Description

Imation Corp. (IMN)

Introduction / Summary

Let’s go dumpster-diving! Before we get into it, I’ll just point out that this idea is far from being “institutional-friendly”, given the small size and thin volume in the name. As a result, its small and volatile and probably not a great option for big funds, and really more of a PA name.

Imation is sad and funky story of mismanagement and ruthless changes in technology that can leave many companies as roadkill on the side of the highway. However, at this point, the company has basically shed all but one business line / asset, and features an activist investor that has taken control and is running the cash of the business as a fund. When I started to research Imation a while back, it was attractive as a classic corporate restructuring situation, where bad businesses were being shed and decent, smaller ones kept and invested in. The story is not as clear cut today, but maintains fairly low downside (in my opinion anyway).

Imation has been circling the toilet bowl for some time as its optical (read: blank CDs and DVDs) and tape media and other similarly irrelevant businesses have been in a massive multi-year decline. Lost among all the crap is Nexsan – an enterprise storage business (think EMC or NTAP) – that, while not knocking the cover off the ball, is a viable, decent business that I view as alone worth more than the company’s market cap (and certainly more than current EV, which, being that it’s currently negative, is a low bar if there ever was one). While its difficult to put a meaningful price target on it given the lack of information about what the company will look like financially as just Nexsan for the next 1-2 years (until they release Q4 earnings at least), I think IMN has potentially multiples of upside over the next 12-18 months. Like I said, the company is trading below cash and the Nexsan asset is worth something, even if not much.

For those interested, I recommend reading Clinton Group’s proxy materials sent to shareholders here: http://www.okapivote.com/imation/Clinton%20Group-%20Imation%20Proxy%20Statement.pdf

And additional presentation here: http://www.okapivote.com/imation/IMN%20Clinton%20Group%20Presentation.pdf

Company Description / Segments and Products

Imation is / was a data storage technology company, primarily and historically involved in removable storage media (i.e., external hard drives, tape cartridges, blank CDs / DVDs, etc.). The company’s direction has changed over the last few years and, after shedding a bunch of assets / business over the last year, is now only comprised of Nexsan and Connected Data (which is being rolled into Nexsan), a provider of external enterprise storage systems. The company previously reported in two segments (essentially consumer and enterprise) and four sub-segments:

Consumer Storage & Accessories

Essentially removable storage sold to consumers (e.g., blank CDs / DVDs, USB flash drives, etc.) and cheap consumer electronics accessories (e.g., speakers, headphones, smartphone cases, etc.). The segment has declined at a 20% CAGR from 2011 through 2014 and is down 24% year-over-year through 3 quarters of 2015. As of Q3, CSA represented 52% of total revenue.

Consumer Storage Media

Products include optical media (i.e., blank CDs and DVDs), USB flash drives, flash cards, and external hard disk drives. The most structurally flawed of the products sold here – optical media – made up 64% of the group’s revenue / 30% of total revenue in 2014 and has declined at a 25% CAGR from 2011-2014.

Audio and Accessories (A&A)

Products include speakers, headphones, and other cheap accessories (like smartphone cases and screen protectors). This business used to be decently material for the company, at one point more than 16% of revenue. However, in the strategic move away from consumer (towards enterprise), management sold off the Memorex and XtremeMac businesses, which took a bite out of the A&A business.

Tiered Storage & Security (TSS)

TSS is a more fancy way of saying enterprise-focused storage products. The segment essentially breaks down between 1) removable tape storage cartridges and other similar archive-focused removable storage media (e.g., RDX storage, until it was recently sold); 2) enterprise storage systems, under the Nexsan brand (i.e., competes with the likes of EMC, NTAP, HPE, and others); and 3) IronKey-branded encrypted data products.

Commercial Storage Media

Removable magnetic tape cartridges make up more than 90% of this group, which has been in massive decline for a while. For the uninitiated, but without getting technical, there are three primary storage technologies in use today – flash, disk, and tape. Flash is the latest and greatest, featuring excellent speed / performance, power efficiency, and high density (i.e. lots of storage in a small form factor). However, while flash prices are coming down, it still remains the most expensive on a per-gigabyte (GB) basis, leaving its use for more performance-focused situations / applications. Disk is what has been the norm for quite a while now, with inferior performance to flash, but at a fairly low cost point right now and better technologically than tape. Tape is the old-world storage technology, which while dirt cheap at this point, is really only usable for archive data – i.e., information that must be saved but is rarely, if ever, accessed.

