Communications Systems Unloved Restructuring Story Portends To 70% Upside

Communications Systems: Unloved Restructuring Story Portends To 70% Upside|Must Read May 31, 2016 7:30 AM ET

by: Lester Goh

Summary• Due to declines in fundamentals, investors appear to have given up on

Communications Systems, evident by the Company trading at a discount to book.

• However, management is not resting on their laurels. R&D has been increased and Communications Systems is refreshing its product portfolio to reinvigorate growth. A rationalization of operations is also underway.

• Fair value of ~$11, implying ~70% upside.• Estimated liquidation value of ~$71m exceeds the Company's current

Communications Systems: Unloved Restructuring Story Portends To 70% Upside - Co… Page 1 of 15

http://seekingalpha.com/article/3978320-communications-systems-unloved-restructuring-st… 1/8/2016

market cap, suggesting substantial protection on the downside.

To say that Communications Systems (JCS) ("JCS", "CommSystems", or "the Company") has underperformed would be an understatement.Since 2011, the top-line has declined by ~25%, or ~$36m, gross margins have thus contracted roughly 1200bps from ~41% to ~29%, operating margins have similarly retreated, and the Company is currently more or less breaking even on a free cash flow basis when one adjusts for the lumpiness by averaging results over multi-year periods.The bear case is predicated on such a pattern continuing.Unsurprisingly, investors have apparently given up on JCS, evident by shares trading at a discount to book. However, it seems like shares are too cheap at the moment and appear to be pricing in a draconian scenario, something that I disagree with, upon deeper analysis. The JCS story is not a slam-dunk, but its not exactly shabby either.Management has clearly gotten the message the market is sending, and they are not resting on their laurels. By inferring from the actions that management have taken (and are taking), it is quite clear that the Company initially thought that its top-line would recover without much effort on their part. In light of business developments in recent years, this particular line of thought is likely non-existent at the current time.



As an example, operating expenses remained rather elevated since 2011 even in the face of declining sales (i.e. current expense levels are likely able to support revenue levels in excess of $145m), which was due to overly mature product offerings.Back-To-Basics: Refreshing The Product Portfolio + Rationalize OperationsBroadly, executives appear to be tackling the aforementioned issues by being laser-focused on R&D in order to introduce new products which would hopefully reinvigorate growth. R&D spending has tripled from ~$2.8m in 2013 to ~$8.3m in 2015 and has begun to bear fruit.While these numbers may appear minuscule in absolute terms - this is certainly so when you consider that the 800lb gorilla in the space is Cisco, I gather that JCS can thrive by focusing on niches whose total market size is too small for giants such as Cisco to bother entering. So JCS can do well by focusing their limited resources largely on a small subset of customers or on markets with broad applications with mostly homogeneous customer demands.For the former, this is evident when you consider that the Company's Suttle segment primarily caters to large telecoms such as Verizon, AT&T, and CenturyLink. As for the latter, this is apparent in the Transition Networks segment.It is clear that significant progress has been made on this front - see here, here, here, and here - in recent years. More examples of new product development, qualifications, and certifications can be seen in their recent investor presentations (specifically, this 2015 presentation - slides 7, 8, among others).Importantly, management is targeting 29% new product revenue relative to total revenue in 2016 (presently 14%), growing to 36% in 2018. By all indications, this seems highly plausible (more on specific segments later).In the Company's segments that involve manufacturing (i.e. Suttle & Transition Networks), JCS either outsources ~33% to contract manufacturers (Suttle), or fully outsources (Transition Networks). Thus, gross margin leverage derived through manufacturing would be present, but not prolific. New products which naturally carry higher margins would further augment gross margin expansion.



