Description

Note: ZMTP is a $2 stock that trades approximately 15K shares per day on OTCQB. I know that it is too small for many VIC members, but I think that microcap investors will be interested in this idea.

Summary: Zoom Telephonics (ZMTP) is a $28 mil. market cap company that competes in the retail cable modem market. In May, 2015, Zoom won the right to produce modems under the Motorola brand name. This minor miracle should result in triple digit revenue growth in 2016 and a higher stock price.

Introduction: Zoom has struggled for most of the past twenty years due to its historical dependence on dial-up modems. The company currently generates roughly $12 mil. in sales from broadband and dial-up modem sales. The Motorola licensing deal is transformative as Motorola is the leading brand in the retail modem industry. Zoom has an unusual opportunity to greatly increase in size in a short amount of time.

History

            Zoom Telephonics (ZMTP) has been a small producer of consumer electronics for decades. Frank Manning, Zoom’s CEO, co-founded the Boston-based firm way back in 1977. Its early products included such amazing gizmos as automatic telephone dialers. Zoom began to focus on dial-up modems sold at retail back in the 1990s. The firm had success in this market as annual sales peaked at $100.2 mil. in 1996. The good times did not last, however, as the modem market changed quickly. Retail demand and pricing began to fall as manufacturers began to install dial-up modems in new PCs. Zoom’s sales fell precipitously in 1997 and did not recover. It was not long before consumers began to switch to broadband on a large scale. Zoom introduced DSL, broadband, cable, and VoIP products, but continued to struggle. Its sales fell to $18.3 mil. in 2006, a decline of more than 80% in a decade.

            Zoom got involved in the Chinese reverse merger mania in 2009. Zoom used to be called Zoom Technologies and trade under the symbol ZOOM. By the late-2000s, its problems had pushed its stock price down into penny stock territory. In January, 2009, the struggling company announced the acquisition of a Chinese mobile phone maker called Gold Lion. Zoom’s U.S. business was not integrated with Gold Lion. Instead, Zoom was split into two companies. The Chinese business took the Zoom Technologies name and stock symbol. The original Zoom, Manning’s U.S. modem business, was renamed Zoom Telephonics and adopted the symbol ZMTP. The Chinese ZOOM operated a business for a few years but it, like many other Chinese reverse merger companies, was beset by accounting issues and failed. There has not been any relationship between ZOOM and ZMTP for years. This report concerns only Zoom Telephonics (ZMTP).

            Zoom has never had significant sales to cable operators. The modem market changed after consumers switched to broadband. American consumers began to rent broadband modems from their cable or phone providers. Zoom did not benefit from this trend. Dial-up modem sales remained its primary source of revenue until, believe it or not, the year 2011. While Zoom has sold broadband modems for years, it has never had a significant direct business with the MSOs. It has always focused on cable modem sales through retailers. Most of its modems are sold to consumers who want to eliminate monthly rental fees. Zoom, by the way, continues to sell dial-up modems. Its 2014 10-K states that, “Industry analysts believe that the market for our dial-up modems is likely to continue to decline.” I agree with those insightful analysts.

The Current Business

            Zoom has been a steady performer in its market niche. Its annual revenues have hovered around $12 mil. / year for the past few years. It is a testament to Zoom’s strong relationships that it has been able maintain shelf space at major retailers. Its distributors include Ingram Micro, Tech Data, and D&H Distributing. Retailers that stock Zoom modems include Best Buy, Wal-Mart, Amazon, Newegg.com, and Fry’s. Zoom has had relationships with salespeople at these distributors and retailers for many years. Its modems are usually sold at lower price points than those of competitors. It has carved out a niche as a quality, low-price alternative. Zoom’s DOCSIS 3.0 cable modem is typically priced at $69.99 at retail. Comparable modems from competitors, such as Linksys, Arris, and NetGear, are usually priced at $10 - $20 more. Retailers have strong profit margins on modems and like to offer several different brands at different price points. While the functional differences between a $70 modem and a $90 modem are slight, many consumers are willing to pay extra for a recognizable brand-name. Motorola has been the leading brand-name in the modem business for a long time.

