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3 Highly-Rated SumZero
Special Situation Stocks
Labrador Iron Mines (LIM) (LIM CN)
Analyst Details
Name
Title
[HIDDEN]
[HIDDEN]
Industry
Hedge Fund
Location
$6.17
$5.70
EXPECTED
RETURN
PRICE AT
RECOMMENDATION
CURRENT
PRICE
ASSET CLASS
EXPECTED TIMEFRAME
GEOGRAPHY
Common Equity
1 year to 2 years
North America
RECOMMENDATION
SITUATION
COUNTRY
Long
Event / Special Situations
Canada
Vice President
Company
Undergrad
215.8%
NYU Stern School of
Business
Los Angeles
The author of this idea may have a position in this security and may trade in and out of this position without
informing the SumZero Elite community before hand.
THESIS
What makes a great investment? An unknown company that trades at a discount to intrinsic
value because of its limited Wall Street coverage? A company where the management team owns
many shares along with passive investors thus aligning interests? A stock valued at well below its
NAV even assuming conservative modeling estimates? A market capitalization that dropped
significantly recently and now trades at only 2x the run-rate Free Cash Flow generation of the
company's capacity? A direct identifiable catalyst that should trigger a collapsing of the implied
sizable discount to fair value? Strong growth prospects? Maybe a large shareholder that
represents a material percentage of the daily float that is forced to sell for reasons other than the
true propsects of the company?
LIM CURRENTLY IS AN INVESTMENT THAT EXHIBITS ALL OF THESE CHARACTERISTICS.
----------------------------------------------------PROFILE
Labrador Iron Mines Holdings Limited (TSX: LIM) is considered to be an "Exploration" iron-ore
producer. I consider them to be a "producer" because they have just crossed the leap from an
"explorer" that typically burns cash to simply find resources to an actual production company
that is generating sales by profitably extracting assets and selling them for a profit.
LIM is focused on the development and production of the Schefferville Projects located in
western Labrador and north eastern Quebec. The projects comprise 20 direct shipping ("DSO")
iron ore deposits forming part of the historic Schefferville area iron ore district where mining of
adjacent deposits was previously carried out by the Iron Ore Company of Canada from 1954 to
1982. LIM plans mining in varying stages, the first of which comprises the James and Redmond
deposits located in close proximity to existing infrastructure.
The Company has made significant strides in 2011 during this start-up year towards full scale
mining operations at the James Mine. On June 29, 2011 the first loaded iron ore train departed
Silver Yards for the Port of Sept-Iles travelling over the TSH and QNS&L railways. This historic
event marked the first commercial iron ore train from the Schefferville area in almost 30 years.
----------------------------------------------------CAPITALIZATION
At September 30, 2011, the Company had $37.9 million in unrestricted cash and cash
equivalents and $7.5 million in restricted cash. Subsequent to the end of that quarter the
Company began to generate cash proceeds from the first shipments of iron ore. The prior
financing in April 2011 was oversubscribed with 8mm shares sold at $12.50 and 666k sold at
$15/share. This capital raise provided LIM with more than enough capital to get their Stage 1
production up and running. Each of the 5 stages are designed to help fund remaining production.
----------------------------------------------------HISTORY
Iron Ore mines were operated in LIM's region by the IOC prior to the 1950's. They were stalled
as the IOC shifted production to other regions, but the infrastructure has been left largely intact.
There are some areas in the latter stage development profile that still will require further
investments in rail etc, but the first few stages are largely intact without much further capex
requirements. LIM started in the early 2000's as iron ore pricing rebounded due to limited
global supply and growing emerging market demand, specifically from China. The original
founders John Kearney (CEO) and Bill Houley (Chairman of parent corp. Anglesey) decided to
purchase the assets and ramp up iron-ore production. They IPO'd in 2007 at $4.00 as an
exploration company and followed up with a secondary and then a 3rd equity offering. The
secondary was in 2010 at $5.55 and $6.65 while the 3rd offering was completed in April 2011 at
$12.50 and $15.00. The proceeds from these offerings were used to ramp up the assets into a
production ready status and included expenses for acquiring leases, stripping, de-watering,
transportation etc. This most recent April 2011 issuance raised more capital than needed given
the Iron Ore commodity price spiked temporarily. LIM is using the proceeds for capex to
complete the processing plant, infrastructure at the mine site, and initial funding for mining.
----------------------------------------------------SPECIAL SITUATION
Passport Capital was the largest independent shareholder in LIM with 9.6mm shares earlier in
2011 representing nearly 25% of the total company. Besides LIM's parent corp Anglesey with a
33% ownership, Passport was the single largest shareholder in this small cap iron-ore producer.
They have been selling per Canadian exchange filings confirmed by LIM management. They sold
despite buying into the 2011 equity offering just months ago at $15.00/share. Per the Passport
2011 investor letter, there is a bit more detail into their decision to blow out and pressure LIM
shares down from $14 to under $5 recently. With an average volume of under 0.5mm shares,
when a shareholder with 18x the daily avg volume decides to eliminate its holding quickly, that
generally has a negative effect on the stock price. LIM traded down by over 75% (since Passport
bought in the April 2011 offering) before rebounding slightly here in 2012.
Passport’s fund was down (–8%) in Q4 2011 and lost over (–18%) for the full year 2011. That is
some horrible performance there, and they decided to make some key changes at the company. A
change in portfolio managers is certainly a possible explanation, but they don’t mention that in
the investor letter. They note that they sold LIM primarily because it was an illiquid investment
for them and they decided to eliminate all of their “illiquid investments” given their weak
performance in 2011.
“Many of our biggest illiquid equity positions significantly underperformed in 2011. Two
examples of these were Labrador Iron Mines which was down (–58%) in 2011 and Crew Energy
which was down (–42%) in 2011.”
“We are extremely disappointed by our results for the quarter and for the year. We failed to
anticipate the extreme divergence between global and U.S. markets.”
Beginning in August they saw a dramatic decline of roughly 50% in liquidity at some of their
illiquid holdings. They decided to further reduce exposure to illiquid equities given their bearish
forward-looking economic assessment. As of the beginning of Q4’11, they had 20% of the fund
tied up in illiquid investments, so they reduced that exposure virtually in half to 10.6% as of
Q4’11. As of 1/6/12, the illiquid securities were just under 10%.
“While we are thematic investors, we seek a relative degree of diversification by holding
numerous equities in each of our themes as opposed to being highly concentrated. A number of
investments that had been top ten positions during 2011 performed dismally.”
----------------------------------------------------GROWTH
Management has consistently noted a 1mm tonne annual increase in production from 2012
guidance of 2.5mm tonnes to 5mm tonnes run-rate. This year's production will be separated into
3 phases designed to improve recoveries and at an expansion line that can treat lower greade
ores. The 1st two faces recovered over 500k tonnes and the 3rd phase is set to recover 2mm tons
for a total production target of 2.5mm tonnes. The total Stage 1 capex requirement is $100mm,
and management has guided to each of the 5 stages requiring a similar $100mm capex budget.
The current James location is actively being mined and they are working on investing in the next
mine -- the "Houston" ore body. The James location has 8.1mm tonnes of indicated reserves, but
the Houston ore body has at least a 10 year life.
