Description

ClearOne (CLRO)

Overview

We believe ClearOne presents a compelling upside opportunity with little chance of permanent downside as the undisputed leader in the audio endpoint conferencing market.  Our analysis indicates shares will likely double, with the potential that a strategic could acquire the business for more than a 100% premium to current prices.  

ClearOne recently broke a streak of 13 consecutive quarters of Y/Y revenue growth, causing growth investors to rotate out of the stock and a rapid decline in price over the last six months.  With 64% gross margins, $37M of net cash and annual EBITDA north of $10M, we feel the business fundamentals provide ample upside to the current valuation.  Couple this with a small video business that is growing 50% annually, and an aggressive stock repurchase plan, and we think the stock is bound to re-rate over the next few years.

The Business

Professional Audio Communications Products

ClearOne’s core business is in providing audio endpoints for conferencing and presentation spaces.  Our research indicates that their products are unrivaled in quality, performance and reliability. The view is that for any conference or presentation space, the audio experience is non-negotiable.  Audio needs to be crisp, reliable and natural.  ClearOne’s solutions are built to this specification, and boast a technical superiority that has given them recognition both at the enterprise level and the channels that they sell through.  Their end customers include blue chip companies that range from Apple, Tesla and Facebook to large financial institutions.  Some have gone as far as ripping out their old solutions to implement ClearOne’s.

The value proposition is clear.  If you spend hundreds of thousands to millions of dollars to outfit a space, the audio endpoints that fit into that space are the last thing you will (or should) compromise.  We liken it to buying a Ferrari, but not the premium tires.  While ClearOne made its name in the high-end, they also serve the entire value chain with great products at a competitive price.  Their dominance is such that they command over a 50% market share in the professional audio endpoint vertical.  They are also hyper-focused on protecting their dominance, illustrated by their 2014 acquisition of Sabine, their primary supplier of wireless microphones, in a $10.3M cash and stock deal.

This segment represents 80% of revenues.

Unified Communications

ClearOne has also been quick to move into adjacent verticals such as table top conferencing and collaboration solutions that have recently emerged.  In 2014 they acquired Spontania, a SaaS web conferencing product that enabled ClearOne to be the only company offering the enterprise an entirely software-based video product line.  Think of this product as a GoTo Meeting or Webex that is built for the enterprise and desktop conferencing phones

This segment represents 13% of revenues.

Network Streaming and Digital Signage

Both of these verticals stem from the 2009 acquisition of NetStreams from Austin Ventures.  Network streaming is the distribution of audio/video over traditional IP networks, much like you might see on a TV piped through a sporting arena or airport.  The key here is you can ride the existing network without having to pull a separate one to support these deployments. Most competing solutions require you to build a dedicated network, and have limitations of scalability.

Digital signage refers to the distribution of video to largely static displays, often integrating with dynamic data requiring a management console.  This is the vertical being served when you see a flight board at an airport, digital billboard, or fast food menu.  As the costs of LED screens have dropped and this technology has advanced, this market has grown rapidly.  The payback for a digital sign is very quick given the opportunities to overlay ads, implement dynamic pricing, labor savings etc. Look around and you will see this everywhere.

While there exist many competing offerings under this vertical, our research indicates that ClearOne offers comparable performance at a significantly reduced total cost, largely by eliminating truck rolls for upgrades, the ability to ride the existing data network and configuration modifications.

This segment represents 7% of revenues, and is growing at 50% annually.

Sales & Distribution

While ClearOne has a clearly differentiated product, they have also developed an incredibly loyal sales channel.  ClearOne distributes its products exclusively through VAR’s and supports the channel with the same level of attention that they do their own R&D teams.  The industry is comprised of local A/V integrators that spec out jobs and have the ear of the customer.  The customer rarely requests a specific configuration and is rather looking for a total product solution that fits their needs.  This means that the VAR’s recommendation is usually what is implemented.  With the channel enjoying a healthy mark-up, VARs have a clear bias for recommending ClearOne as the products sport high performance and support, coupled with favorable economics to them.  We believe this approach has allowed ClearOne to protect its healthy gross margins by sharing the pie and maintaining a variable cost structure.

It has been a natural evolution to move into video distribution markets as they are largely served by the same channel partners.  ClearOne’s addition of video allows A/V integrators to consolidate their relationship while earning better margins than competing solutions that often sell direct to the customer.

Capital Structure

Price: $10.50

Shares Outstanding: 9.0M

Options Outstanding: 0.8M @ $7.78 average strike

Market Cap: $94.5M

Cash: $37.0M (includes $20.3M of long-term investments)

Debt: $0

Enterprise Value: $57.5M

ClearOne boasts a pristine balance sheet with $37M of cash and no debt.  The cash number benefitted from a $11.5M influx in 2012 from IP-related litigation, and another larger settlement related to auction rate securities.  It’s important to note that $20.3M of this cash is classified as long-term investments, a non-current asset, causing the number to look artificially lower at first glance.  These assets are investment grade bonds, with maturities of less than 5 years.  The company has been great stewards of this cash, buying back $9.1M of stock since 2012.  They also initiated a quarterly cash dividend in late 2014 and have since increased it to $0.05/share – a 1.9% dividend yield at current prices.  In March of 2016 they announced a $10M stock repurchase and have already executed $4M against that authorization.  They also bought back another $2M of employees vested options, bringing total buybacks this year to $6M.

