Thursday, November 8, 2012

My investment process applied to eOn, a net-net trading at 3x FCF

eOn Communiations (EONC) typifies many of the current net-nets, cheap, but with some warts, but most importantly, tiny.  eOn has a market cap of $2.3m, 30% of the shares are locked up by insiders leaving only $1.61m available for purchase.  This investment is off limits to anyone who isn't a retail investor, which isn't always a bad thing.

I want to use this post to show the way I approach stocks.  My posts don't reflect the process I went through to invest or find a stock, only the final product.  My method is what I call the lazy way to research.  If you don't know I'm not a professional investor, I do this on the side, and I have a job and a family so I'm always looking for shortcuts.

I've heard of investors who will develop a circle of competence, they will target some industry and read all the material they can obtain to build a gigantic foundation.  Once the foundation is established they begin to look at players within the industry.  There are bank investors, insurance investors, tech investors, I'm none of those.  I don't have the desire, or the time to do something that exhaustive.  With my time and interest limitations I needed to devise a shortcut.  When I stumble on a name my goal is to exclude the company from consideration as fast as possible, the faster I rule out an investment the less time I waste.  Working in this manner lets me cover a lot of ground quickly.  I might miss some opportunities where I really need to dig in the weeds, but with 60,000 stocks worldwide I can afford to miss a few gems.  A great example of this is the current banking warrants.  I know a number of people who love certain banking warrants.  By the time I dig through the prospectus and really understand all of the details of the warrants I could have looked at five small caps.  Neither is right or wrong, just different.

The first step in my process is to form a thesis on why I'd be interested in going long in the first place.  Sometimes I can't do this, and I move on.  After having the thesis I work to figure out exactly how the company could go wrong, my thesis could go wrong, or any way I'd lose money.  It's usually in this process that I spot something that I can't overcome.  Sometimes it'll be too much debt, or a broken business model.  If I get to the end of this process and either I come to the conclusion that the investment can't go wrong, or it can go wrong and the risk is acceptable, I will buy shares.

There are two important points to remember, I establish a long thesis quickly.  The reason I can do this quickly is because I'm looking for obviously cheap companies.  If I have to work hard to determine why a company is a good investment it's not for me.  If I have to worry about how much the company is spending on toilet paper and utensils it's not cheap enough.  The second point is that after I establish the long thesis I work as quick as possible to discredit it.

Before looking at eOn I want to point out one last thing.  This process works well for me because it fits my personality.  If you're the exhaustive study type of person trying to adopt this is the quickest path to failure.  Learn how you operate, and invest accordingly.

The short, the quick, the long thesis

eOn is a VOIP communications provider, they manufacturer and sell their equipment and solutions across the US and Puerto Rico.  The company sells through distributors and to clients directly, a majority of their sales come from the distributor relationships.

The company has a $2.3m market cap against a NCAV of $4.3m, and a book value of $6.1m.  In the most recent year the company made $512,000 which is $.12 p/s.  The company generated $1m in cash flow, and $770k in free cash flow.  The company is clearly cheap, with a P/E of 6.6x, a P/FCF of 2.9x, and a P/B of .37x.

Management is heavily invested owning 29% which is an encouraging.  The second encouraging aspect is that management's salaries are normal.  The CEO makes $290k, and the CFO makes $140k, both acceptable salaries for officers who run a company with $22m in sales.

Here is the net-net worksheet for eOn:


Ruling it out

The first thing I looked at was what does eOn do?  As mentioned above the company is in the VOIP industry, both as a manufacturer, and as a solutions provider.  Their products are sold to call centers, businesses, and anyone else who needs a VOIP solution.  The hardware is custom designed, and the software is built on an OpenSource Linux platform.  The company doesn't appear to have any differentiating factor. There's no reason I couldn't buy five VOIP phones on Amazon, and install my own Asterisk server thus implementing the same solution cheaper than what eOn could provide.  The company's advantage over an Amazon purchase is the ability to offer a complete solution and an integrated package.  My problem is services are only 22% of their revenue, most of their money is made selling off the self commodity components.

One thing that concerns me a lot is how easily the company can move from a profit to a loss.  Investors naturally look at companies in percentage terms, and in multiples to improve comparability across companies.  I think it's helpful to look at things in absolute terms sometimes.  The difference between an operating profit this past year, and the prior year was about $800,000.  In general a VOIP telephone costs about $130, add in the back end server for a few grand more, and you have a system.  The price of a system to serve 10 users might cost $3500.  A system to serve 1,000 users might cost $150k.  This means the difference between a profit and a loss is five large accounts or 228 small accounts.  VOIP is a very saturated market, outside of very small companies it seems everyone's phone systems are already converted to VOIP.  In order for the company to remain profitable they need to continue to sell these devices to the shrinking unconverted consumer, or sell replacement devices.

An endgame for a lot of net-nets is an acquisition, that could be the case with eOn, but I doubt it.  There are already a number of large players in the VOIP market, and from what I can tell eOn doesn't bring anything unique that an acquirer would want.  The clients eOn has wouldn't move the needle at a larger VOIP provider like Cisco.  The VOIP market is very saturated with large players who all have differentiated offerings, and have economies of scale in manufacturing.  The only acquisition I could see would be if the CEO wanted to take the company private.  The company is too small for a private equity firm to purchase as well.

The last negative against eOn is found on the balance sheet.  There is an entry for notes payable to related parties.  When related parties are called out in the balance sheet my it gets my attention.  It turns out that eOn's founder had started a second company in addition to eOn to provide similar services.  A few years back eOn purchased that company and financed the purchase with a note to the founder.  It seems a little questionable that the founder used eOn to cash himself out of a previous holding.

The company also has some operating leases which aren't on the balance sheet and could be a problem in a downturn, but the leases are really minor compared to the other points above.

Pulling it together

None of the negatives completely kill the investment.  If eOn was trading at a P/E of 10x, or at 80% of book value the negatives would quickly kill this thesis.  But at half of NCAV with a P/E of 6x there is a lot of room for error.  The biggest factor holding me back from investing in eOn is really the dynamic of the industry they're in.  I realize the company is selling for too low of a valuation, but at the same time I can't see how they continue to grow as they're fishing in a quickly shrinking pond.

As always thoughts and comments to the contrary are appreciated!

Talk to Nate

Disclosure: None

3 comments:

  1. Do you think the customized inventory is worth half book? If not, the long thesis dissolves.

    Also, -50m in retained earnings is something to think about.

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  2. I think for it to go from 6 X to 10X something has to happen, to change or unlock the value. I look it this way 1) Growth- and what you are stating and from my personal exp( ve VOIP for last 5 yrs) I do nt see much of it- not much change in working capital and no Capex ( gives your real pic from companies point of view).2) Good mix of financial structure actually on higher side for my liking, with negative earnings it will be problem to service debt in future. There is only one hope which is change in management which might lead to unlocking of the value. in summary this is a small mature likely declining company. Margin to NCAV is excellent on companies which will survive and actualy might turnaround but this company i dont see that and net-net will be the play but than again comes the value of the inventory and also management willing to go to liquadation rather than exhausting intially all sources.

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  3. "By the time I dig through the prospectus and really understand all of the details of the warrants I could have looked at five small caps."

    TARP warrants aren't at all difficult to understand. And once you understand 1, you understand 20. The actual companies can be more difficult to understand, of course.

    ReplyDelete