The declines in tape are secular in nature – no one really uses tape anymore outside of a small group of stubborn, old-time tape users, who are probably averse to change and see no reason to move to something else as long as tape remains dirt cheap and works. Everyone else on the planet is using disk or flash, which has become exceedingly cheap at this point, leaving minimal value prop in using tape over disk for archiving needs. Certainly, one would be hard-pressed to find a tape user among anyone who was not using tape when it was more widely used.

IMN’s tape sales have declined at a 16% CAGR from 2008-2014 and the commercial storage media group represented 28% of total revenue in Q3 2015.

Storage and Security Solutions

As opposed to all the other product categories, which account for more than 80% of total revenue, this segment consists of what management actually is focused on – this is the Imation’s future. The group is comprised of Nexsan storage systems and secure / encrypted “mobile data solutions” under the IronKey brand. Additionally, IMN recently purchased Connected Data, though my guess is that it ends up under the Nexsan umbrella. IronKey got unloaded last month, so I’m not going to get into that business.

Nexsan has 3 primary products – 1) E-Series – disk-based storage array qualifying as one of the best “cheap and deep” storage offerings, aimed at stuffing tremendous capacity into the smallest form factor possible and at the lowest price possible. Typically aimed at secondary storage use-cases, such as file-based storage (e.g., word documents and excel files, as opposed to database storage or other performance sensitive workloads); 2) NST – hybrid (flash + disk) storage array; and 3) Assureon – disk-based archiving appliance.

Connected Data is a single product – called Transporter – which is an appliance-based solution that is added to existing storage infrastructure and creates a private-cloud-based file sync and share functionality. Basically, it’s a way for an organization to offer the equivalent of Dropbox or Google Drive in a secure, private-cloud manner, behind the organization’s firewall.

The group did $123M in revenue last year and is likely to do around $115M this year (not counting revenue from the Connected Data acquisition), though forex accounts for a large headwind and currency-adjusted growth is up over last year. Of course, since IronKey was just unloaded, that would have to be backed out of the revenue estimate. Again, there will be more of a clearer picture once Q4 results are released, but I believe Nexsan + Connected Data will end up at ~$100M in annual revenue (give or take $5M) for 2016.

Situation Background / Timeline

The Clinton Group’s presentation and proxy materials give an excellent timeline going back a decade for anyone looking for the full-blown history of how the company got to its current situation. I’m going to try and give the more abridged version.

Imation was spun out of 3M in 1996, focused primarily on manufacturing tape storage products, which were sold to the enterprise / commercial market. With tape storage media going the way of the west, IMN made a sensible pivot to becoming a more diversified provider of removable storage media, thus expanding the business outside of tape, but essentially maintaining the same business model. As things turned out, removable storage media – optical media, external disk drives, and flash media – would end up having significant consumer appeal (blank CDs / DVDs, external hard drives, USB flash drives, etc.), and management decided to strategically move toward consumer electronics markets.

By the mid-2000s optical media became the company’s largest individual product area – by and large consumer-focused – and IMN doubled-down with acquisitions in the space (Memorex; XtremeMac) to secure its industry position. At this point, IMN made a conscious decision to move toward consumer electronics – the Memorex and XtremeMac acquisitions contained significant consumer electronics pieces and optical media in general was strongly associated with those products (i.e. blank CDs typically used for music burning, which allowed for brand extension into audio accessories, like headphones and stereos). Locking-in this direction, the board brought in executives with consumer experience (as opposed to technology experience) to run the business.

Of course, the consumer electronics is vastly different than enterprise technology – margins are razor thin and the technology – essentially commoditized – is basically irrelevant relative to branding. Plus, enterprise technology is often sold via a network of value added resellers (aka “VARs” or “the channel”), the network for which must be invested in and built out, as opposed to selling a bunch of cheap consumer electronics products into retail stores.

As anyone moderately technology-literate knows by now, optical media has been in massive decline in recent years. The peak for IMN was in 2008, when optical revenue hit $852M and overall company revenue was $1.98B. The reasons for optical’s decline are fairly obvious, but just to mention a few anyway – the rise in storage density (i.e. more storage in smaller form factors); the standardization around USB-based storage (as opposed to optical media); the rise in cloud storage as the ultimate in “transportable” data; the rise in mp3 players and, eventually, smartphones and tablets, with significant internal storage capable of handling most storage needs.

Adding insult to injury, many of the more upstream storage component manufacturers found it easy enough to vertically integrate and enter the removable storage space (STX, WDC, SNDK to name a few) without really incurring extra costs to their businesses. With optical media quickly becoming irrelevant and tape storage’s slow death no longer so slow, management decided that going further into poorly-branded, low-margin, no-moat consumer electronics and removable storage was no longer the optimal approach. Instead, management decided to pivot back to the enterprise, acquiring IronKey and Nexsan in 2011-2012 (more on this below) and otherwise divesting chunks of its more consumer-focused businesses.