Valuation

In our valuation analysis, we looked at three different scenarios.  Our standard practice is to look at valuations on a three-year forward basis and the calculations below are our projections for CLRO’s stock price at the end of 2019.

In the low case, we assume the company neither grows nor makes any meaningful improvements to its operating metrics.  While possible, we view this as quite unlikely as the company is an established market leader who is continually investing in the development of new products.

The base assumes 5% revenue growth in 2017-2019 while increasing EBITDA margins by 2% over that time.  We view this as the most likely scenario.

The buyback case contains the exact same assumptions as the base case, but uses their $9M of annual cash generation in 2017-2019 to buy back stock at an average price of $13.50, a 29% premium to today’s price.  We believe this would be a reasonable use of cash as the company already has $37M of net cash and is already re-investing heavily in new product development.

In all cases, we believe the company warrants at least an 8-10x pre-tax FCF multiple as a cash-rich market leader, but have included a wider range in our analysis.

Low Case

Base Case

Buyback Case

Management and Board

CEO Zeynep “Zee” Hakimoglu is clearly the shining star here.  She took over the company over a decade ago, when it was plagued by a criminal past, and righted the troubled ship.  She cleaned up management, refreshed the product portfolio, and restated financials while rebuilding the sales channel.   In the midst of this, she weathered the 2008 financial crisis and the misfortune in trying to redeem her auction rate securities at the wrong time.  Throughout, she has been supported by what we view as a shareholder-friendly board.

Zee holds a material amount of stock and options, and routinely retains her vested options.  The largest shareholder, Edward Bagley, holds almost 30% of the stock and we believe is generally supportive and a healthy check on management.  If a reasonable bid comes in for the company, Mr. Bagley knows it will likely be the only way to monetize his large holdings.  In the interim he has provided Zee and CFO Narsi Narayanan with the latitude to run and grow the business.

Summary

We think the long-term prospects for ClearOne are promising.  With their end-markets gaining momentum and displacing traditional travel, the need and pricing power for a premium offering will remain intact for years to come.  A robust R&D function that has demonstrated an ability to innovate through both new product introductions and patent awards is evident.  Parlaying this experience into video seems like a natural progression, and a market many multiples as large.  Additionally, delivering these solutions through a well-thought out, scalable channel seems like a smart approach, and this sales channel may be one of the company’s most valuable assets.

The business produces much more cash than can be re-deployed, and management/board has decided to aggressively return that cash to shareholder through stock repurchases and a small dividend.  We believe this is the right approach as it allows them to shrink the share base in a low-growth environment, while leaving them with enough cash make an acquisition should one present itself.

ClearOne maintains high levels of both A/R and inventory.  Our understanding is that this is a concerted effort to protect the channel by not squeezing them on terms and holding enough inventory to always satisfy their requests in a timely manner.

On a standalone basis the company seems to be a gem, boasting high-end products with the margins to prove it.  Factoring in improving capital allocation, we don’t see how shares don’t re-rate at some point. With the recent acquisition of Polycom, we believe the company could surface a credible offer if this was the desired exit plan.  The recent soft quarter and rotation of the investor base provides patient investors with what we believe will prove to be an exceptional entry point.

Other Considerations

• Royce recently sold their position, which could explain the rapid price decline.  However, it appears that they were selling with a mandate to liquidate quickly.

• The company put in place a $10M buyback plan in March and already executed on $4M of it.  We expect they might be able to retire $10M of shares this year given they we rebuying as high as $12/share earlier this year.  We also believe it is likely they will use all their cash flow over time to retire shares as they currently sit on $37M of cash or cash equivalents and are already maxing out reinvestment in new products.

• We have been guided to long-term organic growth of 5-8%.  Things might get worse before they get better, and if that’s the case shares may languish.  We believe the company will continue to be very profitable despite any lag in growth, and will aggressively retire shares during this period.

• The company won a $11.5M patent award in 2012, demonstrating the patents are real and valuable.

• There is likely another $5-7M of A/R and inventory that could be freed up if need be, but there is no need currently.

• ClearOne is a Utah corporation.  While we are unclear of the risks here, we see no evidence of minority shareholder oppression.

• Polycom/Mitel combination:  http://www.polycom.com/company/news/press-releases/2016/20160415.html.   Mitel was ultimately outbid by Siris Capital, and we believe they would love to have the product portfolio of ClearOne.  The rich valuation paid for Polycom provides a nice comp to an almost pure play.

Catalyst

Return of Capital to Shareholders

Potential Target of lerger entity