ARRIS / Motorola

            Motorola has long been the industry leader in the retail cable modem market. The first cable modem sold at retail was introduced by General Instrument in 1999. Motorola acquired GI in 2000 and launched the first DOCSIS 2.0 cable modem at retail in 2001. This modem established Motorola as the leader in market share. Motorola launched its first DOCSIS 3.0 modem at retail in 2009. Two years later, Motorola was split into two companies. One of the new companies, Motorola Mobility, held the modem and set-top box assets. Google acquired Motorola Mobility in 2012. The next year, Motorola’s Home Division was sold to ARRIS for about $2.35 billion. ARRIS, which will report nearly $5 bil. in revenues for 2015, generates approximately two-thirds of its sales from set-top boxes, gateways, modems, and routers. It sells a lot of equipment directly to MSOs. The Motorola acquisition increased ARRIS’ presence in the set-top box business and diversified its customer base. It also gave ARRIS the temporary right to use the Motorola name on modems sold at retail.

            ARRIS’ right to use the Motorola name on retail modems was not permanent. Licensing rights are still controlled by Motorola Mobility / Google. After completing the Motorola Home deal, ARRIS began to sell modems branded as “ARRIS / Motorola SURFboard”. The “SURFboard” name dates back to the original GI modems when the term “web surfing” was still a thing. ARRIS’ Motorola license ran for two years and was later extended for another year. ARRIS warned that it could lose the right to use the Motorola name in its 2014 10-K:

Our use of the “Motorola” brand name is limited.

In connection with our acquisition of Motorola Home, we were granted the right, as extended, subject to certain conditions, to continue to use the Motorola brand name on certain products for a period of two years after the acquisition. We sell those products in geographic regions and through distribution channels, especially retail, under the Motorola brand where the “ARRIS” brand is not as recognized.

Shelf space in retail outlets can also be impacted by how recognizable a brand is by customers. If we are unable to successfully rebrand those products, our sales in those regions and channels may decrease. Further, the loss of the use of the “Motorola” brand may result in a lower amount of shelf space, or space in less desirable areas, which may impact our sales.

            The retail cable modem business is relatively small. I have not found any decent industry estimates. Annual retail shipments sales for cable modems in the U.S. are only $150 million (wholesale). Most consumers (about 90%) rent their modems from cable providers. This is somewhat irrational behavior as the typical rental fees of $7 - $10 / mo. are a total rip-off as compared with the $70 or so cost of a new modem. It is believed that more people are starting to understand that it is cheaper to buy than rent and that the retail modem business is growing. The retail cable modem industry may be growing at 20+% / year. ARRIS does not break out its retail modem sales in its financials, but it has an estimated market share of 75%. The ARRIS / Motorola brand modems, therefore, may generate annual (wholesale) sales of something like $110 million. The rest of the market (NetGear, Zoom, Linksys, others) may generate annual revenues of around $40 million. Zoom’s current market share is roughly 7%.

Zoom Zooms In         

            Zoom won the right to use the Motorola brand name in 2015. On May 18, 2015, Zoom announced, “…an exclusive license agreement with Motorola Mobility LLC for the Motorola brand in connection with consumer cable modem products, including cable modem bridges, cable modem/routers, and cable set-top boxes containing cable modems for the USA and Canada. The agreement begins on January 1, 2016, and runs through December 31, 2020.” Manning had been working on this agreement for a long time. ARRIS did not publicly discuss the loss of the Motorola brand in any great detail. It issued a statement that implies that SURFboard, not Motorola, is the key brand in the modem market. Here is the statement:

21 May 2015ARRIS & MOTOROLA

Today, ARRIS is announcing that as of year’s end, we will no longer be using the Motorola brand on our retail products.

Since our acquisition of Motorola Home two years ago, we’ve anticipated this transition by accelerating our investment in making ARRIS the trusted name and global leader it is today. Now, we’re ready to usher in the next wave of industry innovation under the ARRIS brand.

When we acquired Motorola Home, we inherited a 60-year legacy of award-winning innovation—including the legendary SURFboard® line of products.

The SURFboard is the most widely recognized and most popular retail cable modem —with more than 135 million sold, covering 90% of the market. It’s the retail standard. And it has an impressive history of firsts—including the first wireless broadband gateway, which brought wireless Internet into millions of homes around the world.

That legacy continues today at ARRIS.

As we’ve grown our global brand, we’ve also accelerated our investment in the SURFboard line of products. The result is a new legacy of firsts, including the world’s first 802.11ac cable modem gateway and the world’s first 16×4 channel cable modem, delivering the fastest wired and wireless cable Internet speeds available today.