JCS does not appear to hold any quarterly conference calls, and the Company has also only recently started discussing the sales contribution of its new products and the fact that it is likely to grow at rapid rates going forward. Notably, it does not break out new product contribution in its regulatory filings.As a result, it seems likely that the market has not fully understood the implications of the refreshment of the product portfolio would have on the firm's growth and margins - recent share price action certainly supports this assertion.Rather, it seems as if investors have sold almost solely on headline results (i.e. top-line decline, gross margin contraction, etc), not bothering to dig deeper. Seeking Alpha also has next to no coverage on the Company, with only 3 articles being penned to date, further suggesting that my thesis isn't well-known. Street coverage is similarly sparse, something that should not be surprising seeing as JCS does not hold quarterly conference calls - they simply issue quarterly press releases detailing results.Apart from new product development, management has also recently embarked on initiatives to change the business structure (which notably included the hiring of Roger Lacey, former SVP for strategy & development at 3M) as well as rationalize operating expenses. In my view, bears are likely skeptical with respect to the extent of the potential restructuring benefits, whereas I hold the opposite view.As an example of expense rationalization, the Transition Networks segment has seen its SG&A decline by ~$3m, with costs being taken out from areas such as supply chain, sales & support, admin, among others, as seen below. Management also issued a press release to give investors an update on their progress.



Source: 2016 Shareholder PresentationAs the above slide alludes to, there is still much to be done to rationalize the Company's operating expenses. The question is, how much?Management sees 1100 bps of margin improvement through OneCSI (their restructuring initiative), and historical numbers suggest this is a reasonable expectation, particularly as the Company's segment mix have not changed much over the years, apart from a small ~$1.4m bolt-on in 2015 and other mostly immaterial changes (they sold the Austin Taylor facility after ceasing operations; Austin Taylor generated minimal revenue relative to the Company's total).



2015 revenue numbers are approximately $108m. JCS achieved a similar amount in sales in 2006 and 2009. In those years, SG&A amounted to ~26%-29% of sales, down from the current number of ~38%. At the 27.5% mid-point, this implies post-restructuring operating expenses of ~$30m, down from the current figure of ~$41m.The Company also purchased and began to implement a new ERP system during 2011-2012 to standardize all business units on a common platform. ERP for Transition Networks went live in 2013 and Suttle, 2014. This should allow for operating efficiencies across JCS.On the gross margin side, there is room for expansion as well. Here are some numbers:

Source: Company filingsIn the bolded years (2006, 2009, and 2012) gross margins ranged between ~33% and ~40% respectively on ~$105m-~$115m of revenue, as compared to the current gross margin of ~29%. I believe that the above margin range is reasonably attainable as it was achieved on revenue levels similar to the current run-rate of ~$113m.Segment mix remains fairly similar with the present period (Suttle & Transition Networks still account for the majority of total sales), so there is little reason to not expect post-restructuring gross margins to be in the same ballpark.Segment-By-Segment AnalysisAs I alluded to earlier, the Company has four segments: Suttle, Transition Networks, JDL Tech, as well as Net2Edge - the latter being created only recently.

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Revenue 115m 121m 123m 110m 120m 144m 104m 131m 119m 108m

Gross Margin %

33.4 35.4 38.1 38.1 42.6 41 39.8 34.2 35.4 29.3



SuttleLets say you're a cable company. You use many electronics and miles of cabling to make the end-user connection possible. Your worst fear is that if one of these components fail - failure results in expensive truck rolls, deterioration in brand perception, and other unsavory outcomes.Suttle, among other things, makes the structured wiring which improves the reliability of these components, reducing the total cost of ownership (less maintenance required), and improving asset (the cabling) life. JCS mentions that their products can reduce TCO, CapEx, OpEx, and truck rolls by >50% - so clearly, there is a significant value-add.Thanks to the increased investment in R&D, Suttle is emphasizing the development of solutions, instead of individual products - it even renamed its website to suttlesolutions.com. Suffice to say, this bodes well for sales growth and gross margins.Business over the years has been mostly rosy, with sales growing in excess of 20% in the years 2013 and 2014 due to new products, increased telecom deployments, and growth in high-speed connectivity.2015 saw a bump in the road where the segment experienced disrupted orders as customers curtailed spending, which also resulted in pricing pressure.Going forward, however, sales should recover - clearly, 2015 was a industry-wide issue, not a Suttle-specific issue - if you look at the capital spending plans of major telecoms (AT&T, etc), they are all projected to massively increase.This increases in capital spending is driven by growth, not maintenance - growth tends to be more robust, thanks to the exploding demand for data, voice, and video, as a result of increased smart device penetration. 1Q '16 already reflects this, with Suttle's sales rising ~11% and backlog jumping ~47%.Transition Networks