Whether you agree or disagree (or at least sympathize) with management’s strategic decisions over the last few years, the larger issue has been awful execution more than anything else. Management has essentially held two very clear goals – 1) find ways to stabilize top-line; and 2) optimize the cost structure to align with the structurally flawed businesses – and has failed spectacularly in both areas.

In terms of stabilizing top-line, from 2008-2014, optical revenue has declined at a 20% CAGR ($852M to 219M), tape has declined at a 16% CAGR ($549M to $197M), and the overall business has declined at a 15% CAGR ($1.98B to $730M). Even when adjusting for changes to the portfolio, the divested revenue from Memorex and XtremeMac is roughly the same as what Nexsan and IronKey account for today, so there isn’t much of a net change. Bottom line, while optical and tape have been racing to zero, the consumer electronics business was a flop and then largely divested, the other products (mostly external disk, solid-state, and USB flash drives) have slowly withered away without any discernable differentiation (declining at a 10% CAGR since 2008), and the Nexsan and IronKey acquisitions haven’t really moved the needle thus far.

What about profitability? While cash hasn’t really been all that burned operationally – cumulative FCF burn from 2011-2014 was only $41M – SGA and R&D haven’t been cut in lock-step with revenue declines, causing their respective % of revenue to rise significantly and consistently over the last several years. Anyone looking for the full management beat-down can check out the Clinton Group materials, where they trash management’s performance ad nauseam. Bottom line, management has done a very poor job, even considering the circumstances. Of course, this didn’t stop management from handsomely rewarding themselves for a job poorly done, which gave an activist (the Clinton Group) even more ammunition to toss management out.

Nexsan

Nexsan was founded in 1999, with its first products focused on backup and archiving, which is where the company continues to enjoy a strong reputation through today. Nexsan was among the previous generation of “hot” storage startups, many of whom went public and / or were ultimately acquired (e.g, Isilon, Compellent, Equalogic, 3Par, and Left Hand Networks). Nexsan’s secret sauce was always a strong cheap-and-deep storage solution, aimed at secondary storage workloads. Without getting too technical, data storage is typically classified in terms of primary, secondary, and tertiary (or Tier-1, Tier-2, Tier-3). Primary refers to data that is used often, is often mission-critical to the organization, and is typically performance-sensitive. Database storage is a good example of a primary storage workload. Secondary storage is often associated with file-based storage or “fixed” items, such as word documents, excel spreadsheets, pictures, and videos. The data is considered “secondary” since its typically not performance-sensitive and doesn’t underlie any mission-critical applications. Tertiary storage refers to data that is rarely accessed, such as archived data or backup snapshots.

In secondary storage, the name of the game is price and total cost of ownership (TCO), which in the storage business often boils down to power consumption and physical footprint. It’s not sexy, but there is a sizeable market for “everyday storage” to handle common data files. Nexsan found success by squeezing tremendous capacity into a small form factor for disk-based storage (providing excellent storage density), providing excellent power efficiency (Nexsan was one of the pioneers of automated spin-down of disks not in-use, which lowers power consumption), and maintaining strong reliability (i.e. long product life with minimal disruption). As a result, Nexsan solutions have typically been attractively-priced for small and mid-size organizations looking to fulfill everyday storage needs.

In addition to Nexsan’s cheap-and-deep storage solutions, which used to be the SATA-Beast line and is now the E-Series, the company has brought two other products to market that are also solid, if unsexy, but certainly solid market appeal. First is Assureon, which is a backup and archiving appliance with strong data encryption and other backup-focused software features. While many organizations are moving backup and archiving functions to the public cloud, there is still a decent market for on-premise backup/archiving solutions in instances where 1) the cloud isn’t an option for regulatory reasons (e.g., federal, state, and local governments; government agencies; financials); 2) the data is being accessed more than normal and thus performance matters to a certain degree (in which case, on-prem storage typically trumps the cloud). For example, video surveillance backup – in fact the NFL is a large Nexsan customer for its video department; and 3) managed service providers offering their own hosted solutions to customers, who are essentially using Assureon as the basis for their backup-as-a-service offerings.

