Value Investors Club / Hemisphere GPS (HEM)

Description

After soaring to as high as $4.92 per share less than three months ago, Hemisphere GPS has come crashing back to earth, not due to deteriorating fundamentals or a poor outlook, but due to Wall Street’s schizophrenic nature and margin call selling from a few funds and individuals.

With over $0.37 per share in cash, Hemisphere trades at 14 times my estimate for 2008 and 9 times my estimate for 2009, despite a sales growth outlook of 20% to 30% for the next three to five years.

This is a stock in which investors have repeatedly been rewarded by taking advantage of short-term sell-offs and looking longer term. For example, when I first recommended it (when it was called CSI Wireless) the stock traded at $1.50 per share, and last year it traded at $2.75 before rising to close to $5 per share. I expect it to trade to at least $6 by the end of next year, based upon soaring sales, earnings and cash flow.

GPS for the farm, otherwise known as Precision Agriculture (repeat from last report)

Precision Agriculture uses GPS to plant, fertilize and harvest fields with pin point accuracy. Instead of using traditional foam markers or guessing, farmers utilizing precision agricultural devices can save time and money with exact usages of fertilizer and fuel. Farmers can also work longer hours in any one day due to relying on GPS and not eyesight. This allows farmers to have a quicker harvest. The newest devices actually steer the tractor or vehicle for you according to the GPS layout of your field.

Precision Agriculture did not exist ten years ago. Today, approximately 30% to 40% of U.S. farms use some form of GPS device in their farming. With today’s high fuel prices and high fertilizer prices, it is not hard to see why Precision Agriculture has taken off. Input costs for farmers (oil, gas, fertilizer, seed, pesticide) have been soaring, and utilizing GPS and auto-steering can save you 3-5% of your input costs resulting in a payback that is less than one year and in some instances 6 months. GPS has become a must purchase.

Prices on products go from about $999 for a “hobby farmer” GPS device to $40K for the high end systems. The average price for precision agriculture systems is $8,585 according to Frost & Sullivan (a consultancy group).

A recent study by Caledonia Solutions found that one out of every four commercial corn producers already owned a guidance system and ownership should grow another 50% in 2008.

Check out the following excerpt from the AEFP (Alberta Environmental Farm Plan) Journal, which explains how and why GPS is so helpful and valuable to farmers:

“Outfitting the tractor with a Global Positioning System (GPS) has helped Tony Pliva reduce herbicide and other inputs used on his Southern Alberta farm. By reducing the amount of overlap on each equipment pass, he estimates he's saving about 6.5 acres worth of inputs on each quarter section.

Although it varies with the crop, the Drumheller-area farmer says that translates into an overall input savings of between $5,000 and $10,000 per year.

"It's surprising when you make the comparison," says Pliva, who crops about 2,800 acres of grains and oilseeds. "Without the GPS, during field spraying, I was overlapping about 100 feet over a quarter-section. And over the whole farm that adds up."

A quick calculation shows that a 100-foot spray overlap on a quarter section—a half mile-long field—equals about 6.5 acres and over 17 or 18 quarters, which totals about 112 acres of overlap. Although crop inputs will vary, if seed, fertilizer and chemical range between $50 and $100 per acre, that adds up to $5,000 to $10,000 per year.

The Outback GPS (A Hemisphere product) unit costs about $6,600. Considering the value it brings to his operation, Pliva estimates that the system will be paid off within a couple of years. "And reducing the inputs is also good for the environment," he says.”

Hemisphere sells a range of Precision Ag products (repeat from last report)

Hemisphere sells products for three separate markets: Ground Agriculture, Air Agriculture and Precision Marine. The two agriculture divisions’ sales represented about 85% of revenue in 2007 with 15% being in Marine. Hemisphere’s products range in price from as little as $999 hobby farmer solutions to $15,000 full sub-inch accuracy auto-steer solutions for farmers with 500 acres plus. Also included are guidance products that tell you when and where to drop seed and fertilizer to the company’s eDrive that actually steers the tractor for you.

In the North American aftermarket for precision agriculture market, Hemisphere has 50% market share based upon units sold and components in underlying products. For example, all of Raven Industries (NASDAQ: RAVN) precision agriculture products have Hemisphere’s Crescent chips inside.