This segment solves connectivity issues. One of the problems customers face with regards to network constraints is distance restrictions. A common scenario is as follows: customers usually use multi-mode fiber within buildings, and single-mode fiber between buildings.This makes sense because multi-mode fiber have distance potential of ~550 metres while single-mode fiber can reach 10,000 meters. Naturally, single-mode fiber costs way more.But using both would leave gaps in coverage across an area. Transition Networks makes the stuff that allows you to integrate single-mode and multi-mode fiber, eliminating coverage gaps. Sure, you could just add more fiber, but it is much cheaper to integrate.The ramp-up in R&D is also benefiting this segment - JCS is targeting >25% new product revenue as a percentage of total revenue by 2017, up from ~12% at the current time.Business activity in this segment may appear uninspiring as sales is more or less flat in 2014 and 2015, but that is mainly due to government spending; the government is a large customer here.2013 saw a ~20% y/y decline in sales, but that was clearly due to the sequestration which called for broad cuts across many different programs.With budgets forecast to remain stable, while it is hard to see Transition Networks growing unless government spending rises substantially, it is also hard to see it losing large chunks of revenue, barring a repeat of the sequestration.JDL TechAs for JDL, this segment is a managed service provider. A typical managed services agreement goes something like this: JDL helps the customer maintain corporate IT, resolves issues, and supports the customer's user community. Essentially, customers outsource their IT to JDL.In this segment, business is extremely lumpy, and this is reflected in its revenue dynamics.



Sales jumped 6x from ~$5.4m in 2012 to ~$33m in 2013, due to the winning of a large Miami Dade County contract. In 2014, sales fell ~75%, as said contract was completed. And in 2015, revenue jumped ~83%, due to the winning of the Broward County contract.Clearly, the model hinges upon winning large, multi-year contracts. However, there is reason to believe that segment sales will grow nicely, at least over the next few years.As discussed, the Broward County contract was won in 2015, which added ~$7m in incremental revenue. Management issued a press release which mentions that the total contract value is ~$83m, to be realized over the next half-decade. So there is ~$76m left to go, which should allow sales for this segment to rise going forward.Net2EdgeNet2Edge was created after Transition Networks acquired Patapsco in 2014 to combine the acquiree's technology with their Ethernet capability.One of the pressures faced by carriers is whether to migrate from legacy networks. In technical terms: how can you move on from TDM or ISDN without your customers (who rely on these traditional services) moving on too?Retiring TDM/ISDN networks is not an easy decision to make.If you retire these traditional services, you lose a meaningful recurring revenue stream and the loyalty of enterprise customers whose mission-critical functions often rely on these traditional services.If you don't retire them, you'll be confronted by limitations and high maintenance costs - one of which is the lack of skilled personnel; as the workforce ages, those with the technical expertise to work with TDM/ISDN eventually retire, while the new recruits lack such expertise - as it is considered outdated, no one's being trained on TDM/ISDN anymore.Net2Edge makes the stuff that allows carriers to virtualize their traditional services over the Ethernet using circuit emulation, enabling carriers to transition to Ethernet without impacting enterprise customers.



