Upfront note: I am long both LGL and the LGL warrants. LGL is a thinly-traded microcap which is only appropriate for investors with long-term time horizons. Please use limit orders and do your own research on the stock.
Recent results at LGL (LGL) have been an absolute disaster. Revenues have declined to just $28.1m in the past twelve months, down 40% from 2010's high of $46.7m. The company's lost $2.40 per share in just the first nine months of this year, amounting to almost 50% of today's share price, and the company's backlog is at a multi-year low.
So the headlines are obviously terrible. But despite the terrible results, LGL represents one of my favorite risk/reward opportunities for 2014.
Let's start with a quick overview, but for those interested you can find a good deal more in the company's 2013 Annual Meeting slides. LGL is a holding company whose main asset is MtronPTI, a designer and manufacturer of standard and custom engineered electronic components used to control frequency and timing of signals in electronic circuits. The company's products are mainly used in Aerospace/Defense(65% of revenues) and internet communications technology (ICT, 35% of revenues) end markets.
The key to understanding LGL's business is that their products are smaller components in larger products. LGL works with original equipment manufacturers to custom design components for their products. Some of these products enjoy life cycles as short as nine months, some of them can enjoy life cycles over ten years. Thus, if LGL produces for a product that gets popular, then their subcomponents will enjoy a long revenue cycle and high margins.
However, that life cycle also creates cyclicality. If LGL misses out on a few sales opportunities, then it will create a multi-year sales hit. And because of LGL's high operating leverage, that cyclicality can create wide swings in results. For example, at their last sales peak in 2010, revenues were $46.7m, gross margins were over 35%, EBITDA margins were over 16%, and the stock was >$20 per share. In the last twelve months, revenue has been just over $28m, with gross margins only 28% and EBITDA margins below -5%, and the stock has fallen below $5 per share.
So what makes a cyclical business with high fixed costs and a declining backlog an attractive value investment?
It starts with the company's assets. After adjusting for a small loan the company has outstanding, the company has excess cash on its balance sheet of ~$3.20. In addition, they have ~$2.10 of net working capital (in this case, working capital excluding cash minus all liabilities) for a net current asset value of ~$5.30 per share. In other words, there is a lot of asset protection here with shares trading for just ~$5.00 per share.
And those current assets aren't the only assets the company has going for it. The company has net operating losses of $6.2m (almost $2.40 per share) that are no longer reflected on their balance sheet, in addition to $1.8m in various other tax assets (~$0.70 per share). Finally, the company has $4.4m in PP&E on their balance sheet ($1.70 per share), consisting mostly of two owned building in South Dakota and one in Florida. It wouldn't be a surprise if the PP&E was slightly undervalued on the balance sheet, as one of the South Dakota buildings has been on the books for as long as I can find 10-Ks (the early 1990s). Ignoring any potential undervaluation in PP&E, add everything up and the company's book value comes out to over $7.20 per share ($10.30 if you added back all of their off balance sheet tax assets).
Obviously, those numbers are interesting against a share price of ~$5.00. But there are plenty of companies trading for less than book value, so the question is why it makes sense to invest in LGL, a cyclical, money losing operation, versus other companies trading for under book value.
The big reason is that earlier in the year the company was approached by an investment group interested in acquiring pieces of their operating subsidy. In response, the company formed a special committee to consider strategic options. The company followed the announcement up on June 28th with a press release stating they continued to review the acquisition proposals and maintained a share repurchase program, and again with an announcement in July stating they continued to review options. Finally, in their 3rd quarter earnings release, the company announced the first fruits of the strategic review process: a new executive and (more importantly) a restructuring program that would lower the company's structural costs by 10% on a go forward basis.