Nexsan’s other product line is the NST, which was a more recent move for Nexsan and is a move up-market into more primary storage use-cases. NST is a line of hybrid storage appliances, similar to NMBL, Tintri, and Tegile (as well as the Johnny-come-lately hybrid products from the typical storage behemoths, e.g., EMC, Dell, HPE, NTAP, etc.). For the uninitiated, hybrid storage aims to capture the strong economics of disk-based storage (at least as long as it remains the cheapest functional option), but upping the performance ante by adding some flash to the appliance. What results is a hybrid appliance where the storage controller moves “hot” (i.e. highly-access, more performance sensitive) to the flash media, while keeping “cold” data on disk. This results in using flash to the degree its needed without splurging on an expensive all-flash appliance. In general, hybrid appliances have found success as primary storage options in more mid-size businesses who don’t necessarily need the best of the best for their primary storage needs. NST has garnered some early success and is considered a solid, measured move up-market for Nexsan.

Putting a bow on Nexsan from a product perspective – based on my research and in speaking with resellers, while the company doesn’t have the same appeal as an EMC or a NTAP, Nexsan’s customers are typically big fans of their products. They are inexpensive and reliable and thus carry strong appeal in small and mid-size organizations where price and reliability often trump cutting edge technology and performance, particularly for secondary and tertiary storage use-cases.

The Clinton Group Gets Involved

The Clinton Group (CG) began accumulating a position in Q4 2014 (based on its first sighting in CG’s 13F). Sensing a coming attack, or perhaps being told outright that it was coming, then-CEO Mark Lucas added a line to IMN’s annual shareholder’s meeting invitation that basically said CG many send proxy materials and they should be ignored. CG immediately punched back with an open letter to shareholders and a full-blown presentation (i.e., the proxy materials). I linked to those materials above, essentially delving into the nitty-gritty of how the company has been woefully mismanaged and in sore need of new management and a new direction.

With a pretty compelling argument, CG got 3 new members onto the board: Bob Fernander (storage expert), Barry Kasoff (restructuring expert), and Joseph De Perio (CG portfolio manager) and proceeded to clean house and implement a wide-ranging restructuring plan, the short version of the plan being:

1. Get rid of crappy businesses that have no potential for stable revenue and / or poor profitability / unprofitable profiles

2. Refocus remaining ongoing entity around Nexsan

3. Get smarter and more opportunistic with cash

1. Strict ROI hurdles for every penny spent

2. On the lookout for interesting acquisition targets

4. Bring in experienced management / effectively align compensation with shareholder interests

5. Remain open to any and all “strategic alternatives”

Before I get into the progress of what’s been done thus far, I want to pivot back to Nexsan a bit since its what the company is essentially going to be going forward.

Looking Closer at Nexsan

Let me be clear that I don’t view Nexsan as some major growth business that has the potential to be a 10+% top-line grower. However, I believe Nexsan is certainly a viable business that should remain stable and grow in the single-digits over time. Put another way, while I don’t think Nexsan is some unearthed diamond, I also don’t think it’s worthless or going to zero and that the existence of a stable market for the company’s products makes the business worth something, as opposed to the nothing its currently valued at.

With that as a preamble, Nexsan has faced 4 issues that have stalled growth over the last 1-2 years:

1. The storage market in general has been under pressure from the cloud, as well as new storage tech that is lengthening sales cycles, pausing purchase decisions, and in general disrupting the market. Nexsan is certainly not immune to these issues, but their core market and niche-ish appeal remains intact and they’ve actually outperformed many larger storage peers in recent quarters (certainly NTAP);

2. Poor and inexperienced (as far as enterprise storage goes) management;

3. Poorly built-out sales and marketing function, including a poor channel presence, both of which are crucial in infrastructure IT; and

4. FX headwinds, which aren’t specific to Nexsan, but have hurt headline revenue comparisons for the last several quarters.

What’s changed? While the storage market is still under pressure – pretty self-evident for anyone moderately familiar with enterprise storage (or enterprise IT infrastructure for that matter) – Nexsan’s particular market niche appears to be mostly stabilizing. From the perspective of new storage technology taking share, all-flash and hyper-converged storage (i.e., the prevailing new storage technologies) doesn’t have particular appeal for most Nexsan use-cases. Why? Because the primary players here (e.g., Pure Storage or Nutanix) are chasing Tier-1 EMC and NTAP  business and Nexsan’s cheap-and-deep secondary storage is neither on their radar nor the best target for their sales pitch.

Plus, while the cloud is a problem for everyone, Nexsan’s focus on encrypted data features (and customers sensitive to those issues, like the government) has resulted in a customer base not as likely to move such storage to the cloud. As far as management and a proper sales and marketing infrastructure, the Clinton Group has thrown out the old management team and brought in storage industry vets, while green-lighting cost-conscious and ROI-cognizant investments into the business to clean it up and put Nexsan in position to succeed.

