Sunday, November 18, 2012

A profitable cash box, or a cash box with profits?

A common feature of most net-nets is a pile of assets with a tiny obsolete business attached.  While his isn't always the case, is the exception not the rule to find a good profitable business selling so cheaply.  Metalink (MTLK) was suggested to me by a reader (thank you!), they're a foreign issuer, a cash box, and a net-net, the siren call was strong, how could I not look at them?

There's a certain market cap threshold where even I get a little queasy.  I don't have a problem investing in a company with a $6m market cap, yet once the market cap drops below $3m I start to get nervous.  I get nervous because my pool of potential buyers shrinks.  I know that by investing in the microcap space I'm already limiting myself to retail investors, and small funds, but below a certain market cap I'm limiting myself to other individuals as crazy as myself.  Metalink falls below my psychological threshold of $3m, although only slightly.

Metalink might be the first investment that literally checks off every potential box for a net-net.  Profitable: yes, mostly cash: yes, obsolete business: yes, no debt: yes, no liabilities: yes, no leases: yes, no future direction: yes, and on and on.

The company is a DSL chipset manufacturer.  For anyone born after 1988 DSL is a technology that ushered the US onto the information superhighway.  DSL technology was an enormous improvement in internet connection speed.  Allow me to take a quick walk back in time.  I remember my first modem, it was 2400 baud, I had a friend with a 4800 baud of whom I was jealous.  I'm guessing a few readers are thinking "wow, 2400 baud, he's young" and the rest are clicking to Facebook while the thought "what's a baud" is forgotten.  Technology quickly went from 300 baud, to 1200, to 2400, to 4800, then 9600.  From there we jumped to 14.4, and finally 28.8 and theoretically 56.6.  When the dot-com bubble was booming most people were connecting to the internet at 28.8k or 56k speeds.  In about 10 years connection speeds had increased 10x.  This is the reason the internet boomed, we always had those networks (BBS anyone?) but they were so slow that anything more than colored text was unusable.  Telecom companies were looking to maximize connection speeds using existing technology, which were copper wires and DSL fit the bill.  When a human talks on the phone voice only utilizes a portion of the frequencies that the wire can carry, DSL sought to fill this extra space with data.  Customers used to have to install DSL splitters to block out the data frequencies on their land lines.

DSL technology seems so quant today where we can connect at speeds of 10 Mbps or 25 Mbps on a standard internet package.  But keep in mind the jump, a standard DSL connection was 768kbps verses the fastest model a 56k which at most could do about 43kbps.  Going from a fast modem to a DSL connection was almost a 20x increase in speed.  A similar jump was possible with cable, but not all neighborhoods were wired for cable, whereas anyone with a phone in theory could have DSL as long as there was a DSLAM installed at the local switchboard.  The limit to DSL was the drop distance, that is the distance from the DSLAM to the end point.  The longer the distance the slower the speed of the connection.  Warren Buffett claims all knowledge is cumulative, I never thought the things I learned about DSL 15 years ago would be relevant today, yet here we are...

Metalink comes into the picture in the sense that they coordinate manufacturing and distribution of DSL chipsets.  For years they were involved in the research and development of new chips, but as DSL has moved from the front to the back of the broadband line they eliminated all R&D.  The company has whittled themselves down to simply a distributor of their old DSL chipsets.  They outsource fabrication to third party chip fabs and sell to a few remaining customers.  The company end of lifed their chips back in 2008.

The company doesn't have much going for them in terms of a future outlook, they aren't developing any new products, and plan to continue selling existing products until clients don't need them anymore.  The business has stabilized and the current run rate should be expected into the future until demand ceases.  With a more normalized cost structure they've moved from losses to making a profit.

Let me summarize the high level discussion before diving into the details of this investment.  Metalink sells an outdated obsolete chip technology that's currently profitable with an uncertain outlook.

The starting point for analyzing Metalink is the balance sheet, here is their balance sheet summarized in my net-net template:


The company has an excellent balance sheet with $1.89 in NCAV, a discounted NCAV of $1.82 and a net cash position of $1.67.  It's worth mentioning that shares are trading at $1.04.  In other words, this is a profitable net-net selling for less than net cash outside of Japan.  Their location (Israel) isn't without risk, which I'll discuss below.

I want to call out a few things from the balance sheet, the first is the company doesn't have much inventory.  This is because chips are manufactured as customers demand them, and are shipped straight from the fabrication location.  The chips that have been manufactured but haven't been received by the customer are what's been captured on the balance sheet.

The second item I want to call out is the lack of liabilities.  The company has some accounts payable, that's it, no other liabilities.  I don't think I've ever seen a company with so few liabilities.

Metalink's record of profits has been much worse than their working capital management.  They were consistently unprofitable until they sold off a loss making division a few years ago.  Since then they've only had the DSL chip business that doesn't generate much revenue, but it's enough to cover fixed expenses with a tiny bit left over.  While the company is profitable the statement I'd make is caution needs to be taken when considering their future.  The business is unsustainable and it's possible sales could dry up, I don't know if that's in six months, or three or nine years, regardless of the timing it will happen eventually.

A discussion of Metalink wouldn't be complete without a discussion of management and their plans for the pile of cash.  Management owns 40% of the outstanding shares, which isn't a majority, but enough to push the company in any direction they want.  In the 20-F statement the company mentions they would like to use their cash for something strategic, possibly an acquisition.  This is where things get a little crazy in my mind.

The company only has one employee at this point, the CEO.  He's essentially arranging the fabrication, then the shipment of the completed chips to the destination location.  He's also in charge of filing the SEC statements, and whatever else a middleman does.  The company has $5m in cash and is looking to do something with it.  The problem is that while $5m is a lot of money in normal people terms, it isn't all that much in business terms.  I'm not sure what sort of company besides a smaller local one could be purchased for $5m or less.  And I can't imagine purchasing a company and trying to get up to speed and taking control with only one employee either.

Due to the logistical problem, and the low absolute level of cash I don't see an acquisition in the company's future, more likely is a tender, or a buyback to completely go private.

I'd be remiss if I didn't point out the biggest risk to this investment, which is Metalink's location.  The company is located in Tel-Aviv, which as of late isn't the safest place in the world.  The job the CEO is doing appears to be done from home, and in theory could be done anywhere in the world.  He's a plane ride away from moving the business to London or New York.

The second biggest risk is the uncertain future outlook.  We don't know if Metalink will be churning out DSL chips for the next three months, or the next three years.  We also don't know what the CEO will decide to do as his next move, will he tender for the outstanding shares, or will he go out and buy whatever he can for $5m?  If you can reconcile those two risks and are comfortable with them I don't think there's any problem purchasing shares of Metalink.

Talk to Nate about Metalink

Disclosure: None

2 comments:

  1. Sounds like a more extreme version of SODI - the legacy business, the corporate governance...

    -Jonathan

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  2. Thanks for a solid write-up, Nate. I believe you should have quantified just how profitable MTLK currently is. In 2011, the company reported EPS of $.28; and through the nine months ended 9/12, EPS of $.16 (vs $.12). Also, revenues are up and impressive 43% year-to-date, suggesting the company has found a source of enduring/expanded demand for its products.

    Finally, with an accumulated deficit of over $140M, I would guess the company is sitting on a treasure trove of tax-losses that might be attractive to an acquirer/merger partner.

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