchants.

PLT has well-established distribution channels with its distribution centers being in many countries such as Mexico, Thailand, Netherlands, Czech Republic, China, Australia, and the U.S. On that front, PLT uses third party warehouses in the Czech Republic, Thailand, Netherlands, China and Australia while it operates warehouse facilities in Mexico, China, and the U.S.

It offers its services under the Poly, Plantronics, and Polycom brands, while its Consumer gaming headsets are sold under the sub-brand RIG.

Its manufacturing operations consist primarily of assembly, testing, and packaging, which are performed in its facility in Tijuana, Mexico. However, PLT outsources the manufacturing of many of its products to third party manufacturers in China and other Asian countries. For instance, PLT subcontracts the manufacturing of most of its voice and video products to Celestica Inc., Askey Computer Corporation, Foxconn Technology Group, Pegatron Corporation, and VTech Holdings Ltd. These companies are all third-party electronic manufacturing service providers. PLT uses Celestica's facilities in Thailand and Laos, and Askey's, Foxconn's, Pegatron's, and VTech's facilities in China. At the conclusion of the manufacturing process, these products are distributed to channel partners and end users through warehouses located in Thailand, the Netherlands, and the United States, and in some cases, direct to channel partners.

As of March 2019, PLT has approximately 1,450 worldwide utility and design patents in force, expiring between calendar years 2019 and 2044.

The Polycom Deal

In July 2018, Plantronics completed the acquisition of Polycom for approximately $2.2 billion in stock and cash. Polycom's revenues were primarily tied to group video conferencing systems, while Plantronics' revenues were primarily tied to headsets both for enterprise use and for retail consumers. As a result, PLT became a global provider of open, standards-based UC&C endpoints for voice, video and content sharing solutions, as well as a comprehensive line of support and services for the workplace under the Polycom brand.

As a consequence of the acquisition of Polycom, PLT issued approximately 6.352 million shares of its common stock to Triangle Private Holdings II, LLC, an entity indirectly controlled by Siris Capital Group, LLC, equivalent to approximately 16% of its issued and outstanding shares, which has made Triangle PLT's largest single stockholder.

Additionally, PLT entered into a Stockholder Agreement with Triangle pursuant to which it appointed two individuals selected by Triangle to its board of directors.

The Negative Impact On The Balance Sheet

From a fundamental standpoint, PLT doubled its annual revenue thanks to the Polycom deal, as illustrated below:

Source: PLT's website

and below:

Source: PLT's website

However, its gross and operating profit margins declined substantially, its operating income dropped from $123.5 million in FY 2018 to ($109.3) million in FY 2019, and the company reported significant losses both in FY 2019 and in Q1 FY 2020, as shown here and here.

On top of this, PLT levered up buying Polycom. Specifically, prior to the acquisition of Polycom, PLT had $500 million in 5.50% senior unsecured notes outstanding and the ability to draw up to $100 million against a revolving line of credit agreement with Wells Fargo Bank, National Association. In connection with the acquisition of Polycom, it borrowed an additional $1.275 billion, which was financed through a senior secured term loan bearing interest at LIBOR plus 250 bps maturing in July 2025 and replaced its existing line of credit agreement with a secured credit agreement. As a result, the company moved from zero leverage before the Polycom deal to leverage of 3.4 times (as of June 2019) proforma the Polycom deal.

After all, we don't really understand why PLT sacrificed its financial strength in July 2018 to acquire Polycom. To us, this deal is questionable.

We know that the current CEO, Joe Burton, previously worked at Polycom, so he might have a unique insight into Polycom, which urged him to lever up and buy it:

Mr. Burton joined the Company in 2011 as Senior Vice President of Engineering and Development and Chief Technology Officer and was promoted to various positions including Executive Vice President and Chief Commercial Officer before being named President and Chief Executive Officer and appointed to our Board of Directors in 2016. Prior to joining the Company, Mr. Burton held various executive management, engineering leadership, strategy, and architecture-level positions. From 2010 to 2011, Mr. Burton was employed by Polycom most recently as Executive Vice President, Chief Strategy and Technology Officer and, for a period of time, as General Manager, Service Provider concurrently with his technology leadership role."