----------------------------------------------------RESERVES
LIM has indicated reserves of 165mm tonnes although they infer that a more updated accurate
assessment would indicate up to 2x the original estimate from the 1950's survey, or greater. The
current reserve base is "severely understated" per management. The quality is some of the
strongest and purest iron-ore available globally. Their soft ores were formed by supergene
leaching and enrichment and is composed of fine grained iron oxides. The James deposit already
received "excellent" results from their chemical, physical and metallurgical testing which was
performed by Studien-Gesellschaft (SGA). Their lump ore samples are at 66.98% Fe and are
considered very favorable in light of their low managanese, sulphur, phosphorous, alkaline and
titanium traces. They have favorable sintering characteristics, low silica and low alumina
content. They have a competitive advantage as the only pure play public Canadian iron-ore
miner. Even the large cap peers have resources in questionable political regions. LIM has access
to rail and direct access to port via its IOC relationship.
----------------------------------------------------MANAGEMENT
Management at LIM (excluding parent corp Anglesey) own about 5% of the total shares including
CEO and Chairman John Kearney with a direct 1.63mm shares representing 3%.
This management team was assembled well as most executives have had successful prior
experiences with jr miners. Some of the executives were formerly at Kinross Gold which was
acquired.
----------------------------------------------------VALUATION
Assuming the 165mm tonnes indicated reserve (base case), at an avg $100/ton iron-ore price
(discounted heavily from current $140/tonne for future supply-side increases), LIM should
generate over $6bn in sales. With cash costs of $50-$60/tonne (management guidance and
analyst estimates), the gross profit would be over $6bn and Free Cash Flow including a run-rate
growth capex est would come down to about $3.2bn versus the current market cap of $340mm.
Even with discounting at a very conservative 15% WACC, the NPV in the base case is $1.0bn or
$18/share versus the current $6.25 for nearly a 3x return to fair NAV.
Assuming the reserves are adjusted to 300mm tonnes as the original IOC estimates have been
proven to be extremely low, the project revenue assuming a very discounted $100/tonne price
would be $7.8bn. Gross profits would total about $15bn and Free Cash Flow net of all capex and
taxes would be $7.8bn versus the current market cap of $340mm. Even after discounted at our
very conservative 15% WACC, the NPV would be $2.5bn or $45/share versus the current
$6.25/share.
As you can see, there is tremendous upside even using a very bearish life-time iron-ore average
price of $100/ton which is over a 45% haircut to the current spot price. The large global iron-ore
players like Rio Tinto have a virtual oligopoly on the market and whenever pricing drops, they
immediately halt production thereby creating a natural floor price.
Certainly future equity dilution is a risk and miners have other operational risks as well, but with
the massive discount to NAV here, LIM is certainly trading a level that more than compensates
you for that risk.
Comparatively, Cliffs Natural recently purchased Consolidated Thompson just recently in April
2011 for access to the attractive Bloom Lake and Wabush mines. Since Wabush was 25% owned
by a 3rd party (Wuhan Iron & Steel), when you adjust that minority interest out, Cliff's
purchased an effective iron-ore producer with 6mm tonnes of annual capacity. Over the next 5
years, LIM is expecting to ramp up to 5mm tonnes of annual production, not quite the
Consolidated level, but close. Yet despite this similar production outlook, CLF paid $4.2bn for
Consolidated, but LIM is trading at $340mm. While not exactly comparable, the 1200%
premium paid for Consolidated should highlight the discount in LIM's shares!
The few analysts that cover LIM are quite bullish. Octagon Research has a 1/16/12 report with a
$14.25 PT, Jennings Capital had an $18 PT but lowered it to $11 when iron-ore pricing dropped
in late 2011, and Credit Suisse has a $8.30 PT from 1/12/12. CS cites a statistical correlation with
iron-ore prices that implies "39% equity upside". Their proprietary HOLT analytical software
implies that the sector is currently trading well below fair value and even below the cost curve.
With average forecasted pricing, CS believes LIM has over 100% equity upside. CS specifically
notes the likely reason for the large discount implied in the stock price is the "blowout" by their
2nd largest shareholder Passport Capital which moved from 20% to under 5% ownership. They
believe the stock is "unsustainably cheap," and I agree.
----------------------------------------------------CATALYST
Aside from BHP strikes, flooding in Australia, or unexpected increases in demand from China
increasing the spot price, LIM is expected to ramp up production by 1mm tonnes annually, from
2.5mm tonnes this year, to 5mm tonnes run-rate. This production ramp up should get them to a
run-rate EBITDA of over $300mm and Free Cash Flow of over $175mm by 2015. That would
represent a forward FCF Yield of over 50% with no debt. If LIM can operate successfully over
this ramp-up period, the stock should trade at a much more reasonable 15% FCF Yield which
would imply a $25 stock price by 2015.
LIM is expected to provide an update to their very rough reserve estimates this month. Their
original reserve estimates from the prior owners in the early 1950's indicated 165mm tonnes of
reserves yet there newer projections are uncovering significantly more reserves. LIM would
rather spend their capital on production versus a complete resource evaluation, but they
indicated that in the stages where they are required to assess the reserves, they are running at
about 2x the original estimate. This could indicate as much as 300mm tonnes of iron ore, and at
$150/tonne, that would represent over $40bn in life-time sales.
Petsmart Inc. (PETM)
Analyst Details
Name
[HIDDEN]
Company
[HIDDEN]
Undergrad
Location
27.4%
$53.41
$55.13
EXPECTED
RETURN
PRICE AT
RECOMMENDATION
CURRENT
PRICE
ASSET CLASS
EXPECTED TIMEFRAME
GEOGRAPHY
Common Equity
1 year to 2 years
North America
RECOMMENDATION
SITUATION
COUNTRY
Short
Other
United States
Queen's University
San Francisco
The author of this idea may have a position in this security and may trade in and out of this position without
informing the SumZero Elite community before hand.
THESIS
A couple other people beat me to the punch in posting PETM as a short, and there is some
overlap, but I think there is some additionally helpful info here...
Company Overview / Situation Background
PetSmart, ticker “PETM”, is the largest retailer of pet food and pet products in the US with 1,120
stores that are primarily located in or near regional shopping centers and often co-anchored with
destination superstores such as Kohl’s, Home Depot, Lowes and Best Buy. PetSmart carries 10K
different SKUs and makes money from selling merchandise (89% of revenue) and services such
as grooming, training, boarding and day camps (11% of revenue). Merchandise revenue consists
of consumables (pet food, treats, litter) which is 52.5% of revenue, hardgoods (pet supplies and
other goods including collars, leashes, health care pet supplies, grooming and beauty aids, toys
and apparel) which is 34.4% of revenue, while pet sales (tropical fish, birds and reptiles) are the
remaining ~2%. The bulk of the services revenue (80%) is from grooming which is typically
allocated 900K sq ft per store, while hotels and training make up the balance (13% and 7%
respectively).