The world has taken notice. Our commitment to building the fastest, best-performing, and most reliable devices in the world has cemented ARRIS’s relationship with its leading service providers. The ARRIS brand is now in tens of millions of consumer homes, thanks to a variety of innovative new products, numerous awards, word of mouth, and our sponsorship with NASCAR.

When you choose ARRIS and our SURFboard line of products, you’re getting the result of a legacy of innovation and a continued investment in inventing the future.

            I understand that ARRIS lost the Motorola license for several reasons. A major one was that the people at Motorola Mobility did not like the co-branding. The packaging and marketing of SURFboard products downplays the Motorola name. Zoom will not put its name on the packaging of its Motorola modems. Another significant issue was that ARRIS is not a retail-focused company. It has a conflict of interest when it comes to retail modem sales as it is highly dependent on sales to MSOs. These firms prefer that consumers throw their money away on the monthly rental fees. Also, ARRIS has little incentive to promote new technologies that encourage cord cutting. It does not really want to grow the retail modem business. Further, I understand that it has poor relationships with major retailers as ARRIS does not have a strong retail presence. Zoom, on the other hand, has no conflict of interest and has longstanding relationships with consumer electronics retailers.

            Zoom had to convince the licensing people at Motorola Mobility / Google it that could successfully market Motorola modems. Motorola, obviously, would not have transferred the brand rights if it believed that its licensing fees would crash. Motorola’s licensing people put a lot of time and effort in awarding the licensing deal. They met with Zoom’s staff and toured its manufacturer in China. Manning claims that the Motorola people thought Zoom’s manufacturer was one of the best that they had seen. Manning convinced the licensing people that Zoom was ready and able to market Motorola modems. It is likely that the Motorola licensing fee is in the range of 5 – 10% of sales. Zoom is developing completely new products and packaging for the Motorola product line.

The Road Ahead

            Zoom’s business will change dramatically in 2016. It has now been about seven months since Zoom was awarded the Motorola license. Its management has been in discussions with retailers and absolutely believes that they intend to stock the new Motorola modems. Zoom will also continue to market modems under its own name. Manning told me that he anticipated that some retailers would discontinue the Zoom-branded modems, but they have not done so. Retailers want to stock both the best-selling Motorola modems and the lower-cost Zoom modems. Zoom’s modems are manufactured in China and shipped to Tijuana, Mexico, for testing and processing. While Zoom has used the Tijuana facility for years, it has only worked with its manufacturer in China for about eight months. Manning raves about his new Chinese manufacturer. He told me that product design and manufacturing for the new Motorola modems are on schedule and that Zoom will be ready to ship products in Q1 2016. Some of the Motorola products may not be available until Q2.

            The competitive landscape will change when Zoom introduces its Motorola modems. ARRIS cannot ship Motorola-branded modems after January 1^st. I understand that ARRIS stopped shipping them in October and has already begun to ship modems without the Motorola name. ARRIS is betting that the “SURFboard” name is important to consumers. I do not think, though, that consumers care about it very much. Most of them just want a good-looking modem that they know will work with their cable provider. My assumption is that ARRIS will hold approximately 50% of its current market, but will lose much of the rest to Zoom’s new Motorola modems.

New Investment & NOLs

            Zoom recently completed a private placement to fund its expansion. Historically, the company financed itself through small rights offerings of just a few hundred thousand dollars at a time. It has not done any real investment banking business in many years. Zoom needed a relatively significant amount of capital to fund the Motorola expansion. In September, the firm announced that it sold 4.9 mil. shares @ $0.70 / share for net proceeds of $3.42 million. The investor was Boston-based hedge fund Manchester Management. The co-managers of Manchester, Jeb Besser and Morgan Frank, are experienced microcap investors. Some of their stocks have been written up by others on VIC. Manchester is now an insider of Zoom as it owns more than 32% of the outstanding shares.