Or perhaps, he levered up buying Polycom in order to increase his compensation package, given that his base salary was approximately $700,000 in FY 2019 and his total annual compensation is partly dependent on financial measures such as net revenue, non-GAAP operating income, and non-GAAP operating margin, as illustrated below:

Compensation Element

Principal Objectives and Link to Business

Performance Measures

Fixed

Base Salaries

Attract and retain key talent; drive performance through individual contributions

Not applicable

Fixed with At Risk Component

Restricted Stock and Restricted Stock Units

Attract and retain key talent; drive individual long-term performance; align corporate and stockholders' interests

Stock price performance

At Risk

Annual Cash Bonuses

Attract and retain key talent; drive individual performance to achieve annual operating and financial goals

Financial measures (Net Revenue and Non-GAAP Operating Income) and Shared Executive Goals

Performance-based Restricted Stock Units

Attract and retain key talent; align corporate and stockholders' interests; create sustainable long-term value

Total shareholder return of our stock as measured against an index of companies

and below:

Corporate Performance Goals

Threshold

Target

Maximum

Fiscal Year 2019 Funding Metrics

Weight

(50% of Target)

(100% of Target)

(150% of Target)

Net Revenue

40

%

$800M

$890M

$930M

Non-GAAP Operating Margin

40

%

19.0

%

22.5

%

24.1

%

Shared Executive Goals

20

%

100

%

Revenue, non-GAAP operating margin, and non-GAAP operating income have gone significantly up pro forma the Polycom deal, as illustrated below:

Moreover, it's worth noting that the CEO is not a significant shareholder because he owns just 348,000 shares (May 2019), so we believe that his interests are not fully aligned with shareholders'.

Actually, this is not the case only with the CEO. According to the previous link, insider ownership is very low because all directors and executive officers as a group (17 persons) own just 1.7%, so we believe that insiders' interests are not fully aligned with shareholders'.

Headwinds

These are the most significant headwinds that we believe will weigh on the stock in the foreseeable future:

1) Leverage (Net debt-to-Adj. EBITDA): As noted above, upon completion of the acquisition, PLT increased its indebtedness in an amount materially greater than historical levels, so its net debt is $1.4 billion, and its leverage is approximately 3.4 times (June 2019), based on the EBITDA guidance for FY 2020.

From a cash flow standpoint, we doubt the accretive power of this acquisition. There is no question that PLT doubled its annual revenue, thanks to the Polycom deal, given that it had serious organic revenue growth problems on a YoY basis before the deal with Polycom as shown here, here, and here.

However, revenue growth for the sake of revenue growth does not make sense if it's not translated into increases in annual operating cash flow and annual free cash flow that could be used for significant debt reduction and business growth in the next quarters.

In other words, it's clear that to-date, the Polycom deal has failed, in our opinion. The potential benefits (i.e. expansion to new markets, product diversification, operational efficiencies, cost synergies etc.) have not increased the operating CF and free CF that will offset the negative impact from the high leverage.

Actually, the operating cash flow has dropped significantly since the completion of the deal. As linked above, operating cash flow in Q1 FY 2020 was $8.3 million, down from $32 million in Q1 FY 2019, while free cash flow was just $3.8 million in Q1 FY 2020, down from $28.2 million in Q1 FY 2020.

It's also noteworthy that the interest expense has risen dramatically on a YoY basis due to the high leverage. And this interest expense will continue to prevent the company from returning to profitability.

Specifically, interest expense was approximately $24 million in Q1 FY 2020 and is estimated to be almost $100 million in FY 2020.

