Description

What happens when a company transitions from one that sells products to one that sells products and a recurring service? Companies that successfully achieve this get revalued at much higher valuations and their stocks go up by multiples.

Underneath the surface, KVH Industries is transforming itself and is about to become a growth machine with a powerful recurring revenue stream from a new business model. With a rock solid balance sheet of $37 million in cash ($2.65 per share) and no debt, this Rhode Island based company is cheap, selling at 1.3 times tangible book and 0.8 times revenue. What makes KVHI a steal is that the company could double annual revenue and earn north of $2 per share annually in the next three to five years. My guess and bet is the stock will not be trading at less than $4 per share excluding cash if that happens.

The Lesson of CAM Commerce

In 2006 and 2007, one of my best performing investments was a company called CAM Commerce. The stock was around $15 when I found it and the company was struggling as its point of sale system (think glorified cash registers) business was declining. But this decline was masking a new payment processing business they had launched called X-Charge. CAM Commerce was going to mom and pop type retailers and telling them that they could save 15% to 20% on their payment processing by coming to X-Charge and being combined with many other mom and pop retailers and getting a volume discount.

X-Charge was a wonderful recurring revenue business with little in capital expenditures and was growing at triple digit rates, but this was being disguised by steep declines in their legacy business. Investors eventually realized this and the stock vaulted higher. CAM Commerce was bought out in 2008 for $40 per share.

What I learned from CAM Commerce is the power of a changing business model and the value of recurring revenue stream to a company that didn’t have one before.

A Legacy Business that sells to the RV and Leisure Marine Market Tanks

Much like CAM Commerce initially was, KVH Industries is currently struggling as its legacy products have experienced plummeting demand. KVH Industries main products have been selling antennas for the RV (Recreational Vehicle) and leisure marine market to receive satellite television. Guess how well that business has been doing in the last nine to twelve months?

In their first quarter of 2009, KVH in their 10-Q revealed the extent of the damage: land mobile products fell 77% year over year and their marine products fell 37%. When your sales for one group of products fall 77%, there really isn’t that much more for them to fall. This huge drop-off in sales caused a $2.7 million operating loss in the first quarter.

Why in the world would you want to invest in such a company?

Hidden Underneath Is Explosive Growth

You want to take a look at KVH Industries because right underneath the surface is explosive growth and great potential from two main areas: The Tracphone v7 and the company’s fiber optic gyroscope business. The Tracphone v7 is a broadband antennae and modem solution to get broadband Internet and telephony on the oceans for commercial ships. Fiber optic gyroscopes judge and sense movement instantaneously and KVH primarily sells to the government for military applications.

Inmarsat Dominates the Maritime Communications Industry

How would you like to be paying $13 to $32 per megabyte to use the Internet at dial up speeds of up to 400k bytes per second (cable and dsl are 2 million bytes/second)? How would you enjoy paying $1.50 to $2 a minute to make a phone call? If you are a shipping company chances are you use Inmarsat’s Internet and telephone satellite services and this is what you would be paying.

How do you get to charge such prices? You effectively have a monopoly. This is why Inmarsat has traditionally had over 60% EBITDA margins, and despite last year’s tough economy still reported a 52% EBITDA margin and a 36% operating margin. These are ridiculously high margins.

Inmarsat has had little competition, but that is changing as a number of players start offering broadband service using the Ku band (often referred to as the VSAT market), which is a higher frequency band. Inmarsat uses L-band, which is a lower frequency band, which limits how much data can be received or sent. Simply, the Ku band offers a “larger pipe” than the L band. Inmarsat cannot switch to Ku band unless it starts sending Ku or other band satellites into space.

The problem has been that VSAT (Ku band) providers have been regional in nature and have not offered global coverage. Enter KVH Industries.

The Tracphone v7, Broadband Internet on the Ocean for a Fraction of Current Cost

In the fourth quarter of 2007, KVH launched the Tracphone v7, their VSAT antennae and Internet and telephony service. The advantages of the Tracphone are many. First, KVH offers monthly flat rate billing at much lower cost than Inmarsat. For example, Inmarsat offers 400k Mb/s Internet service speed for around $13 per megabyte.

