Description

 TII Network Technologies

"If a business does well, the stock eventually follows." - Warren Buffett

Summary

TII Network Technologies (TII) is a special situation overlooked by the frustrated investors who suffered heavy losses waiting for a turn-around that could never materialize.  The Majority of the company's offerings are non-sexy, copper-based products in a telecom industry dominated lately by the fiber hype and hence has been largely ignored by investors.  The recent acquisition of a distressed business, coupled with organic growth in its legacy business, has added substantial value to the equity holders in the company, which we believe has yet to be reflected in the stock price.  Meaningful improvements in operating metrics even at little or no growth will drive the stock price higher with reasonable potential to appreciate 50% in the next 12 to 24 months.  Improved economic conditions may provide additional tailwind to propel its share price even higher.    There was a sharp run-up as we were drafting our thesis and a pullback here may be likely, however, we believe the risk-reward at current quote is quite favorable.

Business

TII Network Technologies designs, manufactures, and sells products in the communication and cable industry for use in telecom networks and have been doing so since the early 1960s.  These products can be found outdoors in the service providers like AT&T, BT, Verizon, Telmex, etc and constitute the backbone for successful delivery of voice, broadband communications services and are essential for their distribution networks.  Although the majority of the products are utilized in Outside Plant (OSP) segments, their products are also employed to interface the service provider's network to the consumer's network and can be found inside homes or apartments.  TII has been growing market share and a strong brand in a multi-billion dollar market in the US, Latin America, and Europe.  A detailed description of products and their applications can be found in the Business section of 2009 10K. 

While recent media hype has speculated that fiber-to-the-human will replace copper as the last mile to telecommunication users, most major carriers like AT&T, BT, Telmex, etc continue to use copper as the preferred medium for final destination connectivity.  Discussion with industry experts we contacted suggested that replacement of copper will take lot more than just a few decades as today's telecom network assets have grown steadily over the last century and require periodic maintenance for continued functioning and will not vanish any time soon.  Copper-based products are in TII's sweet spot, even though they have a decent exposure to fiber based products.  Since the 2008-2009 economic downturn, the company has been growing and capturing new markets from the competition and we have every reason to believe that the company continues to grow organically over next few years.

Background for our Investment Thesis

TII was founded by Alfred Roach, a serial entrepreneur and author of the book "Fire In My Belly" in the mid 1960s.  He remained at the helm of the company till 1995 before turning over his CEO job to his son Tim Roach who continued till 2006.  We were first introduced to TII while performing our due-diligence on Intellon, our write-up on VIC, just a couple of years ago.  Our interviews with a couple of long term shareholders led us to believe that during the ensuing years under Tim Roach, the company was run as a personal piggy bank.  While we do not find it particularly useful to our thesis to corroborate this finding, a quick peek at the company's historical price per share indicates about a 90% loss in market value from mid 1995s to mid 2005s.  Our discussion here focuses on the company's business and management upon the exit of the Roach family in 2006.  Ken Paladino was nominated as the company's CEO at the time when the company was holding underutilized assets, disorganized operations, and a resigned bunch of minority shareholders.  Gradually, the company revamped with young, ambitious, and conservative management and the new leadership gained foothold.  While the industry was fixated on the latest hype, fiber, TII started to refocus on the niche it had built over the past few decades, copper-based networks.  The company's new management has restructured its operations for long-term profitability by undertaking the following actions:

• Shifting high-volume, commodity-like products offshore to enhance margins and focus in-house on niche products needing quick turnaround.
• Restructuring the company's operations by shutting down the Puerto Rico manufacturing plant and relocating its operations to Edgewood, New York, resulting in annual savings of $1.3 MM by reducing headcount by 100%.
• Consolidating the company's operations in a new ultra-modern facility in Long Island with focus on state of art research and development, testing environments and driving expense reductions. The facility also serves as an easy access for TII's customers and to demonstrate the products developed through rapid customer feedback. The move helped in improving operational efficiency, resulting in higher margins.

