Three Cheers for Tucows?

In the past, we’ve profiled a handful of microcap companies (FNET, KSW, LIMC, RMCF), either with discernible competitive advantages, particularly rational management, or an imminent catalyst for unlocking shareholder value.

We continue in that vein today by profiling Tucows, Inc. (TCX), an ICANN-accredited internet domain registrar based in Toronto that manages email services and over nine million web domains. Through its subsidiary Butterscotch.com, it also owns one of the oldest and most popular software download sites on the Internet. At present, its principal shareholders include: Lacuna, LLC, which controls 17.7% of outstanding shares (as of 3/23/09), Diker GP LLC (13.7%), and Fertilemind Capital Fund I, LP (5.7%).

About two-thirds of Tucows’ revenue derives from its wholesale domain registration services, being the third largest ICANN-accredited registrar in the world and the largest publicly traded. And like other domain registry servicers (e.g., Network Solutions, GoDaddy), its business model is characterized by non-refundable, up-front payments, which generate predictable, positive operating cash flows. More specifically, Tucows receives payment for the annual registration fee prior to providing the full cost of the service, yet it is required to book those payments and costs incrementally. Looking at its balance sheet, one sees what—at first glance—may appear to be a highly-levered, capital-intensive business with nearly $97 million in assets and $75 million in liabilities. Yet, the bulk of these assets and liabilities pertain to prepaid fees and deferred revenues for their domain registry business. In truth then, Tucows is a cash-rich and largely unlevered business that fills its checking account faster than its earnings statement would indicate. In a way, its revenue resembles an insurance premium—non-refundable, and paid up-front—and enables Tucows to keep its cost of capital very low and perhaps even negative.

However, it is not only the balance sheet that masks Tucows’ virtues. In 2008, Tucows took initial steps to divest non-strategic assets and concentrate energies on its most profitable businesses. This process has complicated its cash flow statements and masked its significant free cash flow growth. For example, in 2006, depreciation and amortization charges of $3.9 million were less than capital expenditures ($4.6 million); in 2008, depreciation and amortization charges of $4.8 million far exceeded capex ($2.1 million). Because Tucows has significant amortization expenses—deriving from the intangible assets of previous acquisitions (i.e., customer relationships)—it has far more cash coming into the company today than its reported earnings reveal.

Lastly, Tucows has raised more cash in the last year by liquidating its $7.5 million equity stake in Afilias and a portion of its domain name portfolio. In their second quarter results (coming out in mid-August), Tucows will book a $2 million pre-tax gain on a portion of its Afilias stake; an additional $2 million pre-tax gain will also follow later this year.

Perhaps most interesting though is where all that cash is likely to go. In the last year, Tucows has used some cash to pay down its long term debt, repurchased 4.2 million shares (about 6% of those outstanding) in a “Dutch Auction” tender offer in March 2009, and repurchased an additional 1.1 million shares in a second “Dutch Auction” tender offer in July 2009. And to date, Tucows has ample room remaining in its $10 million stock repurchase program. Though the future capital allocation decisions are difficult to predict, the chains of habit are not easily tossed aside.

All told, Tucows strikes me as a relatively low margin business with low (and perhaps negative) capital costs that has deployed its retained earnings profitably for shareholders in recent years. Though GoDaddy is the dominant player in the sector, Tucows has added customers and concentrated its business lines. If Tucows continues to divest its non-strategic assets and contain its costs, I would not be surprised to see them earn more than $7 million this year ($4.5 million from operations and $2.5 from after-tax sale of investments). With a market cap of $29 million (as of 7/30/09), management and the Board should have an opportunity to buy back shares quite cheaply.

That is, unless enterprising investors find it first.

Disclosure: I, or persons whose accounts I manage, own shares of Tucows at the time of this writing.

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An XTENT-ed Lesson in Shorting?

On May 15th, the Board of XTENT, Inc. (XTNT) announced that it had approved a plan of dissolution. Since liquidations often involve significant uncertainty—particularly concerning distribution timelines—I have found them a fruitful place to look for market inefficiencies. Prior to the announcement, the stock traded at about $1 per share, a price which valued the company at $23.3 million. After the announcement, the stock plummeted to .30 per share, or about $7 million.