1Q '16 is the first time this segment's results have been broken out separately, and highlights management's intentions to bring attention to Net2Edge - sales grew ~70% to ~$600k. Forecasting future sales is difficult as the Company does not offer much detail on the segment. Inferring from the value proposition discussed above, it is quite possible that there would be a reasonably large addressable market here, but we'll remain conservative.Valuation Discussion: Fair Value Of ~$11, ~70% UpsideOnce operations have been rationalized and new products start dominating JCS's portfolio, the Company should be set to be consistently free cash flow positive to the tune of ~$4m-$14m (or more), as it had been during the 2006-2009 period, where it had a similar top-line, gross margins, and operating expenses. Averaging the 4-year period of this FCF range to iron out the inherent lumpiness in business activity suggests normalized FCF of ~$8m. Thus, JCS is valued at an attractive ~7x normalized FCF.These are extremely compelling numbers that do not account for the possibility of a major upturn in the Company's end-markets (ala 2011); these numbers only factor in a refreshment of JCS's product portfolio and a rationalization of operations, which quite closely resembles the 2006-2009 period, in my view. The fact that JCS should be able to consistently generate FCF, which would lead to an improved balance sheet, even in a period where revenues are obviously highly depressed does offer investors some confidence that things shouldn't be that bad in a downside scenario.With a little bit of revenue growth stemming from Suttle, Transition Networks being flat, JDL Tech ramping up the Broward County contract, and assuming no contribution from Net2Edge due to the inherent difficulty of forecasting a segment in its infancy, total sales could reasonably grow to levels in excess of $125m.At such levels, it does not seem overly optimistic to expect the Company to be able to generate $4m-$14m in FCF for a normalized figure of ~$8m in a post-restructuring scenario. A 12x multiple on this ~$8m in FCF seems fair, assumes a low-growth scenario using a 10% discount rate, and would imply a ~$11 stock or ~70% upside from current levels on ~8.8m shares outstanding. Such a target price does not appear heroic given that shares of JCS traded at $9-$12 over the 2006-2009 period, implying that the market assigned FCF multiples to the stock that are in-line with my expectations over said period.



Estimated Liquidation Value Exceeds Current Market Cap, Implying Significant Downside ProtectionJCS owns a 105,000 square foot building in Minnetonka, Minnesota, and three plants totaling 109,000 square feet in Hector, Minnesota, where they do all their manufacturing.The only data point sourced from the Bloomberg terminal which seemed useful was U.S. office price psf, of which the rolling 3-month figure in 1Q '16 was ~$263. This seems far too high to me. Undoubtedly, this figure is heavily influenced by premium real estate in places such as New York and Manhattan.Rummaging through CRE data providers did actually offer useful information to help us reasonably estimate the fair value of the above-mentioned properties.In Colliers' 1Q '16 office market report on Minneapolis, it cites a transaction that is likely to fall in a similar price range as JCS's real estate. Southdale Office Center, formerly majority owned by GE Capital, was sold to Wildamere Properties at $55m. The office complex was a 446,818 sqft property, implying price paid psf of ~$123. CBRE estimates average office cost psf at ~$100 total in Minneapolis, which seems to be a decent gauge of replacement cost.Averaging the two figures from Colliers and CBRE gives us ~$112 psf. Applying this averaged figure on the Company's properties totaling 214,000 sqft implies they are worth ~$24m. With a current market cap of ~$55m for JCS, these properties are certainly material. JCS's offers a breakdown of PP&E in its 10-K, with buildings & improvements amounting to ~$9.4m before accumulated depreciation, suggesting ~$14.5m upside to fair value.The market is likely broadly unaware of the fair value of the above real estate given that, from what I can gather, management has never discussed the Company's real estate in their investor presentations.As of 1Q '16, JCS has ~$15.4m in cash & short-term investments and ~$32m in working capital. Long-term liabilities are minimal at ~$180k. Summing up cash & short-term investments, working capital, the fair value of real estate, and deducting long-term liabilities suggests a liquidation value of ~$71m, compared to the current ~$55m market cap, suggesting substantial protection on the



