Liquidity Services' stock is down about 65% since mid-2012. In a stock market like today's, this fact alone gets my attention. Admittedly, the price action would indicate a struggling or severely damaged company. However, I don't believe that is the case at all for Liquidity.

Once a high-flying growth story that was clearly loved by investors, the company's slowing growth over the past year - still within a still-positive secular industry story and now cheaply priced at about 11 times earnings - presents a strong value opportunity in an increasingly thin market.

Liquidity Services operates online auctions for what's known as "surplus and salvage assets". Essentially, they specialize in the other end of the supply chain - helping government agencies, municipalities, manufacturers and retailers efficiently dispose of both product returns and excess supplies. They refer to themselves as specialists in optimizing the "reverse supply chain" for their clients.

They have multiple channel specific websites that serve millions of buyers and thousands of sellers. They have amassed about 2.5 million buyers onto their collective marketplaces participating in over 500,000 online transactions last year. Their buyer count grew by about 10% in FY 2013. This naturally creates a positive network effect which positively affects the value of their online marketplaces for both the seller and buyer side of the transaction.
A little bit of background may help to set up the stock's current challenge.

Liquidity Services got its start in 1999 and in 2001 their business was launched with the addition of one major customer, the Department of Defense (DoD). This still important relationship covers two areas of service under two separate DoD contracts.

In 2001 they were awarded the exclusive contract to handle the liquidation of the DoD's surplus supplies, "such as computers, electronics, office supplies, equipment, aircraft parts, clothing and textiles".

Then in 2005 they were further awarded the exclusive contract to sell what's known as scrap materials for the DoD, such as "base materials and scrap metals like ferrous and non-ferrous metals, nickel alloy, electronic scrap, rubber, paper and in rare occasions, compost, cooking grease, and recycled asphalt". Of this, basically 70% of this scrap is aluminum and steel and is subject to commodity price volatility. This fact used to more important and injected some volatility into their earnings.

These DoD contracts used to represent the vast majority of their operations. Today, the DoD contracts now represent about 40% of their revenue for FY 2013 and about 22% of total gross merchandise value (GMV) sold through their online auction marketplaces. Given this still important size, a great deal of investor focus has been placed on the renewal process and future financial terms of the two DoD contracts.

Very recently the "Scrap" contract, which was set expire in June 2014, was renewed for its third one-year renewal term at the option of the DoD. Therefore, the smaller of the two DoD contracts will now next expire in June 2015. The stock reacted reasonably well to this news.

The bigger and important "Surplus" contract is set to expire soon in February 2014. The DoD's bid process has been put on hold in the midst of DC's ongoing political issues. I feel comfortable that another one year renewal/extension is very likely.

The main reason for my comfort regarding the Surplus contract extension is Liquidity's embedded relationship within the DoDs facilities and process. Liquidity employees are physically integrated within the DoDs facilities and have proven themselves to be highly proficient in working within the specialized compliance requirements imposed by the DoD. One cited example of this compliance process relates to having to reject an asset/item for auction, such as a sewing machine, simply due to its tangential involvement in the manufacturing of the F-16 (I believe that was the plane). A single compliance slip up can cause major issues and the DoD has worked with Liquidity for over 12 years with apparently high satisfaction levels. All items, of all sizes, are barcoded, inventoried and vetted for eventual auction from a compliance standpoint.

Replicating this process with a new vendor - where Liquidity is the long established vendor of scale with 12 years proven experience and already successfully renewed twice before - is unlikely, in my view.

Clearly, I think the eventual renewal is a short term catalyst for the stock, judging from the reaction of the recent DoD Scrap contact renewal.
Now, despite the importance of the two contracts, Liquidity has and will continue to diversify beyond the DoD. Judging from their acquisition history over the past few years, this has clearly been an ongoing strategy of management.