The aggregate pet spending market is $48B, which has grown at an impressive 7% CAGR over the
past 15 years driven by a slight increase in pet penetration (62% of households or 71M own a pet)
but mainly by the “humanization” phenomena and the rise of “pet parents” - owners who are
passionately committed to their pets and consider them part of the family. Food is $18.3B (38%),
pet supplies/meds are $11B (23%), vet care is 27%, pet services 7%, and live animal purchases are
5%. Mass merchants have captured significant share (47% share of pet food) with Wal-Mart
alone accounting for 25% with Ol’ Roy, the nation’s best-selling (and probably worst tasting) dog
food, while grocers account for 25% share. However, like other specialized category killers (Auto
parts stores, home improvement stores), PetSmart has proven resilient versus the mass threat
because Wal-Mart cannot dedicate the floor space, depth of merchandise, and selling expertise
that the customer desires. In fact, PetSmart has been very well protected as many of the
premium pet food brands with higher levels of nutrition are not sold through grocery,
warehouse club or mass retailers due to restrictions from the manufacturers - 93% of SKUs and
83% of sales do not overlap with mass merchants. As a result, PetSmart has managed to capture
14-15% of the market share in both products and services, and the next largest player, PetCo
(privately owned by TPG and Leonard Green, ~1K stores) has 7% share.
The average store size is 12K – 27.5K sq ft, costs $1.3M in investment ($900K fixtures, $300K
inventory, $100K pre-opening), and does $4.8M in sales per unit ($230 in sales per sq ft), but
recently the Company has shifted to a smaller box model, opening stores that are 12K-15K sq ft
and require $550K initial investment. Unit economics have historically been quite healthy,
turning profitable in the second year and earning 40% ROIC (store level before tax) when they
mature in the fourth year of operations, however channel checks have indicated new stores have
been significantly less productive (50% vs 70% on new units opened), leading to the change in
format. While PETM historically grew square footage at 8-10% annually, the Company slowed
its openings in 2009-2011 to 3-4%, and is now committed to grow at 2-3% annually going
forward.
The Company has three main customer segments: Smart with Heart (13% of customers, 51% of
sales, 10x transactions per year, $657 average annual spend), Smart (48% of customers, 41% of
sales, 4x transactions per year, $150 annual spend) and Mart (39% of customers, 8% of sales, 1x
transaction per year, $34 average annual spend). The Company’s strategy has been to try and
drive Smart with Heart traffic into the store and expand the service offering in order to increase
customer stickiness and attachment and capture more of their wallet and increase the average
transaction size from $31.
PetSmart has been a great growth story over the past five years capitalizing on the
aforementioned growing humanization of pets, and was one of the few unit growth stories in the
hard-line retail universe, growing square footage at a CAGR of 10% between 2004 and 2009. In
addition, investors were attracted to its stable, non-discretionary consumables revenue,
enabling the Company to post positive same store sales during the 2008-2009 recession. The
Company has posted over 14 years of uninterrupted positive quarterly comps and during the last
decade gross margins have never deviated more than 200bps from a band of 29% to 31%. As a
result, the market has historically rewarded PETM with a premium multiple for a retailer,
averaging 18x forward P/E and 9-10x LTM EBITDA. The stock has rallied significantly from its
recession low of ~$15 per share to ~$55 today, representing annual returns of 78% in 2009, 49%
in 2010, 29% in 2011, and up 7% YTD, outperforming the S&P500 every year by a wide margin
(up 67%, 13%, flat, and up 5% YTD).
Investment Thesis
As discussed above, PETM has been a stock market darling and has consistently outperformed
their own guidance and analyst consensus. The management has communicated a financial
model predicated on 2-3% square footage growth, 2-4% comps, 4-6% sales growth, 7-12% EBIT
growth, 2.3% capex and 4-5% share repurchases leading to 11-17% EPS growth going forward.
These targets alone are somewhat aggressive for reasons I will discuss below, but the Street has
upped the Company’s guidance and is above the high end of the range, projecting 18% EPS
growth in 2012 and 14% growth in 2013. On Street estimates, PETM is trading at 18.1x 2012E
P/E and 8.1x 2012E EBITDA, which is a significant premium to the hard-line retail compset, but
my estimates are 8% and 16% below Street consensus for 2012 and 2013, suggesting significant
downside from both earnings misses and multiple contraction. There are three prongs to the
thesis: (1) top-line growth has been artificially inflated and will slow, (2) margins are
unsustainably high and will contract, (3) the impact of the internet will be much greater than
expected pressuring both sales and margins.
(1)Artificially Inflated Top-Line Growth. Because it takes four years for a store to reach maturity
and comp at a “normal” level, comp store sales figures have benefited from a relatively immature
store base (eg Year 2 “comps” are +20%, Year 3 “comps” are +15%). In 2008, 26.1% of the
average square footage was three years old or less, and this figure fell to 22.6% in 2009 (posted
a 1.6% comp), 16.7% in 2010 (4.8% comp) and is projected to be 10.1% in 2011 (expected 5.4%
comp). However, as the Company has slowed store growth, the benefit of this impact will soon
dissipate as the store base matures. The store base three years old or less will only fall ~300bps
from 2011 to 2013 to ~7% (150bps over two years), versus the previous annual declines of
590bps and 660bps for 2008-2009, and comp store sales growth should suffer accordingly.
In addition, the 2010 comp (+4.8%) benefitted from the entry into the flea and tick category,
which will not be repeatable. Previously pet owners needed to obtain a prescription from a vet,
but OTC products became available in 2010. This entry created an estimated uplift of 2-3%
(about ½ of the comp). While we commend the management team for its resourcefulness, it is
unlikely a comparable entry in a parallel category will present itself during the next couple of
years.
Finally, one of the least discussed but most important comp drivers has been the mix shift to
premium pet food. Following the “great pet food scare of 2007”, there has been a significant mix
shift to higher-quality and much higher-priced food. Today premium food accounts for 50%+ of
pet food sales. This mix shift has masked the muted core operations, and should also dissipate as
channel checks indicate we are approaching the maximum penetration of premium food (only so
many customers are willing to get Rover the Solid Gold Green Cow Green Beef Trip in Beef
Broth for $65 for a case of 24).
(2) Unsustainable Margins. PETM’s LTM operating margin was 8.1%, and the Street expects this
to expand to 9.3% by 2013, driving a significant amount of earnings growth. The bullish
argument is that hardgoods (which are 2x the margin of consumables) suffered during 20082009 as customers postponed discretionary purchases for Fido and gross margins fell 230bps
from 30.8% in 2007 to 28.5% in 2009; but that this mix shift should rebound, resulting in gross
margin uplift. Bulls cite that hardgoods slipped from 39.8% of sales in 2006 to a trough of
34.0% in 2009 as Fido went without new toys and accessories. This figure subsequently
rebounded to 34.4% in 2010, but has fallen slightly year to date. The reality is that while there
was decline in hardgoods purchasing during the recession, this has subsequently reversed and
already returned to near pre-recessions levels, which can be seen by comparing hardgoods sales
dollars per square foot or sales per store which fell 14% but have subsequently rebounded 9%,
and are only 5% off the previous high. The reason the mix shift seems dramatic and that
hardgoods might have more room to run is that the aforementioned shift to premium pet food
has elevated the proportion of sales from consumables.