Looking through XTENT’s financial statements, one could find relatively meager resources, no sources of revenues, lavish operating expenses, and a host of off-balance sheet liabilities. In fact, in the first three months of the year, the company burned $9.9 million of their $20 million in current assets on operating expenses (remember—no revenues). As of March 31, 2009, the company had $12 million in cash left to burn.

Upon hearing the announcement about dissolution, the prospective investor’s question was: how much will XTENT likely distribute? And when?

By management’s estimation, shareholders would likely receive 11 to 40 cents per share. Yet, if XTENT’s intellectual property could be sold, distributions could be higher.

However, my glance at XTENT’s assets and preliminary proxy suggested that management’s estimates may have been excessively optimistic. Their annual 10-K showed substantial off-balance sheet liabilities that looked well-defined, making management’s “high range” estimates an unlikely scenario. In the month of April, the company had burned $1 million in current assets, suggesting that any delay in the dissolution process would be expensive. Most simply, management’s “low range” estimate of 11 cents per share looked far more likely than their “high range” of 40 cents.

The remaining unknown was the potential sale of XTENT’s intellectual property. Honestly XTENT’s drug eluding stent systems are outside my circle of competence; I had no good sense of how much they were worth. What was clear was that XTENT had hired Piper Jaffray & Co. to help the company explore strategic alternatives in January 2009, and since that agreement, no desirable alternatives had arose. Perhaps the value of intellectual property could be realized, but I doubted that someone would recognize it after the plan for dissolution who happened to miss it before. In fact, most of XTENT’s major competitors in stent technology—Boston Scientific, Johnson & Johnson, Abbott Vascular and Medtronic—had viable stents of their own. I concluded that any value to the intellectual property was most likely nominal.

All told, I thought that XTENT, trading at 30 cents per share post announcement, was likely a much better short candidate than long. It seemed much more likely that XTENT would return less than 30 cents, and over a very long period—perhaps as long as three years. I didn’t short XTENT because it was hard to borrow with my favored broker, and the upside didn’t seem worth the risk.

Of course, some may know how this story ends. Yesterday (June 4th), XTENT announced that the U.S. Food and Drug Administration has granted conditional approval of the Company’s pivotal clinical program for its Custom NX Drug Eluting Stent System. And the stock has soared the last two days—all the way up to $2.69 per share. Though it remains to be seen whether this conditional approval will yield additional interest for XTENT’s intellectual property, XTENT shareholders have enjoyed a stunning 900% gain.

Lesson confirmed—deal with biotech shorts very gingerly, if at all. The FDA is always good for a long “Hail Mary.”

Disclosure: No position.

Rational Management at FortuNet

Truly rational capital management too rarely resides in the executive suites of publically traded businesses.  More often, a myopic focus fixes on growing the empire by acquiring more assets, all while ignoring the owners’ interests—the productive use of retained earnings.  Or, perhaps worse, abdicated vision instills an aura of lethargy.

Of course I say as much knowing that I risk branding myself a crank. However, anomalies occasionally surface; when one catches glimpses of such glory, praise should abound. And today, the laurels should go to the Board and managers of FortuNet, Inc.

FortuNet, Inc. is a small, established manufacturer of multi-game and multi-player server-based gaming platforms, based out of Las Vegas, NV. With 50 employees, a market cap of $32.24 million, 11.04 million shares outstanding, and a price of $2.92, FortuNet is not going to turn many heads on the NASDAQ Global Market. Investors though would do well to take a look, since the company recently announced (and shareholders recently approved) that it will be paying a special cash dividend of $2.50 per share on May 4th, to shareholders of record on April 24th.

FortuNet had its IPO in January 2006, which brought net proceeds of $23.7 million. And since that offering, the company has struggled to find ways to put that capital to productive use. Some went to dividends, some to buybacks, but the end of fiscal year 2008 saw FortuNet’s bank accounts swollen with nearly $26.5 million in cash and short-term investments. This at a time when the market valued the entire company at less than $20 million. Of course, FortuNet is not the only microcap whose share price has been hammered in recent months; many—like KSW—have cash balances at their bank that exceed their market capitalization. However, unlike FortuNet, most of these companies are content to sit on their cash and count their pennies; or, even worse, dole it out on overpriced and impulsive acquisitions.