Hemisphere’s strategy is to offer more software based solutions than hardware and to offer cost effective solutions to a farmer. It operates in the low to mid-end portion of the market. While there are some products and solutions that cost $30,000 to $40,000, Hemisphere’s goal is to try to find a lower cost solution and get more mass-market adoption.

Slew of new products coming out in q4

Hemisphere is about to launch a slew of new products in the fourth quarter that should drive revenue well into 2009. The most important in my opinion is new high-end auto-steering “Edrive” product that should be the most accurate auto-steering product in the market. Due to its Beeline acquisition last year, Hemisphere is the only precision agriculture company with steer-by-wire technology. This is an important advantage I don’t believe investors fully appreciate, not only for the competitive advantage but also for the margin enhancing aspects of selling a high-end product, which they haven’t offered before.

The company will also be launching an OEM special product that should make it even easier for HEM to gain new OEM customers. HEM is also introducing a dual frequency RTK product, a new base station and a new leisure platform for the marine industry.

Based on History, the Farming Boom has just begun

Wheat, corn and soybean prices have all sold off from their dramatic highs from earlier this year and many are commenting that the “commodity bubble” is over. A simple study of history shows that commodity bull runs are long term in nature and that it is quite normal to have very quick sell-offs. Historically, agriculture commodity bull markets last anywhere from 10 to 15 years in length and this one began three years ago.

Consider that corn prices have only pulled back to the prices they averaged in March of this year, and that today’s prices of $5.75 a bushel is dramatically higher than the $2 to $2.25 a bushel they averaged in 2005.

The pullback in grain prices doesn’t change the fact that worldwide inventories are at 30-year lows; there is consistently increasing demand from Asia and surging ethanol demands. The price for agricultural land has doubled in many parts of the country despite farmers planting crops fence post to fence post. And the fundamental drivers of price are actually just as bullish if not more so now then they were last year.

Due to massive water problems in Asia and increased urbanization of agricultural production, inventories are suffering. Look at the decision Saudi Arabia made to stop producing 2.5 million tons of wheat. The water problem is the big key for agriculture prices and may be the reason that prices continue to rise. Also, considering that a cow eats as much as ten times the grain as a human; when meat consumption increases, so paradoxically does grain consumption.

Precision Agriculture should grow faster than the farm economy as well (updated)

Only 30% to 40% of farmers have GPS guidance systems in North America and less than 10% have auto steering. Adoption is growing every year, and auto-steering especially is becoming a requirement. Where 18 months ago for every 6 GPS units sold, 1 auto-steer was sold, now it is close to 1 to 1.

I encourage investors to take a demo of a tractor with auto-steering and you will realize that there is simply no reason to own a tractor that doesn’t have auto-steering in it. The ease of use combined with the fatigue factor and that’s not to mention the cost savings.

Hemisphere’s chief competitor confirms the precision agriculture growth story. Trimble Navigation (NASDAQ: TRMB) said this on the company’s last conference call:

“The agriculture story remains centered on strong farmer cash flows, the need to mitigate high input costs for fuel and fertilizer, and strong product innovation. Beyond those factors, agriculture continues to develop as an international story with rapid market development beyond our historical core geographies in North America, Brazil and Australia, with new regions such as Europe growing at strong double or triple-digit growth rates.

We believe we can sustain strong performance in this business for the foreseeable future because the underlying market drivers are not likely to subside and since we believe the addressable market remains substantially un-penetrated worldwide.”

International Opportunity, Brazil is just the beginning

In the second quarter, Hemisphere announced that international revenue surged 91% year over year. This is a stunning number, and I think growth internationally is going to continue to be very high.

Hemisphere has developed a very strong relationship with its OEM partner in Brazil, Stara. And Stara has the potential to be Hemisphere’s largest OEM if it keeps growing at its current growth rate. From my research, Brazil has only begun to start using GPS. This is a very large market and growth should continue for years.

I just finished reading a report from the Ag Equipment Intelligence Report on Russia, Kazakhstan and former Russian states and the report described that technologically those markets were 30-40 years behind North American farmers, but that they were now making tremendous changes.

There was also an article in Wall Street Journal in May, on how Ukrainian farms were being cobbled together into larger farms and the very end of the article was how they were just starting to use GPS.

Potential AGCO contract and other OEMs

I believe that in the next few months, Hemisphere will sign a very large OEM agreement with AGCO (NYSE: AG), the $8 billion in revenue tractor manufacturer. Through Hemisphere’s acquisition of Beeline last year, they acquired a relationship with AGCO and I believe that Hemisphere has an opportunity to take over all precision agriculture products for AGCO products, which includes Massey Ferguson tractors.