Up until this year, the Company has historically posted operating margins ranging from 6.8% to
7.6% over the past decade, well shy of the Street projections of 9.3%. As a point of reference, no
category killer hard-line retailer has ever posted 9% operating margins across an economic cycle.
Bookstores (Barnes & Noble) in the pre-internet era averaged 6%, Toystores (Toys R Us)
averaged 6%, office supplies (Staples) averaged 6%, electronics retailers (Best Buy) in the preinternet era averaged 5%, sporting goods (Dick’s) averaged 6%. The only exceptions are home
improvement retailers (Home Depot and Lowe’s) which averaged 10% (but the structure of the
industry is quite different and has the benefit of massive scale), and auto parts (Autozone has
mid-teens margins) – but again the industry is very different, and this is much easier in a 50%+
gross margin business.
In addition, the Company is already run in a fairly lean fashion and there is not a lot of lowhanging fruit. In management’s words, “nothing’s just laying there”. As a result, I expect that
margins will see little expansion from their current levels, dampening earnings growth potential.
(3) Impact of the Internet. Most analysts have seemed to dismiss the threat of increased
competition from internet vendors, citing the fabulous dotcom era flameouts pets.com and
petstore.com and asserting that the shipping costs for large bags of kibble are too prohibitively
expensive to produce a viable economic business model. While it is true that pet food is less
vulnerable than books or electronics, the regularity of purchase and replenishment nature makes
it more susceptible to an online offering. While the consumer wasn’t ready for an internet-based
subscription and delivery service in 2000-2001, times have changed, and amazon.com is making
considerable inroads with soap.com and diapers.com. In July 2011, Amazon.com announced the
introduction of wag.com, an online pet food and merchandise offering with free 1-2 day shipping
on orders of $49 or more. Based on extensive pricing surveys, wag.com is priced at a moderate
discount to PetSmart and Petco (5%) but when considering shipping and taxes, this discount
rises to 15-20%. While shipping dog food made much less sense in 2000 when premium food
was a tiny component of sales, the significantly higher price point and margins make it an
attractive area to target.
The beauty is that this story is unfolding in classic Christensen disruption fashion. PetSmart has
a tiny online presence today ($25M of sales!), and deliberately de-emphasizes their online
offering in order to drive traffic to the store in order to sell more higher-margin hardgoods.
From a recent conference call transcript, “Yes, traffic is really important. I would say if we can
get a couple hundred basis points of traffic increases or comp traffic, it makes the rest of the job
easy, because once you get them in the door, it's easy to put things in their basket.” This focus on
increasing the attachment rate and cross-selling has likely put the blinders on management about
the online threat. Petco has reacted more aggressively, introducing a 5% discount on all
merchandise for members of its loyalty program. Even a small loss of customer traffic to
wag.com will pressure sales productivity as PETM will lose out on the highly profitable
hardgoods merchandise sold in-store. Clearly a shift in consumption patterns will take time to
take hold, but Amazon.com is not a competitor to be taken lightly, and the writing is on the wall.
Management is making all the same arguments that we heard from Barnes & Noble (“there is a
core group of loyal readers that drive the majority of our volume, people want a place to sit and
read”) and Best Buy (“people value our in-store technical knowledge”). There are several ways
this can hurt PETM – loss in sales volume, reduced pricing pressuring margins, or, reduced
margins from required increased online infrastructure spending. Today the Company has
minimal e-presence and outsources order fulfillment to GSICommerce.
It should also be noted that this is not a management team with a lot of skin in the game. The top
3 executives only own $22M of stock (<50bps of ownership).
Valuation / Price Target
Currently PETM is trading at 8.1x ‘12E EBITDA and 18.1x ’12 P/E (street numbers) and 8.6x ‘12E
EBITDA and 19.5x ’12 P/E (my numbers), as my numbers are 7% below 2012 street consensus
and 16% below 2013 consensus.
Hard-line retail comps that are less vulnerable to the internet are currently trading at 13-16x
forward P/E multiples and 7x – 9x forward EBITDA multiples, which is in-line with historical
multiples, while the “internet-challenged” business (Best Buy, Radio Shack, Staples) are trading
at 8x forward P/E multiples and 4x EBITDA multiples. As another data point, Petco was taken
private at the height of the LBO in 2007 for 7.4x forward EBITDA – and this was with five more
years of unit growth left than today.
My base case price target for PETM is $40 (15x 2012E EPS), but if earnings growth dissipates
over the next couple years as I suspect, there is potential for the business to be worth $30 - $35
per share. There are very few limited unit growth, “return on capital” retail stories that trade
above a 15x P/E multiple.
Risks
Inflation Tailwinds. Throughout history, PETM has benefitted from inflation as they have fairly
strong ability to pass manufacturer commodity-based price increases onto consumers. Similar to
grocers, this generally this boosts comp store sales and enables some margin expansion as price
increases mildly outpace increases in fixed cost operating expenses. In the most recent quarter,
the Company commented that 30% of goods have seen a 6% increase so ~180bps of inflation
benefit. If inflation ticks up significantly this would benefit the Company and enable them to
continue to post above average comps.
Customer Stickiness. A significant portion of PETM’s business (50%) is driven by a small, core
group of customers (“Smart with Heart”) that only account for 10% of the Company’s customer
base. This customer base is wealthier, has embraced the store concept, visits and purchases more
frequently, and is more dependent on ancillary services offered such as grooming and doggy day
care. To the extent the customer views their visits to PETM as an “experience” and not a chore,
and is less price sensitive, the threat of wag.com will have a muted impact.
Continued Return of Capital. PETM shifted the business strategy in 2007 from a rapid growth
retailer opening ~100 stores per year (6% of sales) to a slower, more measured pace (~40 stores,
3% of sales) with a greater focus on profitability and ROIC. As a result, PetSmart throws off a
significant amount of free cash flow, enabling the Company to act in a shareholder friendly
fashion. The Company increased its quarterly dividend from $0.03 per share to $0.10 per share
in June 2009, $0.125 per share in June 2010, and $0.14 in June 2011 (current payout ratio of
~22% / 1% yield) and will likely continue this pattern. In addition, the Company continues to
shrink its share count by ~5% annually and remains fairly under leveraged (0.8x leverage).
Continued return of capital to shareholders could help support the share price.
Aware Inc. (AWRE)
Analyst Details
Name
Title
[HIDDEN]
[HIDDEN]
Industry
Hedge Fund
Postgrad
Kellogg School of
Management - 2011,
University of Georgia
School of Law - 2003,
Chartered Financial
Analyst
Location
$3.14
$3.94
EXPECTED
RETURN
PRICE AT
RECOMMENDATION
CURRENT
PRICE
ASSET CLASS
EXPECTED TIMEFRAME
GEOGRAPHY
Common Equity
1 year to 2 years
North America
RECOMMENDATION
SITUATION
COUNTRY
Long
Event / Special Situations
United States
Analyst
Company
Undergrad
86.0%
The University of Georgia
Atlanta
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THESIS
SUMMARY
Aware, Inc. is a Massachusetts-based company focused upon signal processing and
communications technology. At $3.20, we believe the company is currently priced at a steep
discount to its intrinsic value and offers significant upside to $7.33, which could generate a
return of ~130%, while having negligible downside risk. This value is derived as follows:
Biometrics $1.89/share
DSL software $0.28/share
DSL royalties $.039/share
IP portfolio $1.55/share
Litigation $0.73/share
Real estate $0.28/share
Cash $2.21/share
Less debt: $0.00/share
TOTAL EQUITY VALUE $7.33/SHARE
Furthermore, there are reasonable scenarios under which Aware equity could be worth
$10/share or more, producing upside of well over 200%. Of note, neither of these valuations
includes over $2/share of deferred tax assets. In short, we believe Aware offers dramatic return
asymmetry with pricing at a slight premium to liquidation value and upside of 2x to over 3x.