Since FortuNet’s announcement, its market price has soared from its lows. However, even at yesterday’s prices, the market effectively only values FortuNet’s business at about $4.64 million, or 42 cents per share ($2.92 less the upcoming dividend). And this for a business that earned 25 cents per share in 2008.

At these prices, I find FNET a compelling value, whose price and upcoming dividend offers a substantial margin of safety, particularly if the cash distribution is received in a tax-advantaged account (because the distribution may be taxed in a taxable account). After paying out the $27.6 million ($2.5 on 11.04 million shares) on May 4th, FNET will have a book value of about $16 million, or $1.45 per share. And it’s worth bearing in mind that FNET has shown positive FCF over each of the last six years (the only for which Morningstar data is available).

All told, I find FNET’s Board and management worthy of praise, for doing the right thing for its owners, even at the cost of reducing the amount of assets available for them to play with. It requires abundant honesty and candor to openly admit that productive uses for retained cash are too few and too risky. Human nature entices the powerful and capable to overestimate their abilities, and too often the result is irrational capital management. Kudos to FNET; may your fortune match your deeds.

Disclosure: I, or persons whose accounts I manage, own shares of FortuNet at the time of this writing.

Add a Dose of Ready Mix?

One interesting microcap I’ve been studying recently is Ready Mix, Inc., a supplier of ready mix concrete, sand, and gravel products based out of Phoenix, AZ. As of Feb. 25, 2009, 3.81 million shares were outstanding, and 69.4% of those held by Meadow Valley Parent Corp., which was recently acquired by Insight Equity I LP. At Monday’s close of $2.42 per share, the market values the company at $9.22 million.

Like too many microcaps these days, Ready Mix trades far below its book value of 26.44 million (as of Dec. 31, 2008), with 6.04 million in long term debt and $4.2 million in cash. This substantial discount to book is most likely because their revenues and earnings were down from 2007, with annual revenues off about 20%, and earnings per share swinging from 36 cents in 2007 to a loss of 77 cents in 2008. Earnings and revenues were down in 2008 largely due to the decrease in construction spending in their primary markets of Phoenix and Las Vegas. Though management acknowledges that residential construction will not add significantly to their business prospects in 2009, one should note that housing permits were down 59% YOY in 2008, and that annual housing permits are currently at all-time lows (since the Census began tracking starts in 1959). Though residential construction will not bounce quickly in their markets, it is highly unlikely that housing starts will fall much from these levels. If that prediction proves true, Ready Mix may be currently hovering just above its trough level of earnings, and far underrepresenting its true earnings potential.

In the face of a tough construction market, Ready Mix has taken steps to further tighten its belt, even though they did close the year cash flow positive in 2008, due to $4.69 million in annual depreciation expense. For one, Ready Mix has trimmed their administrative salaries and bonuses in recent months. As of Dec. 31st, they only had 24 full-time salaried employees, with the remaining 211 employees hired on an “as-needed” basis. Furthermore, in their most recent conference call, management confirmed that no significant capital expenditures will be made in 2009.

However, the most intriguing piece of this puzzle is Meadow Valley’s majority stake. At current market prices, the remaining portion of Ready Mix is only selling for $2.82 million (i.e., 30.6% of their current market cap). In February’s conference call, management acknowledged that the cost of remaining a public company costs Ready Mix about half a million dollars per year. At current prices, Meadow Valley could take Ready Mix private and make up the capital outlay in less than six years, essentially getting the remaining assets and future earnings for free. Furthermore, it is likely that a Meadow purchase would yield additional SGA savings, as overlapping administrative functions could be streamlined or trimmed. With the Insight Equity deal now closed, Meadow Valley’s management now has the freedom to get back to growing its business and making acquisitions. Given its current stake, Ready Mix looks like an attractive candidate at a cheap price.

Disclosure: No Position