For much faster Internet speeds, KVH offers pricing nearly 75% lower than Inmarsat. The average customer of KVH pays $2000 a month or $24,000 a year. The equivalent usage on Inmarsat would cost $75,000 and that is for much slower speed. This is a substantial difference.

Consider the cost difference of a phone call. With KVH it would cost $0.10 a minute to call the U.S. from the middle of the ocean as opposed to $1.50 per minute with Inmarsat.

The interesting thing about the falling cost of Internet and higher data speeds is that they allow for much more usage and allow for applications that haven’t been used before, such as more interaction between shore and office, for weather maps, facility management, etc. Personal Internet usage for crew moral is a big thing for shipping companies that want to keep employees happy while they are essentially by themselves for weeks and months on end. And finally, more robust data management is also allowed. Services like KVH’s will drive more Internet usage over time. Think of how much you use the Internet and how that has changed over the last few years as speeds have gotten faster.

One example of the increased need for the Internet is that the International Maritime Organization, which operates under the United Nations Charter, has mandated that by 2012 all seagoing vessels will be required to have electronic charting display information systems. These charts, which indicate where buoys are and the depth of sea floor, are constantly changing and can only be downloaded by satellite.

Other major advantages of the Tracphone include that the antennae itself is 75% to 80% smaller and lighter than other antennas. What this means is that you can install it in four to six hours. And you do not need a crane. This is of critical importance in terms of having a ship stuck in port and the extra cost of installation when a crane is needed, clearly an attractive option to shipping companies wanting to save money and time.

Partnership with ViaSat and Its Arclight Technology

A big part of the technological offering of the Tracphone v7 is the ArcLight technology supplied from ViaSat (NASDAQ: VSAT), an $800 million market cap company. VSAT is providing the modem technology, ArcLight. It is this technology that allows the antennae to be so small. The ArcLight utilizes a spread spectrum technology that also allows for the high speed of data from the Ku band satellite.

What is interesting is that ViaSat is interested in offering the KVH/ViaSat modem/antennae solution to the aeronautical industry. So, KVH focuses on marine and ViaSat focuses on air. There is a potential for fee revenue if ViaSat’s aeronautical market takes off. Further down the line, ViaSat wants to go after trains and even military applications such as mobile soldiers connected to the Internet. Their partnership is a validation of KVH and its technology.

The 100,000-ship market for the Tracphone v7 is quite large, at least 300 sold so far

KVH estimates that the potential market size for the Tracphone v7 is 100,000 ships. The size of the deep-sea shipping market is about 40,000 ships. The size of the workboat market is about 40,000 ships and the market for larger various craft is about 20,000 ships. Inmarsat is estimated to be on 40,000 ships.

Since the fourth quarter of 2007 launch of the product, I estimate that KVH has sold around 300 units and is on a current run rate of around $7 to $8 million in recurring Internet service sales. This is based upon management’s comments that the average customer pays $2000. Management will not disclose how many units they have sold, this is based upon my own internal research and it is somewhat verified by the service revenue number, which is where the Internet service revenue number falls. The number is $2.7 million in the latest quarter (Note that there are other random service contracts that cause some lumpiness, but going forward it will be very clear the direction this number is going).

So if the size of the market is 100,000 ships and the average customer pays $24,000 a year, you can start to imagine what the revenue of this company might be as they gain market share.

This is a Different Operating Model for KVH with Big Implications

Emphasizing the importance of changing business models, here is a paragraph straight from the 2008 annual report:

“The TracPhone V7 represents a different business model for KVH. Unlike our Inmarsat- compatible products, where we purchase airtime from a distributor and resell it to our customers, we are the source of the mini-VSAT Broadband service. As a result, we generate revenue from hardware sales as well as recurring monthly revenue derived from subscription packages. We offer both fixed- rate subscription packages ranging from $995 to $6,000 per month and per- megabyte service plans that we believe can be significantly more affordable than competing legacy VSAT and Inmarsat offerings in many instances.”

KVH will now be getting a recurring revenue stream. How big could this stream be? Below are some estimates based upon different scenarios. “$ per ship” is an annual number based upon the company’s average customer spending $2000 per month.