HISTORY
Aware has its origins in the late-1980s when the company began as an IP-focused firm whose
revenue was primarily derived from government research grants. Aware’s research led to a
steadily-increasing patent trove and efforts to commercialize the company’s technology. This
strategy resulted in Aware housing several different operating businesses over the past two
decades as it refined its approach to commercializing its technology.
Ultimately, through a process of business and asset dispositions, Aware settled on two core
operating segments: (1) biometrics software and services and (2) DSL test and diagnostics
software and hardware. These two businesses produce the bulk of annual revenue, and each has
value in its own right. In addition to the value of the operating entities, Aware offers several
other components of value. The first is an IP portfolio comprised of approximately 185 U.S. and
foreign patents and 271 patent applications. These patents cover a wide swath of technology
including audio processing, image compression, video compression and seismic data
compression. Second, Aware enjoys a continued royalty stream accruing from DSL chipset sales
related to a business line it sold in 2009. Thirdly, we believe, but have been unable to confirm,
that the company also likely holds an interest in the outcome of a pending patent lawsuit. Aware
also owns its corporate headquarters.
In sum, Aware is a technology-focused firm with seven separate components of value:
(1)
Biometrics software and services business
(2)
DSL test and diagnostics business
(3)
DSL chipset royalty stream
(4)
IP portfolio
(5)
Patent litigation
(6)
Real estate
As developed in this Report, these value-drivers aggregate to approximately $151mm of equity
value versus a current market cap of around $66mm.
BIOMETRICS
Markets – Aware’s biometrics business has historically centered on selling software component
parts to OEMs and government clients for inclusion in end-use biometric systems. The primary
markets within which Aware biometrics operates are:
- Border control – immigration, passports, national ID cards
- National defense – handheld ID devices for use in the field
- Secure credentialing – personal identity verification cards
- Law enforcement – FBI systems
- Access control – building access
Strategy – from its past focus on component software sales to OEMs, Aware has more recently
begun to develop a services business that consults and assists with the development and
construction of biometric enrollment and analytic systems for governments and other users.
This strategy has the double benefit of creating a separate, profitable revenue source while also
putting Aware in the advantageous position of consulting on projects for which its software
solutions serve as component parts (thus increasing the chance of Aware products being used in
the systems). Further, as a result, the services side of the business serves as a leading indicator of
software demand. Aware’s biometric services business targets small projects that larger industry
players do not seek based on scale.
Within the biometric systems product chain, Aware sells component and application software for
enrollment and server-based transaction management systems. Beyond the development of a
services/consulting business, Aware has also extended the software business toward providing
fully-developed applications rather than simply producing component parts for applications
created by other companies. This migration led Aware to create BioSP, its server-based
transaction management system, and other like products that represent more complete
application solutions.
With this background in mind, Aware’s current biometrics strategy is premised upon continued
growth via (a) professional services and (b) sales of more complete product offerings, both of
which provide larger and more profitable market opportunities than a purely OEM-based sales
model. As discussed further below, we believe the biometrics business is very profitable, a fact
that has thus far been masked by the remainder of Aware’s businesses. Management views
20%-30% annual top-line growth as a reasonable goal for the segment with the possibility of
landing a larger project that would drive 100% revenue growth over 2010 numbers.
Industry/Competition – the biometrics industry is in the midst of a significant growth cycle, with
~20% annualized growth expected to carry the industry sales from ~$4.5bn in 2011 to over
$10bn by 2017. Primary market participants within software and hardware for enrollment
stations include Lockheed Martin, Cross Match Technologies, Unisys, Science Applications
International, L-1 Identity Solutions (Safran), Northrop Grumman, Hewlett-Packard Electronic
Data Systems and NEC. On the transaction management side of the business, competitors
include Safran, Avalon Biometrics, NEC and 3M Cogent.
As is evident, competition within biometrics is comprised of firms significantly larger than
Aware. Aware’s competitive advantage in this context stems from a combination of offering
higher quality software and having a lower cost structure. Beyond the obvious benefit of a high
quality product, the lower cost structure enables Aware to competitively bid for government
contracts and ensures it is more cost efficient for larger OEMs to buy software from Aware
rather than develop it internally.
The biometrics industry has seen an uptick in consolidation as larger players have acquired
smaller firms, enabling the acquirers to complement and integrate their businesses with new
technologies and capabilities. In this vein, French defense contractor Safran SA recently closed
the July 2011 acquisition of L-1 Identity Solutions, while in October 2010 3M acquired Cogent.
Valuation – Aware biometrics has demonstrated steady topline performance over the trailing
three years and is gaining steam as the company develops the services component of its business
and continues to prove itself within the government bidding process, a contracting process in
which success builds upon itself.
Although Aware does not report biometrics results as a separate operating segment, we were
able to back into topline numbers based upon earnings call commentary and 10-K footnotes
(management generally confirmed the accuracy of our estimates). From a 2007 revenue base of
$7.5mm, biometrics produced $10mm in revenue in both 2009 and 2010. Furthermore, with the
development and growth of its biometrics services work the segment has produced, through
3Q11, incremental revenue of ~$2.7mm over the first three quarters of 2010. On full-year 2010
revenue base of $10mm, this represents annualized growth of well over 30%, consistent with
management’s target.
Based on our analysis, we believe the biometrics business is on track for ~$13mm in 2011
revenue. While determining the margins on the biometrics business is not possible given Aware’s
failure to report biometrics as an operating segment, the company’s overall blended gross
margin for hardware and software sales is around 75% and management has repeatedly indicated
biometrics is a highly profitable business relative to the DSL T&D business, thus suggesting gross
margins over 90%.
Given the lack of margin transparency and recent precedent transactions accruing from industry
consolidation, valuing the biometrics business on a multiple of revenue is a reasonable
approach. The detail on recent acquisitions follows:
Jul 2011, L-1-Safran deal, 3.5x revenue
Oct 2011, Cogent-3M deal, 5.7x revenue
(See attached PDF for more complete comp chart)
With a revenue multiple of 3.0x – significantly below both recent transaction comps – Aware’s
biometrics business is worth $39mm on 2011 estimated revenue of $13mm.
DSL TEST & DIAGNOSTICS
Markets – Aware’s DSL T&D business sells software and hardware products used by telephone
companies in monitoring, optimizing, diagnosing and servicing their DSL infrastructures. The
hardware business supplies modem modules to OEMs for inclusion in testing devices for
diagnosing line-based service problems. As noted above, the Company recently announced its
intention to close the DSL hardware business with shipments ceasing during summer 2012. We
view this as a positive as we believe the hardware business is unprofitable at the EBIT level and
represents a drain on cash.
