CoSine Communications, Inc. COSN
May 30, 2006 - 9:44am EST by
2006 2007
Price: 2.45 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 25 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Cosine (COSN.PK) is an opportunity to buy a 50 cent dollar. The stock can be purchased at approximately cash value and the net operating losses (NOLs), which we conservatively calculate are worth 1x the equity, are free. We believe Cosine has limited downside and offers an opportunity to invest alongside a successful investment firm.

Stock price: $2.45
Shares outstanding: 10.1 M
Options outstanding: 147 k
Market value: $24.7 M
Cash: $22.8 M

Key points to our thesis are:
- Cosine is trading very close to cash value (EV = $1.9 M).
- $337 M of unimpaired federal net operating losses (NOLs), which we estimate are worth approximately $25 M.
- Cosine has one employee and no operations and is therefore burning very little cash.
- Steel Partners, a well-known and respected hedge fund, is the largest shareholder (directly owns 24%, 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 two 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. Cosine is contracted to provide limited support to some customers through the end of 2006. All support is outsourced to and managed by third parties.
- 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 and began trading on the OTC market.
- July 2005: The board of directors approved a plan to redeploy “…resources to identify and acquire one or more business operations…” (from 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.

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% shareholders over a three-year rolling period. If the cumulative change of ownership 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 only $3M of the federal NOLs had been impaired.

Second, in September 2005 Cosine passed a shareholder-approved stock trading restriction to strongly discourage any outside party 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: Even if Cosine hadn’t put the restriction in place, it would be dangerous to buy more than 5% of the outstanding shares without detailed NOL impairment calculations. Doing so could cause a change of control and impair the NOL asset. 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 NOL’s were impaired, they would be virtually worthless.

To value the federal NOLs we multiply the unimpaired NOLs by the federal corporate tax rate (35%).

$337 M x 35% = $118 M

We then discount the $118 M (12% discount rate) and slowly increase taxable income over the life of the NOLs. We assume acquisitions will be made in the future, otherwise there would be no income to shield from taxes, and therefore no NOL value. Depending on how fast we assume taxable income increases, the value could be anywhere from $10 M - $40 M (of course, the faster the NOLs are used, the higher the value). Our assumptions give us a $25 M value.

There are also $190 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. Suffice it to say, they could be worth more than $0.

Time value of money – don’t know when an acquisition will occur.
Acquisition risk – Steel Partners is running the show and could make a bone-headed decision. We believe this to be a low probability.


Announcement of acquisition(s) with taxable income
Utilization of NOLs
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