Description
Cosine (COSN.PK) is an opportunity to buy a "50 cent dollar" as the stock can be purchased for less than cash value. Plus, the net operating losses (NOLs), which we conservatively calculate are worth about 2x the market cap, are free. We believe the intrinsic value of Cosine is approximately $4.23 - $6.18 per share compared to the share price of $1.52 at May 11, 2009. We believe Cosine has limited downside and offers an opportunity to invest alongside an activist investment firm.
Facts
Stock price: $1.52
Basic shares outstanding: 10.1 M
Options outstanding: 161 K[1]
Market value: $15.6 M
Cash: $23.0 M
Key points to our thesis are:
- Cosine is trading at a 30% discount to cash value (EV = -$7.4 M).
- $350 M of unimpaired federal net operating losses (NOLs), which we estimate are worth a total amount of $123 M in tax savings, with a present value of approximately $30 M.
- We believe the intrinsic value, based on our assumptions, to be at least $5 per share.
- Cosine has no operations and is burning approximately $600K using the 1Q 09 annualized burn rate (cash flow from ops is lower). In higher-interest rate environments a year or two ago, interest income was sufficient to cover SG&A and we believe that Cosine will likely achieve cash flow breakeven status in the coming year or so with somewhat higher rates.
- Cash is really cash. Of the $23 M in cash, $21.9 M is invested in money market funds and short-term US government agency notes. The rest is invested in short-term corporate debt.
- Steel Partners, a well-known hedge fund, is the largest shareholder (directly owns 26%, but controls 45% through majority ownership of WHX CS Corp.), has a board seat and is actively engaged in the acquisition strategy.
Company History
Cosine, founded in 1998 as a carrier network equipment provider, has undergone a complete overhaul in the last several years. The network equipment business has been shut down, and investors have taken control. Landmark events in the evolution of the company are:
- September 2004 - December 2004: The company laid off most of their workforce and discontinued all products lines.
- January 2005: Cosine announced a stock-for-stock merger with Tut Systems, Inc. The merger was cancelled on May 16, 2005.
- April 2005: Steel Partners filed a 13D showing a 12.6% position at a $2.13 cost basis.
- June 2005: Cosine's stock was delisted from NASDAQ.
- July 2005: The board of directors approved a plan to redeploy "...resources to identify and acquire one or more business operations..." (per 10K). The plan revolves around using the NOLs to offset taxable earnings of an acquired company. To help execute the strategy, Jack Howard, co-founder of Steel Partners, was elected to the board.
- December 2006: Cosine ceased all customer support services associated with its former business. Cosine also outsourced its own business management/administrative function to a related third party for the interim period during which they have no operations.
Valuation of NOLs
Cosine has taken two very important steps that give us confidence that the NOLs are being protected and are worth something. First, Cosine (actually it was Steel Partners) hired NOL specialists to conduct in-depth impairment tests. For those unfamiliar with NOLs, on a very high level, the impairment test looks at the cumulative change in ownership for 5% or greater shareholders over a three-year rolling period. If the cumulative change of ownership for these shareholders exceeds 50%, there has been a "change of control" and the NOLs are impaired (see IRS Section 382 for more details on testing parameters). The result of the Cosine test showed that a maximum of $3 M of the federal NOLs had been impaired, $350 M are unimpaired. Furthermore, these NOL's don't start to expire until 2018 and don't completely expire until several years thereafter.
Second, in September 2005 Cosine passed a shareholder-approved stock trading restriction to limit shareholders from buying more than 5% of the outstanding shares. To read the details of the plan, see the 8-k filed on September 8, 2005. The 5% cap limits an investment to just over $1 M.
Note: What does impairment mean? Simply stated, impairment limits the amount of NOLs that can be used in a given year to a federally mandated percent (close to 5%) of the equity value (market value minus cash) at time of impairment. If Cosine's NOLs were impaired, they would be virtually worthless.
To value the federal NOLs we multiply the unimpaired NOLs by the federal corporate tax rate (35%).
$350 M x 35% = $119 M
We assume acquisitions will be made in the future, otherwise there would be no income to shield from taxes, and therefore no NOL value. We then discount the $119 M (12% discount rate) and assume a slow increase in taxable income over the life of the NOLs. Depending on how fast we assume taxable income increases, the present value could be anywhere from $10 M - $50 M (of course, the faster the NOLs are used, the higher the value). Our assumptions give us a present value of $20-40 M.
There are also $225 M of state-specific NOLs. But due to their limited duration (10 years vs. 20 years for federal) and the various state tax rates, we have chosen not to include the state NOLs in the valuation. Additionally, there are $7.1 M in federal tax credit carryforwards and $79 M in federal capital loss carryforwards. Suffice it to say, these should be worth more than $0 but we have assumed nothing in our intrinsic value calculation.
Cash $2.27 per share
NOLs @ $20M NPV $1.96 per share
NOLs @ $40M NPV $3.91 per share
Intrinsic value $4.23 - $6.18 per share
Risks
Time value of money - we don't know when an acquisition will occur.
Acquisition risk - Steel Partners is running the show and should make a good acquisition. We believe the probability of a poor acquisition to be a low.
Catalysts
Announcement of acquisition(s) with taxable income
Utilization of NOLs
Illiquid - Trading volume of COSN is thin
[1] 118,000 options are near in-the-money, with an average exercise price of $2.55. Of the 118K options, 106K are exercisable at an average price of $2.57.
Catalyst
Announcement of acquisition(s) with taxable income.