The remaining DSL software business is the better of the two businesses, and provides telephone
companies with the ability to test, diagnose and optimize DSL performance from company
mainframe computers without the need for technician engagement in the field or other
hardware-based solutions. This offering drives significant cost savings for telcos, which is an
increasing area of focus throughout their operations given continued migration from landlines
and associated deteriorating profitability.
Aware’s DSL software business also benefits from industry tailwinds deriving from increased
international DSL adoption driving demand for service assurance infrastructure and testing
products. DSL has 70% of the total broadband market with ~400mm customers. Further, there
are more new DSL subs each month than new subs for all other broadband alternatives
combined. Although some are inclined to pan the DSL technology relative to fiber, wireless and
other mediums, the reality is that DSL is the most cost efficient broadband alternative and will
continue to dominate the landscape for the foreseeable future. Optimizing DSL transmission will
become increasingly important, which is precisely the function of Aware’s line diagnostic
platform software.
Strategy – the software business represents the future of Aware’s DSL operations, and the
company is working to grow this business. International telcos were at first hesitant to adopt a
software-based diagnostic and optimization approach, but over the past several years product
acceptance has accelerated and the growth trend is appealing. Accordingly, Aware has been
aggressively targeting this business, which has significantly higher margins than the DSL
hardware business the Company is abandoning. Aware has demonstrated increasing success on
this front with customer wins from two different European telcos during 2H10. Further, the
company is engaged in product trials with multiple other international telcos.
Industry/Competition – competitors within the DSL T&D business include Alcatel-Lucent,
Spirent Communications, Tollgrade Communications, JDS Uniphase, Sunrise Corporation,
Fluke Corporation, Kurth Electronic and Assia. Within the software assurance and optimization
Aware’s management has highlighted Alcatel and Assia, particularly. Assia is a VC-backed firm
focused solely on this niche market. Assia’s investors include industry backers Telefonica, AT&T,
Swisscom Ventures and T-Ventures. Alcatel’s Network Analyzer is that company’s competing
product within the software optimization market. Aware and Assia represent the only
“hardware-neutral” competitors within line diagnostics and optimization.
Value – Aware’s DSL T&D business has shown strong top-line performance. From a 2008 nadir
of $5.2mm in segment revenue and $1.6mm of DSL software sales, 2010 segment revenue grew
to $10.6mm with $4.1mm of software sales, cumulative growth of 104% and 156%, respectively.
Through 3Q11, YTD DSL software sales have increased $200k over the same year-earlier period,
which implies 2011 estimated DSL software revenue of approximately $4.4mm. With the
Company’s recent decision to jettison the DSL hardware business, Aware is dropping a business
that is likely to produce roughly $6mm of 2011 revenue. Importantly, software revenue carries
much higher margins than hardware, with the latter generating 35% to 40% gross margins,
according to management. We believe the DSL hardware business was unprofitable at the EBIT
level, and this business closure should have a positive cash flow benefit over time.
While divining the margins for Aware’s remaining DSL software business is not possible, with
continued sales growth within the business, we believe the DSL software business clearly has
value. Our conversations with industry participants indicate that each of Aware’s, Assia’s and
Alcatel’s competitive software offerings have unique attributes that distinguish them from one
another – one firm’s software is best suited for different telcos depending on the customer’s
systems and needs. This dynamic indicates differentiated technology amongst the competition,
and a likely market for Aware’s DSL business. Given the lack of margin clarity and ability to
determine segment profitability, we believe it is appropriate to look to recent precedent
transactions to determine an appropriate revenue multiple.
May 2011, Tollgrade-Golden Gate Capital, 1.3x revenue
Feb 2010, Digital Lightwave-Optel Capital, 6.1x revenue
Tollgrade is a very applicable comp as the company designs and markets DSL test and diagnostics
software, the same business as Aware’s DSL segment. Similarly, Digital Lightwave sells fiberoptic diagnostic and optimization products to telcos. While the latter is a relevant comp,
Tollgrade is the closer analogue as the company is focused on DSL rather than fiber-optic lines.
Aware’s DSL business should drive 2011 revenue of approximately $4.4mm, utilizing the
Tollgrade multiple results in a $5.7mm valuation of Aware’s DSL business.
DSL CHIPSET ROYALTIES
In 2009, Aware exited its DSL chipset and home networking business whose associated expenses
exceeded revenues annually. To this end, the company sold all related assets (chip designs, 41
engineering employees, two patents, one patent application) for $6.75mm booking a gain of
$6.2mm. The transaction represented a favorable outcome for a business that garnered $500k
to $1mm in quarterly revenue against $1.7mm to $1.9mm in quarterly expenses. Further, as a
data point for valuing Aware’s DSL T&D business, Lantiq paid $6.75mm for the DSL chipset
business which eliminated around $3mm in annual revenue from Lantiq to Aware, an
approximate 2.3x revenue multiple.
In conjunction with the sale, Aware maintained the right to licensing revenue based upon DSL
chipset sales from Lantiq (the acquirer in the DSL chipset transaction) and Ikanos
Communications (Aware’s other major chipset licensing customer). Over the 4 trailing calendar
years, this licensing stream has averaged $2.3mm/year with relatively consistent numbers of
$2.6mm/$1.8mm/$2.1mm/$2.7mm in 2007/2008/2009/2010. This revenue flow represents
pure margin to Aware.
Aware’s DSL chipset annuity is a free cash flow claim on Lantiq’s and Ikanos’ sales. While Aware
does not control the long-term sustainability of these businesses, there is material value in these
100% margin cash flows. As previously noted, the royalty stream has remained relatively stable
over the past four years with an average annual cash flow of $2.3mm. Capitalizing a $2mm
annual cash flow with a 4x multiple values the royalty at $8mm, which is conservative from a
multiple perspective. From a DCF vantage, assuming a 10% discount rate and that the $2mm
royalty decreases on a 10-year straight-line basis results in a $7.7mm valuation. In any event, an
$8mm royalty value appears reasonable.
IP PORTFOLIO
Background – from its inception in the late-1980s, Aware has dedicated significant resources to
developing a robust IP portfolio that totals 456 patents and applications. Much of this work has
centered on developing and evolving technology that drives its biometrics and DSL businesses,
but the portfolio also contains additional assets of value that are unrelated to its core businesses
and are essentially not valued by the market. The first category of non-core IP assets relates to
DSL chipsets, LAN wireless and home networking technology that is no longer applicable to
Aware’s business following the Lantiq transaction which disposed of these business lines. The
second category of excess IP has been described by company management as “other,” essentially
a catchall for the remainder of the portfolio. Thus, Aware’s IP can be categorized as follows:
(1)
Biometrics IP
(2)
DSL T&D IP
(3)
DSL chipsets, wireless and home networking IP
(4)
Other
Portfolio Detail – determining the exact composition of an IP portfolio is not a simple or precise
task. In combing a portfolio, a helpful starting point for categorization of the various patents is
the International Patent Classification codes used to classify each issued patent.
