ESS Technology is a struggling tech company that is now trading below cash value with shareholder pressure to liquidate or take other steps to realize value. At $1.43 the market cap is $51mm compared to cash of $69mm and $15mm-$20mm of additional assets. The company reported a profit in q3 and forecasts another profit for q4(the first quarterly profits in a long while). I believe the floor value is above the current price with the potential for a greater than 2x return if things turn out well.

On 6/4 B. Riley filed a 13-D, they currently own 6.9% of the stock. B. Riley’s style seems to be to find companies with poor operating results but with asset value in excess of the current price, establish a position, and then pressure management to liquidate or otherwise realize their asset value. The 13-D lays out why they feel the business should be liquidated and their estimate of liquidation value. B. Riley’s estimate of liquidation value was $2.69/sh, I encourage anyone interested to read the filing. Also, Loeb Partners has filed a 13-d encouraging the sale or liquidation of the company and owns 11.2% of the stock. (B Riley has recently sold some stock, while Loeb has been buying more.)

At 9/30 their assets consisted of the following:

Cash includes $22mm of after-tax proceeds from the sale of their HQ building in Fremont. The sale agreement has been signed and money is expected to be released from escrow in December.

The 1.6% equity stake in HeJian is carried at their pro rata portion of book value, which is $7mm(note this is also referred to as Best Elite in their filings). The company is planning to IPO in Hong Kong or Singapore late this year or early next year. I’ve not been able to find much on the company other than a PR saying they turned profitable in 2006. Similar comps trade anywhere from 0.8x-3.0x book. Figure book value of $7mm is safe with 2x book being optimistic if it turns into a hot IPO.

B Riley estimates the PV of the Silan royalty stream to be $10mm.

Add all that up and you get $69mm cash + $7mm WC + $7mm HeJian + $10mm Silan = $93mm in non-operating assets, or about $2.60/sh. You can haircut the non-cash assets in whatever way you want to get a number you are comfortable with, although I think there could be some upside with the HeJian stake.

So those are the assets, but what are the liabilities? Other than WC which I accounted for above, there is the $35.1mm non-current deferred tax liability on their books(also have a $6.5mm non-current deferred tax asset). So $93mm - $29mm = $64mm = $1.80/sh so not that interesting right? That’s how it would look on first glance but I believe that this isn’t a hard liability and they may end up not having to pay anything on it.

The liability stems from 2003 and prior, when they were profitable, and has been sitting on the books ever since. Since 2003 they have lost a large amount of money, well in excess of the tax liability, but have since taken a valuation allowance against those losses. So in reality they have deferred tax assets in excess of their deferred tax liabilities, but GAAP says you have to write off your deferred tax assets if you can’t realize them while you can’t do the same for your deferred tax liabilities.

When asked about it on the latest CC mgmt stated that it would sit there until ‘it expires or the IRS challenges us on it’. The liability HAS started to expire(the statute of limitations is 5 years) and last year they released(wrote off) $14.9mm of it. Given the 5 year limit and 2003 being their last year of profitability then you would expect that much of this liability could be off the books over the next year or two.

Furthermore, in 2005 they repatriated substantially all of their earnings helf offshore which elminates this as a potential source of future tax liability.

While I can’t say with 100% certainty that there will not be a significant tax liability I believe there are enough things working in our favor that it seems very unlikely to me and there should be a lot more clarity on this over the next year. Writing off a chunk off the tax liability would be a big catalyst for the stock. If anyone feels like they have anything to add on this issue then please chime in.

Their operating business consists of designing and marketing processing chips that go into DVD players, digital audio players, and digital media players. You can read about their various missteps and declining performance in the B Riley 13d, I don’t have much to add to that. However, they did report a profit of 2cents/share in q3 and forecast 0-4 cents/sh for q4. It’s been about 3 years since they have reported a quarterly profit so this is a good sign, firstly so that liquidation value isn’t eroded by continuing losses and also that the business might have some value. Right now R&D expense is about 15% of sales and SG&A is in the low 20’s. It’s conceivable that they could have some value to a strategic acquirer given that a large company could spread out those costs. They will do around $70mm in sales in 2007($2/sh), so even a low multiple to sales could add significantly to the value of the company.

B Riley and Loeb were able to get mgmt to formally consider strategic alternatives and they have formed a strategic committee. There will be a recommendation in time for the annual meeting, which will be held sometime in December. I don’t have any insight into this but a one time dividend seems like a likely option given the cash balance will soon be more than the market cap once the HQ sale is completed. This could be a further catalyst and would make the undervaluation on the stub more dramatic.

I’ll lay out 3 scenarios for a liquidation value:

Note that liquidation costs come from a mgmt estimate of $6mm-$12mm.

To me the bad case seems overly pessimistic as I estimate the chance of having to pay the full tax liability to be close to zero as they have not been challenged by the IRS yet and the statute of limitations has begun to expire. However, if you believe it is a real liability then you won’t want to own the stock. The average case seems conservative enough to me and would imply a discount to cash value and about 50% upside. The good case gives the operating business a valuation of 0.5x sales which is probably optimistic and would yield a 160% return. It becomes more interesting ff a one time dividend is paid out as the undervaluation on the stub would become more dramatic.

-Statute of limitations expires on tax liability

-Strategic Review announcement sometime in the next month