$ per ship    # of ships    Total Revenue    Op. Margin    Op. Income    Per share
 $24,000     1000     $24,000,000     10%     $2,400,000      $0.17
 $24,000     2500     $60,000,000     15%     $9,000,000      $0.64
 $24,000     5000     $120,000,000     20%     $24,000,000      $1.71
 $24,000     10000     $240,000,000     25%     $60,000,000      $4.29

They have already sold around 300, I definitely think that 1000 is a conservative number and also think that KVH getting 5% of the total market considering the advantages of their offering is doable long term. Mind you this doesn’t consider the dollar amount received when KVH actually sells the antennae, which costs $33,000 and is around $24,000 wholesale to KVH.

With so many benefits, why has the company only sold 300 units in 18 months?

An important question to ask is, “If the product saves you so much money and offers higher Internet speeds why they haven’t they sold more of them?”

First, the company just launched this product in the fourth quarter of 2007. The antennae costs $33,000 and the Internet service cost is upwards of $5,000 a month for the top level of service. This isn’t cheap and isn’t a decision that happens overnight.

Second, the company has been signing up distributors to help sell the product including MacKay Communications and Thrane and Thrane. While the company is selling product itself, to really get traction in the industry it needs to get the sales force of distributors out there selling. Thrane and Thrane just signed up in the first quarter of this year. From my discussions with about a dozen distributors, they are very excited about the product, its potential and its future, with many confirming sales, orders and sales quotes outstanding.

Third, shipping companies have been crushed in the last nine months with the economic crisis. Executives of these companies have not exactly been interested in spending money on capital expenditures when survival is in question, even if the product does save money. As the economy stabilizes this should be less of an issue. Also, KVH has recently started offering a leasing option. This should be an attractive option for customers that have been reluctant to shell out desperately needed cash upfront.

Fourth and more importantly, KVH does not offer global coverage yet. They have slowly been adding geographies. In the first quarter for example, they added the Persian Gulf. KVH plans to offer full global coverage of shipping lanes by the end of the year. This will be an important event, because I believe that several customers are awaiting KVH to offer global coverage before going forward with purchase orders.

Coast Guard and Thrane and Thrane seal of approval

The company has seen some impressive big wins since launching their Tracphone v7. They have had sales to the Coast Guard and the Navy. These government orders are quite important because their approval means a lot due to the intense research, long cycle of qualifying and product verification process.

Equally important is that Thrane and Thrane, the single biggest supplier of antennas in the world, chose to private label KVH’s Tracphone v7 as its own branded “Sailor 700” product in February of this year. What makes this so remarkable is that Thrane and Thrane was working and planning on developing their own product and abandoned those efforts and went with KVH instead. This action speaks volumes to us. And once the full marketing force of Thrane and Thrane gets going, sales should go markedly higher for KVH.

Fiber Optic Gyroscope and Automated Weapons Systems

A gyroscope is used for measuring or maintaining orientation. Gyroscopes help stabilize, guide and point objects by measuring orientation. This can be especially important for moving objects and vehicles. A fiber optic gyroscope (FOG) measures incredibly fast (hundreds of times a second). Further, an FOG has virtually no moving parts, so it is considered the most reliable gyroscope.

KVH’s fiber optic gyroscopes are used primarily in military applications such as automated weapons systems. Humvees, tanks and other military vehicles have guns on top of a turret that soldiers operate. Many soldiers in Iraq and Afghanistan have died or been injured because of sniper fire or explosive devices while being in the turret and exposed to enemy fire. These new automated weapons systems allow the soldiers to remotely operate the weapons from the safety of inside the vehicle. The only way to allow that is to use FOGs that stabilize and instantaneously aim the guns no matter what the movement of the vehicle or the gun.

KVH is a supplier to European defense company, Kongsberg, which has a contract to provide 6,500 of these automated weapons systems to the U.S. military. The CROWS (Common Remotely Operated Weapon System) is a line item in the defense budget. There was $235 million in the budget for 2010 and another $100 million in supplemental spending. The military is rolling this out aggressively.