The acquisition interest is obviously big news well worth diving into for potential investors, and there have been multiple clues that a potential acquisition could unlock significant value. First, management mentioned in several earnings call that the number of parties interested in the company was "more than one but less than ten". In addition, in the first quarter earnings call (before the acquisition interest was released), a questioner asked if company would be an attractive acquisition target given $30m in annual sales and a market cap below $20m. The CEO responded in the affirmative, stating he felt the current stock price undervalued the company. It's easy to see why the company would make such an attractive acquisition: with SG&A for the first nine month of the year running at almost 40% of sales, a strategic acquirer could come in, rip out costs to realize synergies (duplicative management positions, manufacturing facilities, etc.), and quickly realize a strong return.
It's true that most CEOs feel their company is constantly undervalued, so the CEO's feeling on the stock price should be taken with a grain of salt, but the fact that a potential acquirer turned up so soon after that Q&A lends credence to the CEO's statement that the company was undervalued and would represent an accretive acquisition.
It is, of course, tough to figure out what multiple a money losing microcap would garner. But we can pretty quickly figure out that the potential takeout price is well above today's price. First, it's tough to see any company with this clean of a balance sheet and potentially strategic assets getting fully shopped and vetted by multiple parties and winding up with a bid below liquidation value. It's even tougher to imagine a board willingly accepting that bid, especially a board that owns almost 20% of the company. Second, while the sale was several years ago, it's helpful to remember that LGL originally acquired the PTI side of their MtronPTI subsidy in 2004 for $8.8m, ~0.75x price to sales. The company also said they felt the acquisition qualified as a bargain purchase with a fair value of ~$13m, or a bit over 1.0x sales (see notes on p. 44 of the 2004 10-K). Again, the acquisition is obviously dated, but both of those numbers are very interesting given 1) PTI was ~50% of the size of the overall Mtron group at the time of the acquisition and 2) considering the company's trailing sales are $28m versus a market cap under $15m and an EV under $8m.
The company has indicated on conference calls that the strategic review process will most likely be completed by May. I would put the company's earnings release in late July or early August as the outside date for the company to conclude the review. Obviously, I believe there's a decent chance the sale process concludes with the company selling themselves at a strong premium to today's price, but it's important to note that a sale is by no means a foregone conclusion, nor is it the only path to value realization here.
First, the company has almost $8m in unrestricted cash. They've mentioned that they are looking into the possibility of both a JV and/or an acquisition of their own. Normally I'm hesitant to see a cash rich, money losing microcap interested in acquisitions, but in this case I think it could make sense. An acquisition would allow them to realize some operating leverage and, assuming the acquisition was immediately profitable, would help them to start utilizing their tax assets.
Even if M&A fails (both as an acquirer and acquiree), the company's recent restructuring could bear fruit. Management has indicated on conference calls that they believe 2014's results should show some improvement over 2013, though they have stopped short of giving guidance. Combined with the recent restructuring, any increase in sales should return the company to profitability, which would likely drive the stock higher.
So a sale isn't necessary for shares to make sense at today's prices. But I still think a sale is the most likely outcome here. Mario Gabelli owns 17.7% of the company, and his son is the chairman of the board and owns another 14.7% of the company. Obviously, Gabelli has a long history of pushing companies towards strategic deals that make sense for both the acquirer and shareholders. Yes, the company probably isn't a priority for the Gabelli given the small size, but I don't think the Gabelli's would let an opportunity to create this much value for shareholders slip through their fingers.
To conclude the article, I want to discuss one last interesting way to play a potential acquisition. In August, the company distributed warrants expiring in 2018 to each shareholder. These warrants are now publicly traded. Owning 25 warrants gives a person the right to buy one share of stock at $7.50 per share. I personally prefer the downside protection of owning the stock over owning the deep out of the money warrants at these prices; however, given the potential for a sale and the cyclicality of the company's results, the warrants represent a very cheap way to gain a good deal of leverage to the possibility of an extremely favorable resolution to the strategic review process. Investors should beware that the warrants are extremely risky and there's a very good chance they expire out of the money, but they are certainly worth a look for those interested in the stock.
Disclosure: I am long both LGL and LGL warrants. LGL is a thinly-traded microcap which is only appropriate for investors with long-term time horizons. Please use limit orders and do your own research on the stock.
Disclosure: I am long LGL. 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. (More...)
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