Communications Systems Inc.: Deep Value Play Poised For A Turnaround

Summary

• CSI trades at just above liquidation value assuming a planned $10 MM headquarters sale goes through.
• While the company has lost money for four straight years, it is likely to at least break even in 2019.
• Recent news suggests the company is making headway in the "smart city"/IoT space.
• Value of $8-10 per share to a potential strategic acquirer represents substantial upside from current levels.

Introduction

Communications Systems Inc. (JCS) was once a favorite here on Seeking Alpha due to its high dividend and decades-long dividend payout history. As a maker of some of the more low-tech IT products such as network switches, converters, connectors, and cabling, CSI has always operated in a brutal, low-margin business. However, they were able to build a stable cash-flowing competitive position throughout the '90s and '00s through the combination of a reputation for product quality and strong customer relationships with major network carriers and the federal government.

Unfortunately for dividend investors who entered this stock in the early part of the 10's, while CSI had - and continues to have - a cash rich, healthy balance sheet to pay out dividends, what it did not have was a healthy underlying business:

(Source: Company filings)

Since 2010, CSI's revenues have fallen by over half, despite not exiting any major lines of business, and the business has been both net income and EBITDA-negative for four consecutive years. The stock price followed, with the stock down 75% from its high of $20.60 per share in 2011. A brief analysis of current management comments and past employee reviews such as this one indicates CSI under-invested in R&D for many years, instead returning cash to shareholders through dividends, and finally paid the price as many of their largest customers, the tier 1 telecom carriers, left them due to a combination of superior competitor offerings and a secular decline in demand for CSI's leading product line, media conversion equipment that converts signals from legacy copper networks to fiber.

After the losses began and the dividend was eventually cut, CSI became a company of interest to a second class of investors - deep value investors focused on "net-net" stocks whose liquidation value exceeds the market cap, as can be seen, these past articles:

Communications Systems: A Net-Net With A Turnaround Under Way

Communications Systems Inc. - Operational Volatility Clouds Future Outlook

Communications Systems: Unloved Restructuring Story Portends To 70% Upside

CSI has always had a cash-heavy balance sheet with no meaningful debt, and as results worsened the price of the stock began to dip below liquidation value. With true "net-net" stocks, the only way to lose on the investment, in the long run, is for the liquidation value of the stock to decrease through continued business losses. Unfortunately, that is exactly what happened at CSI and only a strong balance sheet - they started their downturn in 2014 with almost $9 per share in net working capital - allowed them to remain a going concern.

Restructuring and Current Position

The current CEO Roger Lacey started his work on turning around CSI in late 2014 through round after round of brutal cost-cutting. Between 2015 and 2019, CSI reduced their full-time employee count from a high of 674 at YE 2015 to 241 at YE 2018, closed one of the company's two major manufacturing facilities in Costa Rica, restructured the executive suite to save $2.5MM annually, sold part of the money-losing Suttle business for $5MM with a $3MM gain, and initiated a (not yet completed) sale of the company headquarters for $10MM. As a result of these cuts, CSI reached TTM EBITDA break-even last quarter for the first time since 2015 and has also stemmed its long-time decline in revenues, with YoY revenue growth to date. The market has taken notice, with the stock up over 150% from its 52-week low and 37% since its last earnings call on July 31st:

(Source: Seeking Alpha)

In addition to the business turnaround, CSI still has a strong balance sheet with significant net cash and current assets. An investor in CSI today gets a business with $34.8 MM in net working capital, of which only $13.6 MM is inventory. In addition, a planned $10 MM headquarters sale is not yet on the books. Allowing just under $5 MM for potential obsolete inventory and assigning no value to the $9.6 MM in PP&E, we have a company with a net asset value of $40 MM. Even with the recent run-up in the stock, CSI is trading at a market cap of just $46.9 MM, meaning that for essentially $6.9 MM one can purchase a break-even business with $66.1 MM in TTM revenues.

Given improvement to just a 7% EBITDA margin, half of what CSI achieved in its best years but likely more appropriate given its lower revenue base, flat revenue growth, and a conservative valuation of 8x EV/EBITDA we can construct a scenario where the ongoing business could be given an EV of $37 MM, which would bring the stock to $8.37 per share, or a 67% gain from current levels, versus downside of just over 15% if the stock were to fall to liquidation value. While there is likely downside below liquidation value, as we have seen in the past, the odds are appealing under any reasonable set of assumptions and warrant a deep dive into CSI's future business prospects.