            Zoom has taken action to protect its tax loss carryforwards. Zoom’s long history of losses has left the firm with more than $50 mil. in NOLs. At 12/31/14, Zoom had federal NOLs of $49.65 mil. and Massachusetts state NOLs of $4.054 million. Nobody cared too much about these NOLs until recently as Zoom had little prospect of making money. Now, though, the outlook is completely different. Zoom recently instituted a shareholders’ rights plan (“poison pill”) to protect the NOLs. Existing shareholders receive preferred stock rights if a shareholder acquires more than 4.9% of the company. Zoom implemented this plan because the recent financing meant that a 5% investment could cause a change of control under IRS rules. Zoom’s poison pill is very similar to one (linked below) that was recently proposed by Windstream Holdings (WIN).

http://investor.windstream.com/investors/releasedetail.cfm?releaseid=932261

New CFO

            Zoom recently hired a CFO. Zoom, like most companies of its size, has a small management team. In September, 2015, it announced the addition of two new board members. One of these, Philip Frank, was appointed CFO a couple of weeks later. Zoom had been without a full-time CFO prior to Philip Frank’s hiring as Manning had been acting in that capacity. Philip Frank has extensive corporate development experience at such firms as Nokia and AT&T Wireless. He has a lot of contacts in the consumer electronics world that could lead to new products or contracts for Zoom. Manning told me that he is very excited about the new opportunities that Frank could bring to the company. Zoom does have some plans to introduce products in new markets.

Other Stuff

            Zoom is developing some products outside of its modem business. While Zoom offers products in several areas, cable modem sales have represented 95+% its revenues and will continue to do so. One new business for the company is a “connected home” service known as ZoomGuard. ZoomGuard allows people to remotely access information from sensors that monitor temperature, motion, lights, etc. Manning believes that this business has potential and intends to continue to invest in it. Zoom has also introduced several VoIP and cell phone products over the years. The company has had a mobile broadband business since 2009. This business has always been small as the company’s products have not been certified by the mobile providers. I understand that Zoom is currently working on certifications with AT&T and Verizon. I do not assume any sales outside of Zoom’s core modem business. If the company does generate any material revenue from new products, it would be a bonus. Zoom’s R&D expenses are very small and should not be a significant drag on earnings.

Financials

            Zoom has 13.2 mil. shares outstanding and a current market cap of approximately $28 million. The company has been operating at roughly breakeven. It has been reporting a gross margin of approximately 30% on annual sales of about $12 million. The company has done a good job of controlling expenses.

            Zoom has provided limited guidance for 2016. The company has forecasted revenues in the (very large) range of $50 - $100 mil. and operating margins of 8 – 10%. I believe that this operating margin range is conservative. It is notable that a recent company investor presentation forecasted an after-tax profit margin of “8% or more” and potential annual net income of “$4-8M or more”. It is very difficult to forecast sales as the Motorola modems have not yet begun to ship. Zoom will begin to ship Motorola brand modems in Q1 ’16. The company will continue to ship modems under its own name. Zoom’s existing retailers have told the company that they intend to stock both Zoom- and Motorola-branded modems. I will use the low-end revenue estimate of $50 mil. ($40 mil. from Motorola brand modems and $10 mil. from Zoom brand modems) for 2016. I assume a growth rate for 2017 of 20%. These estimate generously assume that ARRIS retains more than 50% of its current retail modem business.

            I believe that Zoom’s forecast for its operating margin is very low. This is a company with low overhead and no plans to significantly increase expenses. Much of Zoom’s business is outsourced as manufacturing and processing are done by contractors in China and Mexico, respectively. Its SG&A will increase, but not by that much. It plans to move into new offices and will likely need to add a couple of finance people. Zoom has fewer than thirty employees at present. R&D is increasing as the company develops new products, but it is still quite low. Zoom reported a gross margin of 32.3% in the first nine months of 2015. Next year’s gross margin will take a hit as the Motorola license fees will be included. These (undisclosed) fees are probably in the range of 5 – 10% of sales. The mitigating factor is that the Motorola modems will sell for about 25% more than the Zoom modems. I assume a gross margin of 27.5%, but I think that it could be higher. Based on Zoom’s expenses and industry norms, I think that that an operating margin of 15%+ is possible. Taxes should be close to zero for a long time.

My forecast:

            Zoom’s balance sheet is in good shape. The company raised $3.65 mil. in cash in Q3 ’15 from the private placement and a small rights offering. It used part of the proceeds to pay down all of its bank debt of $841K. Zoom exited Q3 ’15 with no bank debt and $2.52 mil. in cash. It also has a $1.25 mil. line of credit with asset-backed lender Rosenthal & Rosenthal. Zoom has been burning a few hundred thousand dollars per year. While it is currently building inventory for its expected increase in sales, I do not think that it will face any cash crunch. Its latest 10-Q states that its current cash balance is adequate “for at least the next twelve months.” Zoom’s management likely could have raised more than it did in the recent private placement, but it felt that $3+ mil. was sufficient. It is possible that Zoom could need more capital in a few months if sales ramp very quickly. I believe, however, that the company will be throwing off cash in 2016 and that the company will not need financing.

