Description

ModusLink Global Solutions (MLNK)

We like to try to find investments with limited downside and lots of upside (doesn't everyone?).  We are especially focused on finding companies that could achieve sharp increases in valuation as the economy recovers.  We especially like small, off-the-radar, quirky little companies with no debt (preferably a big pile of excess cash), no cash burn, and no analyst coverage that almost no one cares about.  Call it venture capital investing in little public companies with low-risk balance sheets.  We think ModusLink Global Solutions (MLNK) could be such a company.  MLNK was presented at the most recent Value Congress in Los Angeles which we unfortunately were not able to attend.  However, of the ideas we heard were pitched there, this seems best suited to our investment approach.

MLNK is a leader in global supply chain business process management.  MLNK has about 45 million shares outstanding at $4.30 for a market value of about $194 million.  MLNK has no debt and $135 million of cash at 1/31/09 and, in addition, a portfolio of venture capital investments with a book value of about $30 million.  MLNK's enterprise value is about $30 million if you give them credit for their venture capital portfolio at book value.  This enterprise value seems very reasonable considering MLNK's LTM revenue is almost $1.1 billion and MLNK should be cash flow positive for fiscal 2009 even under current economic conditions.  In a better economy we can envision much stronger results for the company as purchases of the consumer products which are sold by its supply chain customers pick up resulting in higher volumes for MLNK.  In the meantime, the company seems to be successfully offsetting reduced sales volumes of core customers with sharply higher sales to new customers and incremental sales from two strategic acquisitions completed in fiscal 2008.  Furthermore, management undertook a massive cost reduction program in December 2008 which should save $20 million in fiscal 2009 and $40 million in fiscal 2010 due to sharp reductions in SG&A expense and improved gross margins due to lower indirect labor.  This cost program should really start to kick in with results in Q3 and Q4 of fiscal 2009 and it is quite large as compared to LTM adjusted EBITDA.

Finally, you are not paying very much for this call option on an economic recovery and rebound in MLNK's results and you have an extremely safe balance sheet while you wait for all this to happen.  On an LTM basis, adjusted EBITDA is approximately $29.5 million with capital expenditures of approximately $14 million expected for fiscal 2009.  While adjusted EBITDA could decline some more before stabilizing, you are currently only paying about 1x LTM adjusted EBITDA.  LTM revenues are $1.067 billion so MLNK is trading at about 3% of revenues.  There is also a very large NOL (roughly $800 million) which should shelter taxes if operating results rebound.  Net working capital per share was about $4.81 per share as of 1/31/09.  Overall, we think the downside is relatively limited and there could be very significant upside if things work out well.

MLNK provides critical processes for clients in the high technology and communications industries.  The services provided by the company are designed to optimize the supply chain by helping companies improve time to market, productivity, and customer satisfaction while reducing risk and costs.  The company's clients include hardware manufacturers, software publishers, storage and consumer electronics device manufacturers, telecommunications carriers, broadband and wireless service providers and other companies.  A significant portion of the customer base operates in the technology sector.  (We note that the NASDAQ is up sharply YTD in 2009).  MLNK was formerly CMGI and changed its name in September 2008 to recognize its complete focus on its supply chain business process outsourcing business.  In addition to its supply chain management operations, MLNK has a venture capital portfolio, @ventures, which had investments in 13 portfolio companies, of which four were not considered material, as of 7/31/08. 

MLNK's three pronged strategic plan for its supply chain business is:

a)  Drive sales growth through existing client penetration and targeting new vertical markets;

b)  Increase the value delivered to clients through service expansion; and

c)  Drive operational efficiencies throughout the organization.

We think MLNK's supply chain value proposition makes some sense.  The company has 30 plants in 13 countries and one of the largest footprints in world.  The company has significant facilities throughout the U.S., in Mexico, Europe, Japan, and China.  Some plants are located close to end customers and others are located in low cost countries where manufacturing and labor costs are most economical.  As the segment results below indicate, Asia is by far the most profitable region due to its low manufacturing costs.

 MLNK's revenue to existing customers is down due to depressed consumer spending on the end products sold by their supply chain customers.  But total revenue is down less due to incremental revenue from two acquisitions in fiscal 2008 and incremental revenue from new customers.  The company's ability to add new customers speaks to it value proposition.  The company had traditionally focused on the technology and software industry verticals but has added some additional industries.  MLNK is able to help customers reduce costs.  This is a major focus of companies in this revenue-challenged climate.  We think MLNK can continue to add incremental revenues from new business and that eventually volumes in its core business will recover.  We expect MLNK to struggle with revenues over the next few quarters due to the recession.  But we expect MLNK to achieve reasonable gross margins and sharply reduced SG&A expenses as the cost savings program kicks in.

Non GAAP operating income (or adjusted EBITDA)

MLNK's management reports non-GAAP operating income each quarter which is basically adjusted EBITDA, with non-cash charges and non-recurring charges added back, so it's a pretty good indicator of sustainable cash generation capability.  LTM non-GAAP operating income was $29.5 million through Q2.  Non-GAAP operating income was $46 million in fiscal 2008 and $44 million in fiscal 2007 (FYE 7/31).  While this number has dropped significantly during the past few quarters and could trend down a bit further, we think there are some counter-balancing factors which should help stabilize it (see Cost Reduction Program below). 