The initial thrust by the new management has provided for a nice reversal in fortunes through significant organic growth, but was abruptly interrupted by the recent multi-generational economic slump beginning in the second half of 2008.  As a consequence, an unprecedented destocking of the inventories by customers resulted in a whopping 40% decline in sales in less than a few quarters.  Undeterred by the downturn, the company improved its cash position every quarter during the downturn by following conservative fiscal management.  The company's board successfully fended off a hostile, low-ball bid by Wilcom in May 2009 that was slightly more than the cash on the balance sheet for this debt-free company.  Aided by its conservative fiscal position and an unfettered focus on customer service, the company began aggressively capturing new customers as competitors scaled back.  When broader economic headwinds receded, the company recorded substantial top line organic growth as evident in the latest few quarters. 

The company restructured its operations with the goal of taking out fixed-costs permanently.  The stringent working capital management during the Great Recession helped the company end 2009 with more than $12 MM in cash and no debt.  Even after the broader stock markets recovered, the company's market capitalization remained low at $16 MM and a ridiculous enterprise value of about $4 MM for a consistently profitable business with EBITDA greater than $2 MM.  The tangible book value at this time was about double its market value.  Perhaps Paladino's locking up of $7 MM in certificate of deposits in a low interest environment may not have sat well with the shareholders.  Maybe the market did not trust his ability to deploy the cash in the face of economic recovery to rejuvenate the company's prospects.  The company's aversion to periodic analyst calls may not have helped attract coverage on Wall Street.  Whatever the reason may be, the company did not get sponsorship amongst investors in spite of growing organically and having improved the valuation metrics.

Recent Transformational Acquisition

The company's acquisition of Porta Systems Copper Products Division in May this year may be one of the most significant events in the recent history.  Deploying excess cash after lengthy discussions at an opportune time helped the company's quarterly run-rate explode without any dilution to shareholders.  The acquisition almost doubled the company's revenues at a very low purchase price.  The strategic benefits of the acquisition include:

• The company added two large international customers, BT and Telmex. TII's earlier attempts to penetrate these two customers independently were not successful. The strategic direction of these newly acquired customers is similar to its major customer AT&T i.e., fiber-to-the-curb and copper-to-the-home, which fit nicely within TII's circle of competence.
• Many of the newly acquired product lines are complementary to the company's existing pipeline. In the long term, there will be numerous cross-selling opportunities such as consolidation of telecom vendors continue. This acquisition also addresses the long-standing request of TII's loyal customers to expand the company's product offerings.
• Low fixed-cost was added as part of this acquisition. Employee count increased by a mere 8 people to current headcount of 52. Viewed differently, a less than 20% increase in employees increased quarterly revenues by 68% in the latest quarter. Overhead G&A costs are absorbed by current a TII workforce.
• CPD's margins initially will not be as high as legacy TII, but the removal of the fixed-costs and improving margins under TII will still impact the company's earnings positively.
• Current company's focus has been to integrate new customers seamlessly with the unprecedented service legacy that TII customers have come to enjoy. Subsequently, management will shift gears for operational improvements to improve profit margins.
• Company's customer concentration, which had been Achilles heel earlier, has adjusted favorably with the CPDs acquisition.
• Porta, a familiar industry brand in Europe and Latin America, is now a TII's brand.

A look at the trading pattern in the months after the acquisition indicates Mr. Market has at best reacted to this event with a yawn.  Inadequate coverage, prolonged misery experienced by long-term shareholders, low market capitalization and low price per share may have stopped investors from taking a second look at this company.  Also, the new management under Ken Paladino has been around for more than 5 years and hence may not be considered new by some unsettled investors, who may have ruled out any chance of successful turn-around.  Fundamentally, however, with this transformative acquisition and with fending off an unsolicited acquisition, management has clearly made a statement that it was up to the task of growing the company for the benefit of shareholders.    