As the adjacent table indicates (SEE ATTACHED PDF FOR RELEVANT TABLE), 54% of Aware’s
issued patents and applications fall within IPCs H04B and H04L and with the inclusion of H04K,
H03M and H04J the total increases to 74% of the portfolio. The H04B and H04L classifications
relate to transmission and transmission of digital information, while HO4K, H03M and HO4J
relate to secret communication; coding, decoding or code conversion; and multiplex
communication, respectively. Each of these categories is associated with communications
transmission and associated technologies.
Making a determination of the specific uses of a given technology by simply reading the text of a
patent is not always possible. To this end, it is helpful to analyze patent classifications across
companies to determine the general areas of technological applicability. The table below
compares the IPCs of Aware’s patents with those of Nortel, Motorola Mobility and Interdigital,
three large firms who are viewed as having extremely valuable patent portfolios involving mobile
communications technology. In July 2011, a consortium of technology firms acquired Nortel’s
portfolio for $4.5bn, and on the heels of the Nortel transaction, Google agreed to acquire
Motorola Mobility for $12.5bn with many commentators speculating the bulk of Google’s
interest was founded upon Motorola’s patents. Likewise, during this same time period,
Interdigital’s stock catapulted from $40 to $70 based on reports multiple technology firms were
eyeballing the company’s intellectual property for acquisition. While much of this interest and
pricing action was driven by wireless technology which has not been a core Aware focus, the
transactions nevertheless demonstrate the increasing importance and value of intellectual
property.
As the table demonstrates (SEE ATTACHED PDF FOR REVELANT TABLE), there is tremendous
crossover amongst Aware and the comparable companies’ portfolios. H04B, the largest
component of Aware’s portfolio is the first, first and third largest components of Motorola’s,
Interdigital’s and Nortel’s portfolios, respectively. Further, HO4L, the second largest component
of Aware’s portfolio is the first, third and third largest components of Nortel’s, Motorola’s and
Interdigital’s portfolios, respectively. Similarly, there is a tremendous amount of overlap
amongst the remainder of the portfolios.
Portfolio Growth & Relevance – Aware’s consistent and escalating dedication to IP creation is
evident from the trend in the number of patents issued annually(SEE ATTACHED PDF FOR
RELEVANT TABLE). Furthermore, from the perspective of IP relevance, Aware’s citation-topatent ratio is very compelling relative to other IP-focused firms that derive significant value
from the sale and licensing of their assets.
Monetization – in September 2010, Aware management announced it was considering the spinoff of its IP licensing assets. In reaction, two members of the Stafford family (which in aggregate
owns 36% of Aware and holds voting proxies for another 10%) rejoined the board of directors in
January 2011, appearing to slow the spin-off process and assess the best means of monetizing
Aware’s excess IP assets. We view the Staffords’ reengagement as a positive given maximizing
shareholder value is likely their sole concern.
Following the Staffords joining the board, Aware’s CEO and two tenured board members
resigned in spring 2011. Subsequently, in October 2011, John Stafford, Jr. was elevated to
chairman of the board, and the executive chairman – Michael Tzannes – resigned from the board
to focus on heading Aware’s patent monetization efforts. In our conversations with management,
a debate amongst the board has become apparent concerning the best means by which to
monetize the excess-IP portfolio with some favoring spin-off and others preferring alternative
routes.
There are essentially 4 likely routes to IP monetization:
(1) Licensing/litigation – Aware directly pursues licenses from and/or litigates against other
companies. This route raises two primary issues: (a) Aware already houses two different
operating entities and adding a third would present increased complexity for investors and (b)
there could potentially be legal blowback risk for Aware’s operations should it pursue litigation
against other technology firms.
(2) Spin-off new entity with excess IP assets and cash – this is the route former management
began to pursue in late-2010. Typically, a spin-off would offer the benefit of tax efficiency, but
given Aware’s $41.8mm deferred tax asset this consideration is not as relevant. Further, there is
a very real question of whether it makes economic sense to split into two separate publiclytraded entities given Aware’s market cap and lack of scale.
(3) Assign IP and retain residual interest – Aware assigns patents to other companies who then
pursue licensing and/or litigation with Aware retaining an interest in the ultimate revenues. As
noted above, in this structure, the assignor’s retained interest (net of associated expenses) is
often around 50%.
(4) Sell the patents
In terms of monetizing the current excess IP portfolio, the preferred route is likely asset sale(s)
of the patents given the significant deferred tax asset that can be used to offset gains from the
transaction, a tax asset that may otherwise be squandered by the tepid profitability of the
operating businesses.
Valuation – patent valuation is far from a precise science as patent beauty is truly in the eye of
the beholder. Nevertheless, there are several means by which to inform a view of value.
The first valuation approach is a “by the pound” method – assessing the total value of Aware’s
patent portfolio based on recent transactions involving similar IP. The above-referenced Nortel
and Motorola transactions provide useful data in this analysis. Nortel was a pure-play sale of
Nortel’s IP. Although Motorola involved the sale of operations and IP, the consensus view is
Google assigned the vast majority of value to Motorola’s IP for defensive and offensive use in
patent litigation against Microsoft and Apple. This is consistent with the fact that Motorola
generated only $76mm in 2010 operating income on $11.5bn in revenues, following operating
losses of $1.2bn and $2.0bn in 2009 and 2008, respectively. Nevertheless, for purposes of
patent transaction comps we assume the Motorola’s operating business was worth book value of
$1.8bn, reducing the patent transaction value to $10.7bn.
As the table indicates (SEE ATTACHED PDF FOR RELEVANT TABLE), Nortel’s portfolio sold
for $750,000 per patent and Motorola’s for roughly $446,000 per patent. Utilizing a $500,000
per patent assumption, results in a $228mm value for Aware’s IP, over 11x the current enterprise
value. Even reducing the assumption by half to $250,000 per patent, equates to $114mm in IP
value, over 5x enterprise value.
One further example of strategic patent value is offered by the recent HTC-S3 Graphics deal. In
July 2011, just days after the International Trade Commission found Apple had infringed two of
S3 Graphics patents, HTC agreed to purchase S3 for $300mm, or $1.3mm per patent. While S3
is reevaluating the deal in light of a subsequent reversal of the ITC ruling, the events
demonstrate the tactical and monetary value of well-positioned technology IP.
Finally, we note the insider purchases of Michael Tzannes, a long-time Aware employee and
former Aware CEO and executive chairman (SEE ATTACHED PDF FOR REVELANT TABLE).
Tzannes is also a prodigious inventor named on the majority of Aware’s patents – if anyone
knows the value of the IP portfolio, it is Tzannes. For several years prior to the announcement of
the IP spin-off in September 2010, Tzannes consistently owned 91,033 shares. Following the
spin-off announcement, in April and May 2011, Tzannes invested $1.02mm to purchase 321,000
additional shares. Tzannes’ investment was effected through the exercise of essentially at-themoney options ($3.18 average basis) that were not scheduled to expire until October 2013; thus,
the option exercises were the effective equivalent of open market purchases. In the nine months
following Aware’s decision to pursue IP monetization, Tzannes – who developed and heads
Aware’s IP efforts – invested cash to increase his share ownership by 4.5x. We believe this is a
bullish indicator of value.