Valuation

            My 12-month price target for ZMTP is $7.50. As seen above, my 2016 estimates are EPS of $0.60 on $50 mil. in sales. My target, therefore, implies forward multiples of 12.5x P / E and 2x P / S. If my 2016 sales estimate is correct, then ZMTP is only trading at 0.5x forward sales. These are low multiples given my growth expectations. Recall also that $50 mil. is at the low end of Zoom’s revenue guidance. If Zoom generates $100 mil. in revenues, then it should report 2016 EPS of greater than $1.00. It is true that my operating margin estimates are higher than the guided range. The low-end of Zoom’s guidance, though, still implies 2016 EPS of $0.30.

Investor Relations / Stock Price

            There is limited information available on Zoom. As a tiny OTCQB stock, it has no sell-side analysts or estimates. There are no articles about it on investment websites like SeekingAlpha. Manning recently gave a presentation at an LD Micro conference in Los Angeles. There was no webcast of the presentation, but the slides are available from the company. The company does hold earnings conference calls, some of which are archived on its website. Manning is very willing to speak to prospective investors.

            Zoom’s stock price has had a huge run over the past seven months. ZMTP was trading below $0.25 before the Motorola deal was announced in May, 2015. The announcement sent the stock soaring up to $1.00 on June 5. It drifted downward for a few months until the new financing was completed in September. ZMTP moved up quickly after that. Investors (apparently) had been concerned that the financing would be more dilutive that it was. ZMTP has been trading around $2 since October. I believe that the stock could go a lot higher.      

Some Risks

            The main risk, obviously, is that Zoom fails to generate strong sales from its Motorola modems. Zoom’s licensing contract with Motorola includes standard provisions on sales levels, licensing fees, etc. I believe that Motorola wants Zoom to succeed and has no expectation of canceling the contract. Zoom won the contract because it has a long history of distributing modems at retail. I am confident that the Motorola modems will get sufficient shelf space at the major retailers. Zoom must, of course, be able to deliver the modems. It has had to design and produce them in a short period of time. Manning told me (in December, 2015) that everything is on track for the Q1 ’16 launch.

            There is a risk that ARRIS could hold most of its market share. I estimate that ARRIS will lose about 50% of its retail market share to Zoom. While I believe that Zoom will get shelf space, it is very difficult to forecast demand. This investment thesis is partially based on the idea that consumers want modems with the Motorola name on them. The Motorola brand has probably lost some value since the company no longer really exists. The good news is that Zoom only needs to grab part of ARRIS’ market share to show big growth.

            The retail market could be damaged by the actions of the cable operators. Cable companies want to retain the exorbitant monthly rental fees. Some of them have made it difficult or impossible for consumers to buy compatible modems. The Communications Act says that cable companies should separate modem rental and internet service. Cable companies, though, have tried to discourage modem buying in various ways. In 2010, Zoom complained to the FCC about Comcast’s modem testing policies. Comcast was, according to Zoom, intentionally making testing difficult to keep modems off the market. Zoom now supports Comcast’s modem policies. The current target of Zoom’s scorn is Charter. Charter is the only major operator that does not include a line item for modem rental fees on customers’ bills. This means that Charter customer cannot save money by purchasing modems. Charter, as you probably know, is in the process of merging with Time Warner Cable. If Charter brings its consumer-unfriendly policy to TWC, retail modem sales would likely suffer. Zoom filed a complaint with the FCC about the Charter / TWC deal in October.

Investment Highlights

·         Zoom won the Motorola licensing rights away from a much larger competitor

·         Zoom is a $28 mil. market cap company that could report 2016 revenues of $50+ mil.

·         High margin business with low overhead means good net income

·         Zoom has approximately $50 mil. in NOLs

·         Instituted poison pill to protect NOLs

·         Zoom has a simple capital structure with no debt and adequate liquidity

·         Zoom has strong relationships with major consumer electronics retailers

·         The retail modem market appears to be growing strongly

·         This stock is virtually unknown on Wall St.

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

Catalyst

new license should produce large increase in sales and earnings in 2016