Right now AGCO uses GPS boards from Novatel Wireless, but software from Hemisphere through Beeline. This will change once the contract is signed.

AGCO is behind technologically to Deere (NYSE: DE), the largest tractor manufacturer in the world. I believe that AGCO is going to make a big push to catch up technologically. What happens when an $8 billion tractor company meets an $80 million equipment supplier? I think that in the next three to five years, AGCO could be larger than all of HEM’s revenue this year.

Freedonia Group, a market research group based in Cleveland, just came out with a report on the long-term demand for ag equipment. In the report, Freedonia says that the big differentiator between North American equipment manufacturers and their up and coming Chinese and Korean competitors was technology and in specific precision agriculture. Could an OEM customer like AGCO buy Hemisphere to keep its competitive advantage?

Other growth Opportunities include Sugarcane equipment and Survey industries

Beyond new OEM customers, consider that GPS penetration in sugarcane equipment is negligible. HEM is working with Stara now to integrate GPS into sugarcane equipment. I expect revenue for this to start in 2009 and this could be a very large market.

HEM is also making inroads into the survey market and is doing testing in mining as well as defense applications. I expect to hear more and more about these new markets in 2009.

Tax bill benefit for q4

Another tailwind for HEM should come in q4, as farmers do their tax planning and realize that the 2008 economic stimulus bill increased the amount you can now write-off to $800,000 of equipment, up from $510,000. But more important, the amount you can write-off in the first year increases from $128,000 to $250,000.

The last time Congress increased the amount you could depreciate, ag equipment sales in the fourth quarter exploded 45%, in an otherwise bland ag year. Now, all the tractor companies are generally sold out of tractors this year, so precision ag equipment could really benefit from year-end buying with farmers looking to offset tax payments. Combine that tax related buying with the launch of a slew of new products and q4 could be much higher than analysts expect.

2009-2010 should see sharply higher earnings

With new products, new markets, new OEMs and new verticals, Hemisphere is poised to keep growing for a while.

Specifically, Hemisphere should grow sales 49% to C$80 million in fiscal 2008 and EPS should be C$0.20 per share. And in 2009, I estimate C$100 million in sales and the company should earn C$0.30 per share.

Comparables and Competition

Hemisphere GPS’ chief competitors are Trimble Navigation (NASDAQ: TRMB) and Raven Industries (NASDAQ: RAVN) and two private companies, Novarient and Novatel Wireless, which was recently bought out by Hexagon AB, a Swedish conglomerate.

The largest GPS company is actually a Deere (NYSE: DE) subsidiary, ComNAV. They sell only on John Deere tractors and to John Deere customers and do not participate in the aftermarket. They do about $400 million in revenue.

Valuation

TRMB trades for 22 times 2008 earnings estimates and 19 times 2009 estimates and RAVN trades at an average PE multiple of 24 times 2008 and 22 times 2009.

If I put a 20 multiple (which is a discount to competitors despite HEM growing faster!) on C$0.20 in earnings for 2008 and I add in C$0.37 a share in cash, Hemisphere should trade at C$4.37 a share. If you apply that same multiple to 2009 earnings and add in the cash you get C$6.37 per share. At its current price, Hemisphere trades at less than 9 times next year’s earnings despite excellent earnings growth.

Why does Hemisphere trade for half of its comparables? I could understand this last year, before it proved it could earn money and perform, but why now?

I would also add that Hemisphere is an excellent acquisition opportunity and a larger company could remove a lot of public company expense and corporate overlap with an acquisition. Further, there could be a bidding war as this is a hot space and Hemisphere has an excellent market share position, distribution network and brand name. Note that competitor, Novatel Wireless, was bought out last year a competitor for 4.5 times sales in 2007. That would give Hemisphere a value of over C$6 per share.

Summary

Time and again Hemisphere has offered investors excellent price point entries that seem at odds with the performance of the company and its inherent value. I believe that now is one of those times and that investors should pick up this very strong growth company at silly value prices.

Catalyst

-Agco contract
-International growth
-Margin expansion
-New OEM partners
-Realization of how good q4 and 2009 will be
-Potential acquisition of HEM

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			2008	2009
Price:	3.14	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	185	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT