There has been much discussion on how Coca-Cola became so dominant. Could it be that it was all from a mistake?
In Part 1 of this series, I wrote about why investors should pay close attention to microcaps that choose to get smaller via dispositions. I then wrote Part 2: Broadway and Seymour, and Part 3: Clearfield Inc which showcased examples of value that was generated via dispositions. In this writeup,
In Part 1 of this series, I wrote about why investors should pay close attention to microcaps that choose to get smaller via dispositions. I then wrote Part 2: Broadway and Seymour, and Part 3: Clearfield Inc which showcased examples of value that was generated via dispositions. In this writeup, we will look at yet another example, Asure Software (ASUR).
Asure Software is another classic example of a divesture. A money-losing division was shut down uncovering a healthy growth stock at an attractive price. Academic research verifies that this is the normal pattern. Prior to a divesture the business financials have underperformed and following the divesture they improve. Not all divesture investment opportunities follow this pattern but most do.
This means that many companies making divestures have lost money in the past. These historical losses are a frequently underestimated asset. Asure Software’s case study will illustrate the value of tax net operating loss carry forwards (NOL’s). In fact, Asure’s entire business strategy after they dumped their money losing operations became centered around utilization of their NOL’s. We’ll also see that in Asure’s case the NOL’s drove behavior that added value to the business but simultaneously kept the share price depressed. Other turnaround companies have similar dynamics in play. Even if you don’t invest in divestures, you may want to understand how tax NOL’s add to the value of businesses, affect strategy, and in some cases depress the stock price.
Asure was incorporated in 1985 under the original name of Forgent Networks. It was a successful multi-media conferencing equipment maker partnered with Intel under the brand name V-Tel. The short story here is that competitive internet-based conferencing technology emerged in the late 1990’s and wiped out their traditional conferencing equipment business. Forgent Networks sold it in 2001 while retaining many early and important patents. Patent licensing revenue totaling more than $100 million sustained the company through the 2000’s decade although legal and other expenses more than offset the revenue. This licensing revenue ended following some litigation losses resulting in a final $36 million settlement in 2007. So there’s been two divestures here. First the teleconferencing equipment business was sold in 2001, and then in 2007 the money losing patent licensing operation was shut down.
So what was left? Asure’s management saw the end of the patent licensing business coming and in 2003 acquired software company NetSimplicity. A second software company, iSarla, was acquired in 2007. Between the two of them there was about $10 million in revenue. There was some cash laying around too, but the company was burning through that at a rapid clip. The well-paid management owned few shares and specialized in losing money. Historical financials adjusted for a 1 for 10 reverse split in 2009 and a 3 for 2 forward split in 2012 are shown below.
You can see that this company also is a long-time loser. Prior to the 1 for 10 reverse split in 2009 the stock was trading as low as 18 cents. Notice the massive per share losses the company endured through the 2000’s decade. Also notice that the IP revenue ended in 2007 and the software revenue grew due to the addition of the iSarla acquisition. Unfortunately, big losses continued in 2008 and 2009 as management didn’t reduce expenses sufficiently to match the reduced revenue.
So the last divesture was the shutdown of the licensing business following the $36 million litigation settlement in 2007. Was this company making a disposition an attractive investment at that time? Not to me, no way. Take it from Warren Buffet, the best way to evaluate management is to look at their track record. In this case, the guys that created all those losses for all those years were still running the company following the patent licensing business shut down. However tempting some situation might be, I advise you to stay away if management has a poor track record. No track record at all or a track record that is hard to evaluate may be acceptable, but run from a bad track record. Asure’s management clearly had a bad track record.
The remaining Asure software business does turn out to be a big winner, however, but not with the management that made the mess. Red Oak Partners, a New-York area hedge fund founded in 2003 by David Sandberg came to the rescue. He bought up shares beginning in the Fall of 2008 and into 2009 and began lobbying for expense rationalization. A nasty Proxy battle ensued and with little management ownership and the track record above the result was predetermined. In August of 2009, shareholders voted for the Red Oak slate. The old CEO resigned prior to the vote and David Sandberg became Chairman of the board. He brought in a new CEO, Pat Goepel, and a new CFO, David Scoglio. Mr. Scoglio’s linked in profile noted that he was known for cost cutting which seemed to be just what Asure needed. Assessing the new management’s prior track record was difficult as the CEO had run divisions of large companies so financials weren’t available. At least Mr. Goepel didn’t have a clearly bad track record and what information I was able to find was favorable. David Sandberg, the Chairman of the Board, was easier to assess. He had racked up historical hedge fund returns exceeding 20% net of fees as an investment manager. I was pleased with that . The early efforts of the new management team to reduce expenses and improve revenues also seemed to be going well. Everything they said they were going to try, they did, and it worked. That, by the way, has continued to this day. By the time of my purchase in early December of 2010, the company was nicely profitable as long as you were willing to ignore some non-cash amortization of intangibles from the iSarla acquisition. I was willing and calculated a P/E of 9 on trailing twelve months earnings.
So what were these two little software companies that people fought proxy battles over? NetSimplicity made Meeting Room Manager. It was software to schedule meeting rooms for small and medium sized businesses and divisions of large businesses. iSarla made time keeping software under the iEmployee brand name for employee time keeping (time clock, vacation & sick leave scheduling etc.). The intriguing thing was that iEmployee was one of the earliest companies to implement the software as a service (SaaS) business model. Interestingly, Asure was busy converting Meeting Room Manager to a SaaS model also and company management stated their commitment to the SaaS model going forward. Larger companies had already embraced SaaS but most of the smaller ones that Asure served were just beginning. Asure had a big head start in offering the SaaS software to which businesses wanted to switch.
Then there were those historical tax losses. Asure had tax NOL’s exceeding $150 million with expirations as far out as 20 years. There were lots of small business software companies that were marginally profitable serving small and medium sized businesses. Since the small business world was beginning to switch to SaaS, these little companies had to invest in their businesses to make the conversion or go out of business. Or just sell out to Asure. Asure could likely add value anyway as they already had 3000 small business SaaS customers to which to market products of acquired companies . More important, Asure could buy these little software companies up and immediately increase their profits by 60%. Asure just wouldn’t pay any income taxes. So there was an industry that needed to be rolled up and publicly traded Asure with $150 million in NOL’s had a natural advantage. I was intrigued.
Then there was the valuation. Asure was trading at a market cap of $7 million dollars and they had $1 million in cash with no debt. Totally absurdly cheap. The price reflected their terrible history under unsuccessful management. But the businesses that lost the money were gone. The management that lost the money was gone. There was new management hired by a successful chairman of the board and both the new management and the chairman of the board had significant personal ownership stakes. The new business was SaaS and it was profitable and growing. Asure was a brand new company like an IPO except there were no brokers hyping it and lots of tax loss sellers dumping it. And unlike most IPO’s, Asure wouldn’t be paying significant taxes for years to come giving them a natural advantage in rolling up the emerging industry. In the 2nd quarter 2010 conference call, the company estimated the net present value of their NOL’s at between $10 million and $13 million. The whole company was trading for an enterprise value of $6 million. Here was a profitable and growing debt-free SaaS company with $10 million in revenue and $11.5 million worth of NOL’s trading for an enterprise value of $6 million. Explain that efficient market hypothesis thing to me again.
When I bought in early December of 2010, there were two things holding the stock price back. One was the usual year-end tax loss selling of a long-time loser nanocap. The other were those darn NOL’s. Some explanation is required to understand how NOL’s can hold a stock down. If a company changes ownership, all kinds of restrictions are applied to using those NOL’s to offset future income. This keeps IBM from buying up every money losing nanocap they find and utilizing their NOL’s to save themselves income taxes. So the first rule if you have substantial NOL’s is don’t get acquired; rather you need to be the acquirer. This was exactly Asure’s strategy.
But there’s a stealth way for ownership to change that can cause the IRS to restrict NOL use also. If you acquire more than 5% of a company, you’re required to file a 13G or 13D with the SEC disclosing the purchase. If enough people acquire 5% of a company, or 5% owners increase their holdings sufficiently, the IRS will know and can rule that an ownership change has occurred and restrict the NOL’s. We’ve seen how NOL’s can jack earnings up 60% so Asure had to prevent that. They instituted a poison pill that triggered if anyone acquired 5% of the shares outstanding or if any 5% holder increased their holdings by even 1 share. On the 2nd quarter 2010 conference call, James Gladney, who owned just under 5% complained about this. He wanted to add shares as he saw the undervaluation that I did but the poison pill forbade it. The people most familiar with the story, the 5% holders, who could clearly see the under-valuation could do nothing about it. These poison pills are not uncommon among stocks with significant NOL’s and it can temporarily hold down the valuation. I’m grateful for it as I got a real bargain a few months after Mr. Gladney’s complaint.
How did I come across Asure? Insider buying by David Sandberg, Dave Scoglio, and Pat Goepel. How did it all turn out? Well it’s still playing out but so far so good. In 2011, the company generated over $3 million in free cash which isn’t bad for a $6 million enterprise value investment. This was primarily from organic growth of their traditional software products. Their acquisitions plans have been going great guns as well, however. The company has made three acquisitions between September of 2011 and now. All three acquisitions were financed almost entirely with debt so dilution has been minimal. The three acquisitions have increased expected 2013 revenues to $31 million and free cash flow to $7 million. That’s roughly a tripling of revenue since 2010 and an increase in free cash flow to a level equal to the market cap in Dec. 2010. The company is buying up competitors, integrating their software onto their own servers, sharing marketing expenses among more products, consolidating office space, cross-selling software to customer lists, and pocketing the cash the acquired companies would have paid to the IRS. It’s a remarkable story. The market cap has increased to $34 million ($6.49 a share) as of this writing. If they really generate $7 million in free cash flow in 2013 as management forecasts, there’s room for the market cap to go higher still to perhaps $50 million. If they can continue to acquire, cut expenses, and pocket the taxes this could be a remarkable investment. So far everything management tries seems to work.
Purchasing Asure now at the current price involves some risk. The company has $18 million or so of debt and there’s integration risk on those acquisitions. When I purchased at an enterprise value of $6 million, however, it was pretty hard to imagine a way I’d wind up losing money. Clearfield was that way too. It was so darn cheap and debt-free that it was a pretty safe investment. The same thing could be said for Elite trading for only slightly above cash on hand. I know it seems crazy to say that investing in nanocaps is a relatively safe investment, but I believe all three of these cases were. Things can always go wrong at a tiny little company to bring it down, I suppose, that can’t happen at bigger companies like Wal-Mart or Intel. Even so, I believe carefully chosen mispriced nanocap special situations with motivated managements can reduce risk to lower levels considering the potential reward.
One last thing on finding divestures. I found Asure Software by screening the insider buying lists daily. This takes some time as you need to check the news on the company and read the latest earnings release looking for signs of a recent or upcoming sale. To me it’s worth it as I’m a stock nut and I’m simultaneously looking for other special situations too. Recently, however, I’ve also been looking for divestures using Google. I search for “definitive agreement to sell” in the Google search including the quotation marks so only the exact phrase is found. I have Google e-mail me links to any search results daily. I seem to get an e-mail with one or two links on most days and find that I can quickly click on those links and assess whether I’m interested. Most of the time I’m not interested, but I have come across a few already that at least were worth digging into further.
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There has been much discussion on how Coca-Cola became so dominant. Could it be that it was all from a mistake?
In 2000, Intuitive surgical raised $46 million in its IPO. In 2001, ISRG hit a low of $131 million market cap, and today is a $70 billion market cap. ISRG stock has risen 9,800% since its IPO.
An alternative lesson to draw from his study is that microcaps are fine but nanocaps are the ticket to wealth; you just have to be poor enough to buy them.