Description

All amounts in Canadian (unless otherwise stated).

I admit that the number of world-class companies in Canada may be arguably counted on one hand. Occasionally, though, there is a diamond in the vast Canadian rough that can produce a decent return.

After many years of heavy losses, a tiny company called Memex (OEE.V, $0.035) caught our attention as it approached profitability in the recent September quarter.

Memex arguably has the three main traits we look for in microcaps: good business (based on its solid market position), high insider ownership, and significant potential upside over the next 3-5 years.

First, good business. The company appears to have a decent offering in the competitive IIoT space. Memex monitors the productivity of machine tools in a manufacturing setting. Customers are often manufacturers in the automotive or aerospace sectors. In particular, the Memex platform works for Mazak and Okuma, the two leading vendors of machine tools.  

Second, high insider ownership. Insider ownership is 14% with CEO David McPhail owning 12%. David brought the company out of receivership in 2007 and has been CEO since 2008. David claims insider ownership is above 20% including friends/family. The former CTO (resigned in late 2016) apparently still has 4 m shares. As background, we like to see at least 20% insider ownership on our microcap positions.

Third, significant potential upside. The current valuation, at around 1x annualized sales (net of cash), looks compelling if the company can continue to grow and reach sustained profitability. Industry timing also appears to be good: Memex’s solution falls into the category of IIoT, which may be starting to rise out of the “Trough of Disillusionment” of the Hype Cycle.

BACKGROUND ON COMPANY’S SOLUTION, “MERLIN”

Founded in 1992 and based in Toronto, Memex offers MERLIN, an IIoT “shop-floor-to-top-floor-communications platform” that provides manufacturing analytics in real-time. In particular, the platform tracks OEE, which stands for “Overall Equipment Effectiveness”, for machine tools. Yes, “OEE” is also proudly the company’s stock ticker: “OEE” on the TSX-Venture Exchange. OEE (a productivity score on scale of 0-100%) is calculated as the result of: Availability x Quality x Performance. The “big six” losses in Availability are maintenance, setup, downtime, small stops, speed loss and productivity time. Quality and Performance are also scored as a percentage. For a typical manufacturer’s machine tools, OEE is 40%. World-class productivity for a manufacturing company’s OEE is seen as 85% or better. 

In their presentation, Memex stresses that customers achieve “average payback in less than 4 months, a 300+% IRR”. I haven’t been able to verify this claim, but anything remotely close to that metric is very impressive for IoT. A shared case study (there are 8 eight case studies on the corporate website) is Magellan Aerospace, which experienced an improvement in OEE from 35% to 85%. That resulted in a savings of $30k a month ($360k a year), against the initial price of $20k for 3 machines.

Overall, Memex has 150+ customers and 200+ installations. Memex strives to book 10-15 installations a quarter, which some installations starting at only 2-3 machines. Customers are roughly split between 35% North America, 30% Europe and 30% Asia/RW.

Memex “partners” with Japanese companies Mazak and Okuma (globally #1 and #2 in machine tools), plus many other large manufacturing equipment OEMs. Mazak is a Merlin reseller (gets 5-15% commission) and has about 400 sales people. Okuma has about 300 sales people. While most customers would likely settle with the already-included IoT functions in the Mazak and Okuma machines, purportedly Mazak U.S. does not use Mazak Japan IoT’s solution.

Memex is also increasingly working to integrate better with ERP vendors, which it cited a couple weeks ago as the reason for several recent customer wins.

BUSINESS MODEL

Effectively, Merlin adds a web server to the tool machine. Connectivity hardware connects the tool machine to the Merlin software platform.  The Merlin platform provides an operator portal (with dashboard, analytics, etc.) and connects to the company’s ERP system.

A typical installation is $150,000 one-time for 30 machines. Each machine is hooked up (with both hardware and software) at a price of $1,700 (cost is around $400). The full installation price includes install labor (typically $3k) and configuration labor (another $3k). Then, there is 15-18% recurring revenue. Over time, that recurring revenue may grow as the company may move more to a SaaS model over the next five years (unclear but the CEO hinted at it when I met with him in April of 2018). 

Memex sees 5 steps to customer success: connect all machines, visualize (dashboards, reports), analyze (with historical reports), optimize (“use the software as an AI virtual lean consultant”), and monetize (through continuous improvement).

There are 65 million manufacturing machines globally, with an average age of 15 years. That’s a massive market opportunity.

RECENT FINANCIALS

While the company had revenue of only $2.85 m and a loss of -$2.2 m for FY18 (Sept.), 4QF18 (Sept.) results were strong, which caught our interest. In the quarter, revenue was $1.08 m (a company record) and cash consumed was only -$22k. Perhaps most impressive, gross margin for the quarter was 81.9%, up from 66.4% in the prior year’s fourth quarter.

Bookings for FY18 were $2.75 m, and bookings for 1Q19 were $1.0 m, another record. As background, Bookings = Revenue + Ending backlog - Beginning backlog + or - Changes in unearned service & maintenance fees. Memex argues that there is a $30 m sales potential (10 times last year’s sales!)  just from fully installing its system in its current customer base.

It appears that the Memex is making staffing improvements. A few years ago, the company reduced sales reps from 10 to 6, which later resulted in sales falling from $2.9 m in F16 to $2.0 m in F17. Now, despite the reduced sales reps, sales have jumped back above that F16 level. Total staff is around 35, including 6 sales reps, 6 in customer support, 6 in engineering, 3 marketing/sales, 3 admin, 3 product fulfillment (testing, shipping) and 4 in management.

SIGNIFICANT UPSIDE POTENTIAL

The company has 136 m shares excluding the significantly out-of-the-money warrants and options. The company has a very small net cash position of $0.4 m.

The upside potential is if the company can more than double sales over the next few years to $7 m. With 75% GM (up from 70% in F18) and modest creep in OPEX to $4.5 m from $4.1 m in F18, that would yield EBIT of $0.70 m, and EPS (untaxed) of $0.006. That implies a PE of only 6 on today’s $0.035 stock. 15-20x for a growing company in IIoT would yield a $0.08 to $0.11 stock, up 139-218% from here.

COMPETITIVE RISK

The biggest risk is competition. Anecdotally, I have read in industry literature that there are about ~400 companies making various IoT gateways. It’s a hyper-competitive space and arguably in the “Trough of Disillusionment” of the Hype Cycle. Competitors include SAP’s MII, GE’s Plant Applications, Rockwell Automation’s RSView and Apriso’s FlexNet. Other competitors include System Insights’ Vimana and Sysco’s PlantStar. A private competitor is MachineMetrics (recently raised $11.3 m in a Series A). Without visiting tens of manufacturing companies, it’s hard to fully assess the competitive dynamics.

EXECUTION RISK

The smaller the company, the more you are betting on management and the more the investment is art, not science. I could cut and paste a bunch of charts and company financials, but the bottom line is the investment is a bet on management to figure out how to continue to grow sales. The CEO David is, shall we say, a hefty man. I frankly don’t know if he/team will be able to execute on the growth plan. The “killer” CEOs I have been lucky to spend time with are generally wiry guys with boundless energy, smarts and determination. Moreover, if the company doesn’t get to operating profitability shortly, debt or further equity raises are likely.

Catalyst

Operating profitability finally reached

Potential sales growth over next 3 years could result in 2-3x appreciation in stock

Share repurchase with excess cash flow

Acquisition candidate