Where Are We Now?

The following actions have been taken since the Clinton Group got involved:

• Previous management and board thrown out - May 2015

• RDX storage sold to Sphere 3D (ticker: ANY) - August

• New management / board installed (Barry Kasoff named president, Joe De Perio named non-exec chairman) - August

• Distribution agreement signed with Arrow for Nexsan products - August

• Announced wind-down of on-European tape media and CSA business  - September

• Expected to be completed by year-end 2015; we will find out where they are up to when they report Q4

• Terminates brand licensing agreement with TDK, resulting in the retirement of TDK’s stake in IMN, roughly 6.7M shares - September

• Acquires Connected Data for $7.5M ($4.4M in stock, $2.6M in debt assumption, $500K in cash); Bob Fernander named interim CEO, Barry Kasoff named Chief Restructuring Officer, and Geoff Barrall - CEO of Connected Data - named CTO - October

• CFO resigns, Kasoff assumes interim CFO role - November

• Sale of Memorex brand and corporate HQ (collectively $20.9M) - January 2016

• Changes to cash investment policies allowing the purchase of public equities and investment funds - January

• Establishes RIA subsidiary - February

• Sale of IronKey for ~$6.7M (including $2M in assumed obligations; roughly $4.65M in cash) - February

• Notified by NYSE of possible delisting due to minimum size reqs - February

So what are we left with right now?

• Roughly $90-100M in annual revenue that should be an overall grower in 2016

• Roughly $64M in net cash

• $76M in net cash as of Q3

• Plus: $20.9M from sale of Memorex and corporate HQ

• Plus: $4.65M from IronKey

• Plus: current value of ANY shares and options held in “other current assets” of ~$2.75M

• Less: $30-40M in cash charges relating to the massive restructuring / wind-down

• Less: $0.5M in cash payment for Connected Data

• Market cap of ~$34M, based on Thursday’s closing price of $0.85, on 40M shares (37M shares following the retirement of the TDK shares, but conservatively adding 3M shares - just to keep it round - from the Connected Data acquisition, though in reality it’s probably closer to 2M shares).

What is Clinton Group Doing?

While its been a whirlwind for the last few months, I think the strategy is starting to crystalize to a certain degree. Clinton is doing 1 of 2 things in my opinion - 1) shedding anything that isn’t Nexsan, setting that up for success, and managing cash as a fund would if and until another opportunity comes along to either sell Nexsan or buy something else; 2) shedding literally everything, with the Connected Data acquisition just a move to try and make Nexsan a little more attractive to a buyer and then using the IMN shell as another Clinton Group-related fund for who knows what.

I’m actually fine with either scenario. EIther way, the company trades below cash and Clinton Group has set themselves up to do quite well if the IMN shell remains public (based on cheap options and shares owned) and generates any kind of value. Whether I’m investing in a publicly traded asset manager or a storage asset with a bunch of cash attached, either way I don’t really see much downside from here based on the cash-on-hand, as opposed to significant upside of anything comes of Nexsan, or if its sold and the resulting cash-laden shell is put to better use by Clinton Group.

Risks

• Who really knows what Clinton is doing here

• Enterprise storage is a challenged area right now and, despite my lukewarm positivity (as opposed to cold-hearted negativity) at Nexsan’s prospects, it could certainly fall on its face

• The stock is so small and volatile and with no real public recognition that positive catalysts are harder to find here by the sheer lack of recognition of good things happening

• Delistment from the NYSE

Valuation

Like I said above, hard to give a strong valuation here and I don’t want to go down the road of projecting EV/Sales multiples from dreamworld (as others have done on VIC with stuck-in-the-mud tech companies.

Simply put, they are currently trading at roughly a 47% discount to net cash, with an asset worth - in my opinion - something. For the sake of argument, if Nexsan could achieve 1% net margins for 2017 (management expects to hit breakeven on a quarterly basis by the end of 2016) on, lets say, $100M in revenue, that comes to $0.25 / share in EPS, or 3.4x before cash considerations. I think that bar is fairly low.

Catalysts

• Releasing Q4 earnings and giving an update on what is going on and what the company looks like right now

• Reaching operational breakeven

• Whatever they decide to do with their cash

Accelerators

Almost anything under the sun, since its basically a blank canvas at this point, save for Nexsan. Accelerated buyback is on the table, as is a sale of Nexsan or the acquisition of a related or unrelated company.

Catalyst

• Releasing Q4 earnings and giving an update on what is going on and what the company looks like right now

• Reaching operational breakeven

• Whatever they decide to do with their cash