Assessing CSI's Turnaround Potential

CSI consists of four business lines, with the following financial picture as provided by management in their most recent 10-Q and investor presentation. Note that a TTM picture would be preferable, but management recently changed their reporting structure and has not provided the below breakdown yet with the new structure. It is worth noting that historically Q3 and Q4 results have been slightly better than Q1 and Q2, although CSI's business mix is substantially different than past years and this may no longer be the case:

	Transition Networks	Suttle	JDL Technologies	Net2Edge	Corporate/Other, Net of Intersegment Eliminations
6M 2018 Revenue	$17.0	$12.8	$1.6	$0.8	-$0.5
6M 2019 Revenue	$18.1	$10.2	$3.2	$1.2	-$0.6
6M 2018 Operating Income	$0.7	-$2.0	-$0.8	-$1.4	-$1.0
6M 2019 Operating Income	$0.4	$1.3	$0.4	-$1.0	-$1.0

Click to enlarge

(Source: 2019 Q2 Quarterly Report)

Transition Networks

Transition Networks is now CSI's largest business line, focused on media converters, network security, and ethernet, and has the most near-term promise, having shown YoY revenue growth and positive operating income. One issue with analyzing CSI businesses is that quarterly results tend to be notably lumpy, as the timing of orders from major customers can cause $1-3 MM swings in quarterly revenue, highly significant for a break-even, at-the-margin company like this one. We will hence carefully look at results to determine if the $1.1 MM in revenue YoY growth shown here represents organic revenue growth, or simply gains due to revenue timing. Management analysis of Transition Networks' revenue for the first and second quarters of 2019 suggests a mixed bag. In the first quarter, sales fell off due to the timing of orders from the federal government, but in the second quarter, sales increased by nearly the same amount due to favorable comps with last year when a major carrier customer delayed spending, and the company was experiencing supply issues.

While comps appear to be mostly a wash, a bullish item does appear in management's analysis of second quarter revenues by product:

Sales of Ethernet switches and adapters increased 55% or $1,004,000 related to the introduction of new products.

(Source: 2019 Q2 Quarterly Report)

This line item certainly would seem to indicate organic revenue growth, as the sales increase came from new products developed by the company, something rare in this company's recent past. And indeed, we see that Transition Networks has introduced an interesting new product in the Power over Ethernet (PoE) space that won an industry award:

(Source: Company news release, originally published at IoT Evolution World)

PoE is a technology that as the phrase implies, provides for the transmission of both power and data over Ethernet cabling. A major use case for the technology is in the "smart city" concept, where a network of surveillance cameras, data collection devices, and NFC/WiFi can be spread throughout a city. Transition Networks' product enables this by transmitting both power and data, the automated setup of individual devices, and the ability to reset and troubleshoot individual units from afar with software. This represents a huge potential cost saving, as cities can avoid expensive in-person maintenance calls for simple on/off resets or minor configuration changes.

While industry awards should always be met with skepticism, a second piece of news would seem to indicate that Transition Networks is gaining traction in this space, as they recently announced a $7MM contract to connect, power, and manage a traffic data network utilizing its PoE switches with a "major metropolitan transportation agency" to be completed in 2019. While the $7MM in revenue will certainly be relevant in the short term, the real value will come if the company can become a player in the smart city/IoT space, as many sources such as this one indicate it is a massive market, currently in the $20B range in the US with substantial future growth.

From the early success of the new PoE product it seems likely that Transition Networks can at least maintain flat revenues, as sales of these new products offset declines in the legacy product line, and at the current run-rate Transition Networks business would generate around $1 MM in operating profit per year before any revenues from the recently-announced contract. But management appears to guide higher, as while this company does not provide guidance, they project "higher revenue due to strong pipeline from federal and commercial clients" and a "higher-margin product mix to improve profitability" in their recent investor presentation. If one adds just one $7MM "smart city" contract on top of that each year at a 45% gross margin with 10% SG&A, in line with the business unit's historical margins, the business would stand to make an additional $2MM in yearly operating income. That brings us to a $3MM run rate, with further upside if management's guidance is believed.

Suttle

Suttle is a legacy business selling relatively low-tech components, such as cables, housings, and enclosures for home and small business networking. The company recently sold its FutureLink business line, clouding any future estimates, but management did provide color on what we can expect moving forward:

Restructuring completed in Q4 2018 and the sale of the FutureLink business allowed Suttle to experience profitability in the first half of 2019, but we expect that after we fulfill our obligations under the Transition Services Agreement, Suttle's ongoing operating income will decline and could return to a loss. As previously announced, the Strategic Committee of CSI's Board of Directors continues to explore options for the remainder of the Suttle business.

(Source: Q2 2019 earnings press release)

The upside case for an investor is probably that CSI completes a sale of the remainder of the Suttle business in short order before additional losses occur. However, it always tends to be easier to sell the best assets first. Still, Suttle made $1.3 MM in the first six months of 2019, and the FutureLink business was only sold for $5 MM, so it is likely that even if they return to a loss, it will not be a large one, as if FutureLink had been driving heavy profits it would likely have been sold for more than a mere $5 MM. Further, management has consistently stated they are looking to dispose of this business, meaning heavy losses are unlikely. A conservative estimate places zero value on the Suttle business going forward, with a small loss of around $1 MM per year for a few years in a downside scenario.

JDL Technologies

JDL Technologies provides infrastructure as a service (IaaS) solutions primarily to healthcare, small businesses, and schools in the state of Florida. Since 2015 over half of its revenue has come from a single customer, the Broward County school district, as part of an $83 MM long-term contract to provide network and data center services, but delays in federal funding for the district have resulted in reduced revenues from this project since 2017.

JDL booked $1.8 MM in education revenue so far in 2019, $2.6 MM in 2018, $8.7 MM in 2017, $11.3 MM in 2016, and $11.7 MM in 2015, leaving over $57 MM left in potential revenue on the original contract. However, JDL has claimed funding delays as the reason for the education drop-off in the last three annual reports, so it remains to be seen if they ever will be able to deliver the rest of the contract. In their last earnings release CSI had the following to say about the education contract:

JDL Technologies Q2 2019 sales were $951,000 and although 4% higher than Q2 2018 sales of $913,000, were below expectations due to funding related delays from our largest education customer. While our customer has confirmed they want proposed projects to be completed, funding needs to be secured before JDL Technologies begins working on these projects.

(Source: Q2 2019 earnings press release)

After years of decline JDL's non-education revenue has finally started growing over the past few quarters but this part of JDL alone is not large enough to support the fixed costs of the business without the revenues from the education contract; in Q2 2019 when JDL booked only $0.3 MM in education revenue, the business lost $0.1 MM, while it made $0.5 MM in Q1 on $1.5 MM in education revenue. In JDL's best years where they booked eight figures of education revenues, the business made $1.2 MM in 2015 and $1.9 MM in 2016.

If the education funding delays are cleared and JDL can return to ~$3 MM in quarterly education revenue, there is potential upside beyond the 2015-2016 numbers, as JDL is considerably leaner now than it was in 2016. Assuming a 30% gross margin (CSI does not provide gross margin by product line but we can estimate from Q1 and Q2) on education bookings, JDL stands to make $0.9 MM per quarter from education alone for the next several years if the current contract is simply delivered as planned. Factoring in small losses from the non-education business and support functions, JDL could easily contribute $2.5 to $3.0 MM in annual operating profits, and at even at the current depressed education run rate should still contribute roughly $1.5 MM in 2019. On the other hand, if funding delays continue, JDL is likely to be no worse than break-even in the near term.

Net2Edge

Net2Edge is a business focused on the transition of legacy network technologies to modern fiber hardware. To this day, many companies still rely on decades-old technologies such as TDN and ISDN for networks tied to critical services. The issue is that maintaining these technology sets is expensive meaning carriers would like to modernize these networks, but many companies have purpose-built applications that only work on these legacy technologies. Net2Edge's products allow carriers to replace the physical backbone of these networks with modern fiber or in some cases a 4G/LTE network but deliver a virtual network to the enterprise customer that appears to be the same as it was before, meaning they do not have to make any changes to their applications.

Unfortunately, Net2Edge's products have required extensive field testing with the telecoms before they can begin any large-scale sales, and the business has been a consistent $2-3 MM per year money loser since its founding in 2015, albeit with roughly $1 MM of that allocated to R&D. Although in 2019 the business has had its best first six months ever from a revenue perspective, that is still in the context of losing $1.0 MM, and part of the revenue gains it recognized was due to the transfer of business from Transition Networks, rather than actual organic growth.

While management has called for "growth accelerating in the second half" in its recent investor presentation this is another case where to be conservative we should probably wait until we see revenues come in to make such assumptions, as revenues at this business have been flat since it began in 2015. In the near term, it seems likely that Net2Edge will continue to be roughly a $1.5-2 MM per year loser for the company.

Near-Term Earnings Model

Putting together the estimates by business line we can build the following NTM operating earnings and EBITDA model for CSI:

	Upside Case	Base Case	Downside Case
Transition Networks	$4.0	$3.0	$1.0
Suttle	$0.0	$0.0	-$1.0
JDL Technologies	$3.0	$1.5	$0.0
Net2Edge	-$1.0	-$2.0	-$2.0
Corporate/Other, Net of Intersegment Eliminations	-$2.4	-$2.0	-$2.0
Operating Income	$3.6	$0.5	-$4.0
Depreciation	$0.6	$0.6	$0.6
EBITDA	$4.2	$1.1	-$3.4
Enterprise Value (8x EV/EBITDA)	$33.6	$8.8	-$27.2
Stock Price (Assuming Current EV of $6.9 MM @ $5.05/share)	$7.91	$5.25	$1.38

Click to enlarge

(Source: Author estimates based on data from company filings)

CSI appears fairly valued as our base case earnings estimate and multiple brings us to a number very near the current stock price, with roughly equal upside and downside. However, the true downside valuation of the stock is significantly higher than $1.38 per share shown in the table above, which applies an 8x multiple to the negative projected EBITDA in the downside case. If we assume management makes the necessary moves to further downsize losing businesses, as they have done in the recent past, the stock should be supported by liquidation value, which is no less than $3 per share and likely much higher than that. With near-term upside of $2.86/share and downside of $2.05/share as of the writing of this article, the odds still may not be favorable enough for many investors given the risk inherent in this type of investment. However, the long-term optionality of the company returning to growth combined with the liquidation value floor may still justify a position for highly speculative investors.

Furthermore, the above analysis considers the value of CSI as a stand-alone concern. As is common across nano-cap public companies who have to support a small revenue base with high fixed management costs, the value of the company to a potential acquirer would be much higher. An acquirer could immediately eliminate around $1.5 MM of the corporate/other costs between management salaries, public filing costs, and board fees, and would probably rationalize the $2 MM/year money losing Net2Edge business as well. Placing an 8x multiple on these moves would add an additional $28 MM in EV ($3.04/share) to the estimates above, before considering any operating synergies in the individual business lines or placing any value on the Broward contract and federal government relationships. This places the upside on the stock as high as $8-10 per share.

While CSI has resisted such sales in the past and even has "poison pill" provisions in their shareholder agreement, in 2018 they initiated a strategic review of the business and have already sold many pieces of the company. For context, the long-time former CEO and current Chairman Emeritus Curtis Sampson at 84 years of age and his son at 60 years of age (two members of the five-person board) own 1.2 MM shares between them or 13% of the shares outstanding. With other key personnel including the CEO in their 60s, it is possible that leadership has an eye towards cashing out in a deal that would likely be highly beneficial for shareholders.

Risk Factors

Any investment in a nano-cap company that has lost money in the last four years is going to be speculative and CSI is certainly no exception. Although the liquidation value should place a floor on the stock, if the company fails to deliver on earnings growth in the next few quarters, we could easily see a pullback to the ~$3 level, and if the company again swings to a loss, the stock could fall below that. Furthermore, even if CSI delivers on earnings in the near term, the fact that the company relies on a few key customers for large chunks of its revenue means quarterly earnings will likely continue to be highly volatile. This has and will likely continue to drive volatility in the stock.

Shares of CSI are also thinly traded, with an average 10-day volume of ~46,000 shares or just over $230,000 as of 9/25/2019. The combination of a volatile share price and small float means this stock may not be suitable for less risk-tolerant investors.

Conclusion

While CSI has performed poorly for several years and investors have paid the price, the pieces do finally appear to be in place for an operational turnaround. In addition, management, for better or worse, has a history of focusing on shareholder value. Despite the almost 150% run-up in the stock from its lows, between the potential for a turnaround and a potential sale to a strategic buyer, there is still enough upside here to warrant a position in an aggressive portfolio. Less aggressive/income-focused investors should look elsewhere.

Disclosure: I am/we are long JCS. 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.