downside. Even if we assign a 50% discount to inventories and receivables, which would shave ~$21.7m off my liquidation value estimate, we would still get a number near the current market cap.Moreover, even in a draconian scenario, I'm pretty sure a 50% discount is far too pessimistic considering that inventory turnover averages ~2.7x - which is not suggestive of significant obsolescence risk, and that the Company's customer base is either slightly concentrated in extremely creditworthy customers (Suttle) or highly diversified (Transition Networks), implying that one would be hard-pressed to see a significant portion of receivables being uncollectible.Catalysts & RisksA significant rebound could very plausibly bring revenues back to the ~$130m-$145m range, which the Company achieved in 2011 and 2013.Note that customers, especially in the Suttle segment which caters primarily to the telecom industry (Suttle saw peak revenues of ~$67m in 2014, ~35% higher than current levels), can create demand extremely quickly, as experienced by Dycom (who caters to a different part of the value chain) whose backlog has exploded in recent quarters, as I wrote about before, suggesting that JCS revenues can spike over a short period of time. Better results should also attract sell-side coverage.What could go wrong?Demand could fall of course, but with a restructured operation, I estimate the Company's breakeven's point to be ~$88m in revenues - 34% gross margins (representing slight gross margin deleveraging on lower revenues), ~$30m in operating expenses, minimal interest expense - implying the top-line would have to fall ~22% on trailing 12-month figures of ~$113m, which suggests a significant margin of safety.Stated another way, we would require a huge and prolonged downturn in telecom capital spending and another large-scale government sequestration to really hurt JCS - neither of which seems highly likely.



Telecoms are currently upgrading their networks to satisfy exploding demand in data, voice, and video, and this does not seem to be stopping anytime soon. Sure, telecom capital spending could experience a hiccup, like it did over the 2014-2015 period, but the overall trend over the next few years should be solidly positive due to secular trends in penetration of smart devices.The probability of another large-scale government sequestration is certainly not zero, but again, it seems highly unlikely; in my experience, betting on a specific political outcome is a great way to torch money.While there is the non-zero risk of a sharp drop-off in demand, current segment trends suggest that this is unlikely - in 1Q '16, all segments grew, manufacturing backlogs expanded ~30% (with Suttle's jumping ~47%, as discussed) - which are suggestive of a stable demand environment.But let's assume the draconian scenario - i.e. the Company's franchises are severely impaired. Even in such a scenario, downside shouldn't be much with liquidation value estimated to be in excess of the current market cap. We can quibble over assigning 10%-50% discounts to inventories and receivables in a hypothetical orderly liquidation scenario, but even then, the value you get is still near the current stock price.Overall, it is my belief that the JCS story is inherently low-risk as it is not hugely dependent on end-market cooperation driving monstrous growth, but instead reliant on restructuring operations to mirror 2006-2009 - not a stretch, since this was already achieved years ago.As discussed, even if things go wrong, downside isn't much. What about risks to the upside?Suttle could grow more quickly than expected as it expands its offerings and as telecoms ramp up their capital spending further, Transition Networks could bag a large customer account, JDL Tech could sign up another huge contract, and Net2Edge could explode. Playing around with assumptions suggest that revenues in excess of ~$150m is quite achievable in such a scenario. An upside scenario would certainly boost FCF potential in excess of the ~$8m average.



To summarize, with downside being solidly protected by liquidation value even assuming draconian discounts to receivables and inventories, and ~70% upside not out of reach, the risk/reward in going long JCS appears highly asymmetric. Daily liquidity of $60k-100k is reasonable for small funds and individual investors.Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.Additional disclosure: Disclaimer: The author's reports contain factual statements and opinions. He derives factual statements from sources which he believes are accurate, but neither they nor the author represent that the facts presented are accurate or complete. Opinions are those of the the author and are subject to change without notice. His reports are for informational purposes only and do not offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester") accepts no liability whatsoever for any direct or consequential loss or damage arising from any use of his reports or their content. Lester advises readers to conduct their own due diligence before investing in any companies covered by him. He does not know of each individual's investment objectives, risk appetite, and time horizon. His reports do not constitute as investment advice and are meant for general public consumption. Past performance is not indicative of future performance.Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.





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Communications Systems Unloved Restructuring Story Portends To 70% Upside