Great CEO

Ken Paladino, the CEO of the company, is a trained bean-counter and a great capital allocator.  One of our acquaintances, and also a large shareholder, has known Ken Paladino since his days at EDO considers him to be conservative and a great money-manager.  Even after thwarting the hostile acquisition in first half of 2009, Ken was under no pressure to utilize the cash that the company was building from its operations.  In fact, he waited patiently for an opportune moment to strike when he purchased CPD division.  Ken did not budge to external pressure of buying the entire Porta Systems and instead cherry-picked what he was confident about: buying just CPD and the Porta brand name.   Before the merger was completed, management ensured that the manufacturing operations were spun-off to its principal contract manufacturer, whose services TII continues to utilize in production of their legacy products, thereby focusing on its core competencies i.e., sales and marketing and R&D.  This action, along with recently moving the gas tubes operation from Malaysian vendor to this principal CMS manufacturer, signifies the deep relationship TII enjoys with this vendor.  As a stockholder, we feel confident that these actions by the management minimize supply-chain risk, as the trust is mutual in this case.   

During our interactions with Paladino, our key takeaways were the following:

• He is laser-focused on enhancing value in the long term. Instead of propping up the stock through analyst calls, he believes in letting periodic financial numbers do the talking.
• Paladino is quite conservative and deploys company finances as if they are his own. We believe he is aggressive going after the market and improving the company's market share. However, he is also very patient in utilizing the financial resources available to him only when opportunity arises. This is clearly demonstrated by the recent CPD acquisition.
• He checks his ego at the door and his sole focus is to grow TII conservatively. He writes his own earnings release and does not employ PR firms.
• He owns 6% of the company and his economic interest is aligned completely with fellow shareholders. Also, we believe his annual cash compensation is at the lower end of the spectrum when compared to similar sized companies in Long Island.
• He is a fast learner, ambitious, and quite amenable to changing requirements in running a business. He is an under-seller and over-deliverer with clear objective to grow TII for the benefit of long-term shareholders. He would like to transform TII into a diverse Network Technology Company and current buyers of company stock will have a long and rewarding journey.

Without hesitation, we believe that Paladino has all the major qualities that are required for a successful CEO.  As TII starts to build cash from operations in coming quarters, we feel comfortable that Paladino will deploy cash at higher returns on newly invested capital returning value to long-term inclined shareholders.

Financials

Below, we present the operating metrics for the past seven quarters, coming out of a recessionary environment.  During the economic downturn, management focused on building cash, capturing market share as competitors failed to deliver, and improving profitability by taking fixed-costs out of the company's operations.  Sales have improved steadily over every quarter, as shown below, while improvements in gross profits were even better.  Management was conservative in its finances by minimizing non-discretionary spend, which however, did not deter them from capturing market share towards the second half of 2009 from the competition.   To prepare for eventual recovery and armed with a pristine balance sheet, the company scoured the market place for opportunistic acquisition targets.  The CEO's 2009 Annual Letter put fellow shareholders on notice about acquisitions (we believe the CPD acquisition was under negotiation at time of writing of the letter), the result of which was the cherry-picking of those product lines beneficial to TII's legacy offerings.  Also, operations in Mexico were restructured in collaboration with TII's trustworthy CMS operator and instantly retrofitting TII's proven formula of operational success to CPD's products.

While a big part of sales growth has been to acquisition, TII's organic growth Q-over-Q in the recent quarter is greater than 30%.  The gross margin percentage was down due to relatively lower margin products from CPD and one-time acquisition costs.  As discussed earlier, Sep-10 quarter seems to have hit bottom and we should see a steady improvement in the coming quarters.  Synergies related to the company's operations and cross-selling of enhanced product line to combined customers will contribute to this improvement as well.  Also, most of the gross margin dollars will trickle down to the operating margins because the company has acquired mostly engineers and sales personnel.     

Valuation

Today, TII is a simple case of an undervalued stock, which we believe presents new investors with a profitable investment opportunity.  Our thesis hinges on the following assumptions:

• Future benefits from merging the company's legacy business with CPD have not been recognized by the market yet. With double the revenue base under the direction of capable and conservative management, bottom-line improvement will be substantial. There is still proverbial long-hanging fruit available to be picked.
• With most customers running their businesses with an eye on an economic slowdown, excessive inventory build is substituted by just-in-time inventory.
• Per management's broad-brush guidance, the combined company will grow organically and it has asked investors to evaluate the success of the CPD acquisition based on improving margins. Also, management has a history of under-promising and over-delivering and, barring quarter to quarter fluctuations, any surprises will be on the upside rather than the downside.