2) Dividend and repurchase program: In FY 2019, PLT spent $13.2 million to buy back its shares, which is significantly down from almost $53 million in FY 2018, as illustrated below:

Fiscal Year Ended March 31,

(in thousands, except $ per share data)

2018

2019

Shares of common stock repurchased in the open market

1,139,548

361,091

Value of common stock repurchased in the open market

$

52,948

$

13,177

Average price per share

$

46.46

$

36.49

Value of shares withheld in satisfaction of employee tax obligations

$

11,429

$

14,070

Moreover, it did not continue to buy back its shares in Q1 FY 2020, which is another indication of the cash constraints this year.

On that front, we project that CapEx in FY 2020 will be at least $20 million, and we estimate that operating cash flow in FY 2020 will not exceed $100 million (best case scenario). As a result, we estimate that free cash flow in FY 2020 will not exceed $80 million (best case scenario).

Meanwhile, the dividend payments in FY 2020 require approximately $25 million, so the remaining cash flow in FY 2020 for debt reduction is estimated to be just $55 million (best case scenario), which is not enough to make a dent in the net debt of $1.4 billion by the end of June 2020.

Therefore, we believe that something's got to give.

We forecast that PLT will not buy back any shares for the remainder of FY 2020, while a dividend cut in the next quarters is very likely. And statistically speaking, a dividend cut will most likely weigh on the stock price.

3) Competition: Competition is strong and is primarily originating from the Asia Pacific region, that offer low-cost products, including products modeled on, direct copies of, or counterfeits of other products, which will weigh on the company's cash flow and free cash flow in the next quarters, in our opinion.

Specifically, according to the annual report, PLT competes broadly in the UC&C market, where it has multiple competitors (depending on the product line) on a global basis. These competitors include, Cisco Systems Inc. (CSCO), Avaya Inc. (OTC:AVYA), ClearOne Communications (CLRO), Inc., Huawei Technologies Co., Ltd., Logitech International S.A. (LOGI), GN Netcom, LifeSize Inc., Snom Technology GmbH, Vidyo, Inc., Yamaha Corporation/Revolabs, Inc., Yealink Network Technology Co., Ltd., ZTE Corporation (OTCPK:ZTCOF), Grandstream Networks, Aver Information, Inc., Sennheiser Communications and others.

One of its primary competitors in the Enterprise Headsets and Consumer Headsets areas and, to a lesser extent, in the gaming and PC audio areas is GN Netcom, a subsidiary of GN Store Nord A/S (OTCPK:GGNDF), a Danish telecommunications conglomerate. GN Store Nord is the maker of the Jabra brand of headsets.

Motorola (MSI), Samsung (OTC:SSNLF), and LG are significant competitors in the consumer mono Bluetooth headset category.

Sennheiser Communications and regional companies are competitors in the computer, office, and contact center categories, while Apple (AAPL), Skullcandy, Logitech, Bose, and LG are competitors in the stereo Bluetooth headset category.

Additionally, Turtle Beach (HEAR), Skullcandy, Logitech, and Razer are competitors in the gaming category while its main competitors in the Voice and Video categories consists of both larger companies, such as Cisco Systems and smaller niche competitors.

On top of this, this competitive landscape continues to rapidly evolve as the industry moves into new markets for collaboration such as mobile, browser-based, and cloud-delivered collaboration offerings and therefore, the release of new products could render existing technologies obsolete.

For instance, a few years ago, Apple acquired Beats that recently inked a deal to be the official headphones of the NBA and USA Basketball while also signing major celebrities like LeBron James, Neymar, Colin Kaepernick, and Serena Williams as brand ambassadors. Beats owns nearly 50 percent of the premium headphone market.

And Apple is rumored to release a pair of high-end, over-ear headphones this year that will be separate from the Beats line to compete with the likes of Bose, Sennheiser and Sony (NYSE:SNE). Some are calling them StudioPods, and Apple's new headphones will most likely include noise cancelling technology, which is an increasingly common feature of premium headphones.

4) The Cisco effect: We talked about sector competition in the previous paragraph, but we believe that the competition from Cisco deserves its own paragraph. Specifically:

A) Cisco acquired Broadsoft in early 2018, and we project that this deal has negative implications for Polycom's revenue.