Nevertheless, for purposes of assigning value to the IP portfolio, we take a conservative
approach and capitalize Aware’s R&D on trailing five-year basis. Assuming straight-line
depreciation of R&D investment from 2006 to 2010 results in IP asset value of $32mm.
However, utilizing a twenty-year capitalization/depreciation schedule – consistent with the time
length of patents – produces an IP asset of $85mm or over $2.50/share of incremental value
(additional upside of 78%). The reasonableness of using a twenty-year
capitalization/depreciation schedule is highlighted by the fact that several of the patents
transferred to Hybrid Audio were filed in the early 1990s, demonstrating the long-term potential
value of technology patents.
PATENT LITIGATION - HYBRID AUDIO
A final, option-like Aware value driver relates to patent infringement litigation surrounding
several Aware patents. In December 2010, Aware assigned four patents to Hybrid Audio, LLC.
Hybrid Audio is a Texas-based entity whose management is associated with Technology, Patents
& Licensing, Inc., a Pennsylvania firm focused on developing, acquiring, managing and
monetizing patent assets.
Three of the four assigned patents fall under IPC code G10L, which covers audio analysis and
processing. These were the only G10L patents within Aware’s portfolio. Although Aware has
provided little disclosure relating to the patent transfer or Hybrid Audio, our diligence leads us
to believe Aware conveyed the patents for $300,000 and retained ~50% interest in any future
net proceeds from litigation or licensing. Our discussions with IP attorneys indicate patent
assignors often retain a percentage of future proceeds. Further, subsequent conversations with
Aware’s management confirmed – although they would not address Hybrid Audio specifically –
that in patent assignments geared toward monetization by the assignee Aware would typically
retain 50%+/- interest in future net proceeds.
The belief that Aware structured a deal with Hybrid Audio for the latter to pursue patent
infringement claims is bolstered by the fact that simultaneous with the assignment Hybrid Audio
filed federal suit in the Eastern District of Texas against HTC, Apple, Dell, Motorola Mobility,
Nokia, RIM and Samsung. The claimed infringement involves one of the four assigned patents
and relates to the processing of audio information under MP3 on products including iPod,
iPhone 4, iPad, iTunes, XOOM and DROID.
While handicapping the value of patent litigation is difficult, the Hybrid Audio suit certainly
appears to involve a colorable claim and significant potential value. Plaintiff’s counsel is McKool
Smith, a national trial law firm with a patent litigation focus. McKool secured several recent
victories in infringement suits against Microsoft, including a $290mm claim in favor of i4i
Limited Partnership that was upheld by the U.S. Supreme Court in June 2011 (SEE ATTACHED
PDF FOR RELEVANT TABLE). In short, McKool is a very successful law firm, having secured
more of the 100 largest U.S. courtroom verdicts than any other firm in the country during 2008
and 2009. Importantly, McKool takes IP infringement cases on a contingency fee basis, which
means the firm has significant economic risk should the lawsuit prove unsuccessful, and must
therefore diligence and select its clients carefully. This suggests McKool sees merit and material
value in the Hybrid Audio suit.
A second positive aspect of the case is its venue in the U.S. District Court for the Eastern District
of Texas, site of the above-referenced Microsoft suit and a great venue for patent suits. The
judges within the District have developed an interest in patent litigation and ensure speedy
process and case resolution. Additionally, the judge assigned to the Hybrid Audio suit, Judge
Leonard Davis, is experienced in IP litigation and technologically knowledgeable having worked
as a computer programmer prior to law school.
An attempt to put a definitive dollar estimate on the value of the Hybrid Audio litigation would
be foolish – there are simply too many variables and unknowns. However, in light of McKool’s
past successes and contingency fee structure, we believe it is reasonable to assume McKool sees
litigation value greater than $100MM. The firm has multiple $100MM+ IP infringement
verdicts over the past several years, and given the incentives and risks inherent in contingency
fee representation and the expense of IP suits, McKool’s business model is predicated upon only
pursuing cases with significant value potential.
Assuming McKool sees at least $100mm in infringement value, the Hybrid Audio litigation
would represent $30mm in value to Aware net of a 40% contingency fee and 50% profit share
with Hybrid Audio. While any value realization from Hybrid Audio is admittedly speculative, we
believe there appears to be real potential for significant value associated with the relationship,
and further the suit represents purely incremental value on what is an already undervalued
business. For valuation purposes, we apply a 50% discount to the valuation above to arrive at
$15mm of litigation value. Without the discount, Hybrid Audio would represent an additional
$0.75/share of value (additional upside 23%).
REAL ESTATE VALUE
Aware owns its 72,000 square foot headquarters in Bedford, Massachusetts. The structure was
constructed in 1982 and sits on 4.03 acres of property.
Aware acquired the property in 1997 for $6.7mm, and it is currently assessed at $5.7mm. This
equates to an appraised value of $79 per square foot. Given recent Bedford office comp
transactions in the $85 to $150 per square foot range, the assessed value of $5.7mm / $78 per
square foot passes the reasonableness test (SEE ATTACHED PDF FOR RELEVANT TABLE).
In any event, at $5.7mm, Aware’s real estate represents 28% of Aware’s enterprise value.
CONCLUSION & OTHER VALUATION CONSIDERATIONS
In sum, based on our analysis, we believe Aware currently trades at 44% of a sum of its
conservatively valued parts with a newly reconfigured board and management that is working to
actively catalyze value recognition through asset monetization.
Moreover, there are components of value that this analysis has not considered. We have
assigned no value to Aware’s $64.5mm of federal NOLs/credits and $18.6mm of state
NOLs/credits, which comprise a total DTA of $41.8mm. There is currently a valuation allowance
taken against the entirety of the DTA, but this asset may represent real value of $2/share as the
company considers asset sales the gains from which the DTA can offset.
Finally, the limited downside risk of an Aware investment bears noting. Taking only cash and
accounts receivable and assuming $5.7mm in real estate value against total liabilities of $3.2mm
results in $2.51 of per share liquidation value. Accordingly, Aware trades for only a 28%
premium to liquidation value, which is all the more meaningful for a company generating
positive free cash flow. This 28% downside to liquidation value contrasts with upside of 129%, a
roughly 5x upside-downside ratio. Moreover, conceivable scenarios exist in which Aware’s IP and
litigation value offer additional upside of $3.25/share for a potential total return of over 230%.
Most importantly, a buyer of Aware is paying nothing for this IP optionality as the Company
trades at only a slight premium to true liquidation value and the biometrics business has clear
value. We believe the asymmetry of return is compelling.
Information, opinions or recommendations contained herein are solely for informational
purposes. The information used and statements made have been obtained from sources
considered reliable but Privet Fund Management LLC neither guarantees nor represents its
completeness or accuracy. Such information and the opinions expressed herein are subject to
change without notice. As of the date hereof, Privet Fund Management LLC and its affiliates own
securities of Aware, Inc. For further information, see Privet Fund Management LLC’s Schedule
13D filed with the SEC. Privet Fund Management LLC and its affiliates may either increase or
decrease their positions in Aware, Inc. without notice. This document is not intended as an
offering or a solicitation of an offer to buy or sell the securities mentioned or discussed.