Beyond the DoD business, Liquidity has a big commercial/retail segment which serves about 600 companies. Unsurprisingly Wal-Mart is their largest commercial reverse supply chain client. This relationship came with their Jacob's Trading acquisition in 2011. Wal-Mart, with a contract that lasts through May 2016, represents about 10% of its gross merchandise value (GMV) - a measure that's different than Liquidity's revenue, of course - sold through its auction marketplaces for 2013. Overall, their commercial segment represents about 60% of their overall GMV sold on their online marketplaces.
The recent decline in Liquidity's growth has been affected by an important silo within their commercial/retail business - including within their Wal-Mart business. Surplus and returned consumer electronics represents about 35% of all retail gross market value (GMV) on their retail auction marketplaces. With the slowdown in PC sales and disappointing TV sales and innovation, this important segment has declined recently and has put downward pressure on their entire commercial/retail business. Management indicated on the last call that a turn for the better is slowly underway. It's still been a drag on growth for Liquidity.

Increasingly, Liquidity is targeting more complex, stickier and more lucrative international business. This was a major focal point of the last conference call and within the last year Liquidity has truly moved into the global marketplace. While this carries clear execution risks and admittedly lengthens the sale process, this global capability focus separates Liquidity Services from their many smaller competitors. They are developing their capabilities to handle complex and grow their credibility with major a Fortune 1000 companies. Success in this strategic initiate may spur another growth spurt and may get investors more excited once again.

Finally, rounding out their other business segments, another smaller but fast growing business is their small government focus via their GovDeals.com marketplace. This segment serves the reverse supply chain needs of cities, counties, state agencies as well as school systems and local utilities. This business segment now represents about 16% of Liquidity's total GMV on their auction marketplaces and it grew last year at about 17% in 2013. From the perspective of future growth potential, they currently have only a small fraction of all small goverment entity business and see this a fertile ground for growth.

Liquidity has historically grown very quickly - yet, in a lumpy fashion. They've made a number of acquisitions over the last 24 months to consolidate a fragmented industry. They may be the only true global player focused on optimizing the reverse supply chain. And, based on the total gross market value of items available to be liquidated in the reverse supply chain, Liquidity has very small share. There is a lot of room to grow despite their slowdown recently.

Their stated 4-5 year goal is to grow their gross market value on their market place from FY 2013's $975 million to $2 billion. We'll see, but if this is near accurate, they'll make a lot more money than they do today. They have more than doubled their revenue since FY 2009.
Liquidity Services' stock is currently trading for about $22 per share and has about $3 per share cash with no debt. They expect to report adjusted EPS of about $1.60 to $1.75 per share for FY 2014 that ends next September.

However, a few adjustments should be made to this adjusted EPS figure.

First, about $0.30 per share should be subtracted to account for non-cash stock based compensation. On the plus side, I would also add back about $0.30 per share after accounting for their excess D&A over their actual capex needs.

So, with these two adjustments, their true EPS really is about the same as their adjusted EPS of around $1.75 per share. Net of their cash balance, the Liquidity's P/E is about 11 times next year's reduced guidance. This guidance may turn out to be conservative for FY 2014.

On a cash flow basis, they produced about $105 million in "adjusted EBITDA" in FY 2013. After taxes of about $25 million and using about $7 million for normal capex needs. This works out to around $70 million on a current 33 million fully-diluted shares outstanding, safely over $2 per share.

They ended FY 2013 with over $90 million in cash and they have bought back shares and have the authorization in place to buy more. As they have, I believe they really should focus on funding their business expansion. Nonetheless, I see this excess cash balance as a form of downside protection if the stock falls much more. Having fallen from over $65 in mid-2012 to $45, then to $35 and now to about $22, I think they'll eventually may decide to support their stock. Frankly, if their secular growth prospects are real, their disclipline in acquiring a more solid competitive position in this industry is far superior. In other words, the stock price will probably just take care of itself.

I have not spoken to management, but my interpretation of the way they communicate with analysts on calls is they are quite strong, vested and focused on the right things. The current CEO is a co-founder of the company and owns a substantial amount of the shars. I was pleasantly struck by their own and the analysts lack of focus on the stock price and typical analyst "financial model building" questions on their calls. Having a business strategy focus is generally good sign, in my view.

I think at 11x reduced earnings and a discount of 65% from its high-flier stock price, today's investors in Liquidity Services' stock are getting a really good risk-adjusted opportunity with real growth potential.