Specifically, Broadsoft was the key integration partner for Polycom. In other words, when companies choose Broadsoft, Broadsoft has a preferred vendor list on whose hardware gets installed as part of the project engagement, and Polycom was, historically, Broadsoft's preferred vendor.

Given that one of the key partners for Polycom was acquired by Cisco in 2018, and Cisco has competitive product offerings, we project that, Cisco's products could be incorporated into Broadsoft's distribution channels.

As a result, we forecast that many orders will most likely shift away from Polycom and will go to Cisco, which could result in significant revenue erosion for PLT.

B) Cisco announced last year at a Cisco Live conference in Orlando that it is getting into headsets. Historically, Cisco phones have been paired with third party manufacturers headsets, including Plantronics.

Cisco's headsets were finally out in late 2018, as shown here, here and here, so we believe that this could again result in significant revenue erosion for PLT.

C) A few weeks ago, Cisco announced that it will acquire Voicea, a videoconferencing company, to improve the capabilities of its WebEx conferencing solution and integrate Voicea technologies into its Cognitive Collaboration initiatives.

Specifically, Voicea has developed EVA, an Enterprise Voice Assistant that records important highlights and provides other artificially intelligent capabilities for online meetings, so we believe that the completion of this deal will be another key headwind for PLT's future cash flows.

5) Goodwill and purchased intangibles: As a result of the Polycom deal, the amount of goodwill and purchased intangible assets increased substantially from $15.5 million at the end of fiscal year 2018 to approximately $2.1 billion as of the end of Q2 FY 2020.

Goodwill impairment analysis and measurement requires judgment on the part of management and may be impacted by a wide variety of factors both within and beyond the company's control.

Therefore, we believe that PLT will incur significant charges in future impairment testing, which will weigh on the Book Value that was just $670 million in June 2019.

Actually, a relatively small impairment of the aforementioned items in FY 2020 could push the Book Value into negative territory while market cap currently is approximately $1.2 billion.

Obviously, this premium is already tremendous for a company with high leverage, continued losses, limited FCF and fierce competition among other headwinds. And fundamentally speaking, things could become even worse in the next quarters.

6) Triangle: According to the latest annual report linked above, Triangle is permitted to sell up to one-third of PLT's shares issued pursuant to the acquisition on July 2, 2019, up to two-thirds of their shares beginning on January 2, 2020, and all of the shares after July 2, 2020, as quoted below:

Triangle will be permitted to sell up to one-third of our shares issued pursuant to the acquisition on July 2, 2019, up to two-thirds of their shares beginning on January 2, 2020 and all of the shares after July 2, 2020. The average daily trading volume of our stock is limited, and any resale of the shares held by Triangle will increase the number of shares of our common stock available for public trading, which may depress the price of our stock. Additionally, the sale by Triangle or their successors of all or a substantial portion of the shares in the public market, or the perception that such sales may occur, could impact the price of our common stock."

As also shown above, PLT admits that the sale by Triangle will most likely depress the stock price.

7) Economic growth concerns: We forecast that a recession in the U.S. or Europe, along with pressure on economic growth in the Asia Pacific and Latin America regions, could have a negative impact on PLT's operations due to its significant exposure to these countries.

Takeaway

We saw the storm coming, and we advised the subscribers to our research "Value Investor's Stock Club" to short PLT above $38 per share.

The latest report confirmed our bearish approach, and the stock has dropped a lot since last June, giving our subscribers the opportunity to record a triple-digit return from our bearish idea.

Pro forma the Polycom deal, PLT has a very weak balance sheet with high leverage, continued losses, and limited free cash flow while outlook is dim.

Therefore, we forecast that PLT will hardly avoid a dividend cut.

On top of this, we expect the company to dilute or sell assets or a combination of them in order to substantially reduce its leverage and bring it down to reasonable levels amid a handful of headwinds mentioned above.

After all, potential buyers are advised to wait before initiating a long position on PLT at $32 per share or go to greener pastures.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in PLT over 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.