Each of these automated weapon systems use three gyroscopes, and each gyroscope costs $3,000 a pop. KVH has announced several large orders for FOGs including a $2.9 million order in April of this year, a $3.5 million order in December and $8 million in two orders last year just from Kongsberg.

Automated Weapons Systems didn’t exist three or four years ago. That is why this business is exploding for KVH, surging 95% in the first quarter, this after a 70% increase in the fourth quarter of 2008.

Fiber Optic Gyroscopes Could Offer Just as Much Potential as the Tracphone

Management firmly believes that the opportunity for FOGs is just as big if not larger than the market for the Tracphone. KVH has a large order for the MK54 torpedo program with the US Navy. Each FOG for a torpedo costs $25,000. This is a multi-million dollar contract.

KVH has a partnership with Novatel Inc., a provider of GPS equipment that combines GPS with FOGs. GPS alone doesn’t account for altitude. Imagine if for a second your car could fly, your GPS couldn’t tell you how high you were, just where you were. KVH has started to marry a device that includes GPS and a FOG, something that is used in autonomous vehicles, surveying and seaport management. Orders are starting to pile in and they have announced over $2 million in orders for this product, the CNS-5000.

Other applications for FOGs include stabilized cameras for helicopters and drones. Think of the news and movie cameras that could use a camera that was stabilized for high speeds and pinpoint accuracy.

Oil & Gas Exploration is a possibility to pinpoint accurately, drill or find oil. Robotics is a potential as FOGs can stabilize robots. Mapping is another big potential. FOGs could make mapping and something like Google maps much more accurate. Undersea exploration is yet another possibility. This is very new and very exciting technology. I expect to hear a lot more from KVH about future wins.

RV and Leisure Marine Won’t Disguise the Tracphone and FOG Growth For Long

In the second half of 2008 and in the first quarter of 2009, the implosion of the legacy businesses have disguised the growth of the Tracphone and the FOG business. But I believe that the nadir of this was in the first quarter. Management has already guided that the second quarter’s revenue will be higher than the first quarter. The question is how fast do the new businesses ramp up. I estimate this year will be the transition year financially.

The company should basically breakeven for the rest of the year excluding the first quarter’s results of a big loss. They should end the year with around $40 million in cash and no debt and head into 2010 with a head of steam.

There are two analysts whom expect sales of about $83 million in revenue and a loss of around $0.20 per share this year (The company lost $0.18 per share in q1). Next year, they estimate sales will increase to over $100 million and the company will post a profit of $0.32 per share.

2010 will be the breakout year and as investors start to see evidence of growth and momentum, the valuation should start to change. As I mention in the estimate box above, this is a company that in three to five years could easily earn $2 to $3 a share. This seems inexpensive for a company that trades for less than $4 per share excluding cash.

Risks

As many of us have learned in the past year, there are many things that can go wrong with an investment. Here are some of the risks I see to this investment.

First, the economy could tank again, along with global shipping. This would cause spending to slow or stop for new equipment and could delay the promise of the Tracphone. Second, the market and sell-through for KVH may take a whole lot longer than I expect. Third, the company’s plan to have “global” coverage done by year-end may be delayed or experience problems. Fourth, KVH’s technological lead may shrink and unforeseen competition may arise. Fifth, the company may experience cost problems in providing Internet service.

Finally, the market may just not care for a while. It may take longer than I expect for the company to get a decent valuation and the stock market’s environment for small and microcap companies may continue to be very poor.

Summary

The opportunity with KVH is to catch a company in the midst of a broad technological and operating model change. The question is how fast is it going to come. I think the low valuation of around book value and a huge cash balance sheet protect you and compensate you for what could be a company that goes up five or ten times in the next three to five years. If you believe that KVH will grab market share for the Tracphone v7, then it has to be worth more than its current share price. If somehow they grabbed 10% of the shipping market, the company would have an annual earnings stream equal to its share price, excluding cash. And this doesn’t even consider the enormous potential of the FOG business.

Catalyst

-continued evidence of Tracphone v7 sales success

-Fiber optic gyroscope sales wins

-new analyst coverage

-completion of global coverage for Tracphone service

-explosion in growth in 2010