Below are our base case projections for next three years.  Also provided are two matrices comparing estimated price per share to estimated fair value of the company.  Since there is no analyst coverage and inadequate guidance from the management, our attempt below is to paint with a broad-brush in estimating intrinsic value of the company.  Per our assumptions, gross margin in the latest quarter is the trough at about 25% (however, backing out non recurring onetime acquisition costs, it is greater than 26%).  To be conservative in our calculations, we chose to estimate fair value based on nominal improvement in gross margins. 

The matrix below attempts to estimate the fair value per share at 25% gross margins.  These estimates are ultra-conservative assuming no improvement in margins from the latest reported quarter.  However, these estimates are not too practical, as Paladino would not have pursued the acquisition in the first place.  Since this acquisition is considered transformational, we believe that the low end of this matrix is not a likely scenario.

A fairly conservative scenario would be that company recaptures a third of its gross margin given away due to acquisition of CPD.  In this scenario, the company will still not return to peak margin performance experienced before the merger because CPD products are generally low margin compared to TII's legacy broadband products with high margins.  The fair value estimates are as follows:

Considering fair value estimates above in most likely scenario, very conservative management acting in the highest interest shareholders' and current price per share, we believe there is a large margin-of-safety for investors buying shares at present price. 

The company has greater than $20 MM in NOLs and will not be paying taxes for several years into the future.  The cash taxes company pays is to account for taxes on the non-cash stock based compensation.   

Corning, Tyco Electric (also a customer), and Schneider Electric are publicly listed competitors, per company's annual report.  These larger companies have only some overlap with TII.  Apart from these, TII competes with several private businesses in different product lines.  Small rivals are being acquired past decade and the trend continues with ADC Telecom acquired by Tyco this month.  ADC Telecom operated at 5%-6% operating margin which Tyco expects to ramp up to 15% in three years and was acquired at 9x 2010 EBITDA. 

Historically, big telecoms have stable relationship with their vendors and churn is non-existent with companies fortified by strong balance sheets.  TII's roster of customers includes big telecom companies in the North America and Europe and almost all of them have been with the company for most part of this decade.   Also, TII's pretax operating margin trailing twelve months is 8.4% backing out onetime acquisition costs.   As can be seen in our matrix above, even assigning more conservative multiples than ADC would provide us with at least 50% appreciation from current levels.  Greater than 40 years of operating histories each for both pre-merger TII and Porta Systems and stable client base in telecommunication industry provides adequate margin-of-safety for our investment.

Risk Factors

• Unsuccessful CPD merger with legacy TII is the biggest risk under present conditions. However, per the conversation with company's management, the merger is on schedule with positive surprises outweighing negatives.
• Major downturn in the global economy or wide fluctuations in Euro or Mexican peso are risks for TII's stock performance. While fixed costs have been permanently removed from the company, we believe unexpected events out of control of the management are a risk.
• Decline in gross margins either due to inflation in raw material prices or competitive pricing of finished product may hurt TII's bottom-line.
• Loss of any major customer is a risk. However, we are comfortable as discussed above and our checks with the management did not lead us to believe anything to the contrary.
• This thesis relies on our read about Paladino as a steward for minority shareholder which may be erroneous.
• While we believe issuing non-cash stock options to key employees is essential to motivate, we worry about excessive dilution if this issuance goes unchecked.

Catalyst

• Successful merger of CPD into TII's operations will most likely accelerate the market value of company's stock. Improved gross margin dollars will be by far the biggest catalyst. With the return to normalcy in legacy TII, along with addition of new sales dollars from acquisition, management has lot more work room to improve company's operating metrics. Cross-selling and merger synergies should help propel company into the radar of value minded investors.
• Effective deployment of newly acquired sales channels to grow the company profitably.
• As data traffic continues to grow and quadruple in next four years, products by telecommunication equipment providers like TII will be consumed new and old telecom networks.
• Currently, the stock is flying under the radar of many investors. However, it may get noticed on stock screens for increased sales without substantial change in market value.
• Any new, accretive acquisition will help company improve bottom line further.