MLNK's management team, like so many others, is tightly managing the business for cash generation.  Q1 is a seasonal high in terms of working capital requirements.  We think MLNK's fiscal year-end cash position (FYE 7/31) will likely be higher than at 1/31/09 and during the Q2 conference call management stated they expected the fiscal year end cash position to be higher than at Q2. 

Capital expenditures for 6 months of fiscal 2009 were $6.5 million and management thinks they will roughly continue at this level for capital expenditures of $13 million to $14 million in fiscal 2009.

Cost reduction program

On the Q2 conference call management stated the effect of their cost reduction program would be to lower SG&A expense by 15% to 20% on an annualized basis and to help improve gross margins due to lower labor costs and facility costs.  The company expects to save $20 million in fiscal 2009 (net of about $15 million of restructuring expenses) and to save $40 million in fiscal 2010 with its cost reduction plan.  The cost reduction plan includes reducing headcount, shutting and restructuring facilities, and simplifying services offerings.

On the Q2 call, management said that of net savings of about $20 million for fiscal 2009 from the cost reduction program and that they expected to see about 2/3 of this benefit in Q3 and Q4.  They also reiterated that the $40 million of annualized benefit in fiscal 2010 would not come with restructuring costs (expected to be $15 million to $20 million in fiscal 2009).

Q3 results

MLNK's is going to report its Q3 results today after the close.  We believe the company will continue to struggle with revenues in the current climate and we expect base customer business to be down similar to levels in Q2.  But we also think that the company will begin to show the fuller impacts of its cost reduction program which should have a positive impact on gross margins and operating expenses.

Customer Concentration

MLNK has significant customer concentration with Hewlett Packard, Advanced Micro Devices, and SanDisk representing about 24%, 11%, and 10% respectively of fiscal 2008 revenues.  A shift in business by one of these major customers can have a large impact on revenues.  The customer base is becoming more diverse as there appears to be solid demand for MLNK's services but this is certainly one significant risk.

Acquisitions

The company made two acquisitions in fiscal 2008 which appear to be going well so far.  In March 2008 the company acquired Open Channel Solutions (OCS) for about $14 million in cash.  OCS provides solutions that manage entitlements for software licenses, maintenance and support subscriptions, hardware features, and rights content.  In May 2008 the company acquired PTS Electronics (PTS) for about $46 million.  PTS provides consumer-electronics service repair and reverse logistics services.  Both of these acquisitions represent the company's effort to enhance the value-added services it can provide to its customers and both acquisitions are providing incremental revenues in fiscal 2009 to date to partially offset revenue declines due to reduce core customer activity due to the economy.

Q2 and Q1 results and conference calls

The Company has also been able to add a substantial amount of new business revenues to help partially offset revenue declines with core customer business.  Q1 and Q2 revenue from new customers was up substantially over prior year and the company expects fiscal 2009 to be its strongest year ever for revenue generated from new customers.  The company has been aggressive in having its sales force focus on penetrating new vertical markets to supplement its traditional focus in the technology and software vertical markets.  The revenue base remains concentrated but is becoming more diversified.

Q2 net revenues were $260.5 million, down 6.3% vs. prior year.  Q2 gross margin was 12.4% vs. 14.0% prior year.  Q2 non-GAAP operating income was $12.4 million vs. $15.3 million prior year.  While global economic conditions continued to impact demand for clients' end products the company said it was aggressively executing its cost reduction plans announced in Dec 2008 to align capacity with unit volumes.  In Q2 while revenue from base business declined about $56 million or 21.8%, the acquisitions of OCS and PTS contributed about $15 million of revenue, and revenue from new client engagements more than doubled as compared to prior year.  New business revenue was $45 million in Q2 vs. $21 million prior year, up 106%.  Q2 revenue from new business was about flat with Q1.  The OCS and PTS acquisitions contributed about $15 million of revenue in Q2.

Q2 gross profit was $32.2 million vs. $38.9 million prior year with lower gross margin due to change in business mix, start up costs related to new engagements, and decreased capacity utilization due to lower volumes.

Excluding the non cash goodwill impairment charges, Q2 operating expenses declined $2.3 million or 7.5% vs. prior year despite the inclusion of $3.4 million of operating expenses from acquisitions of OCS and PTS which were not present in prior year results.  On an apples-to-apples basis, excluding OCS and PTS operating expenses, Q2 operating expense was lower by $5.1 million or 16.8% vs. prior year.

During Q1 revenue from base business declined about $32.5 million or 12.5% while revenue from acquisitions of OCS and PTS contributed $16.4 million of revenue and revenue from new business increased by $31 million or 246% vs. prior year.  So in Q1 revenue from acquisitions and new business were able to offset revenue declines in base business and total revenue grew 6.1% to $291 million vs. $275 million prior year.  However, in Q1 gross margin declined sharply to 9.6% vs. 14.2% prior year and gross profit dollars declined to about $28 million as compared to $39 million prior year.

We think the company's ability to sign up new business speaks positively to its value proposition to customers and its potential to offset reduced business with base customers due to the economy with incremental new business.  Also we note that gross margins improved nicely in Q2 which we think was at least partially due to some impact from the cost reduction program.  The key to MLNK's profitability going forward will be its ability to stabilize or increase gross margin dollars while concurrently reducing SG&A expense.  It seems that Q2 was a step in the right direction, although revenue from base business in Q2 was down even more than Q1.

While Q1 was a disaster, with non-GAAP operating income declining to $3.3 million vs. $17.1 million prior year, Q2 results showed improvement over Q1 as the company's cost reduction programs started to have an impact.  Q2 non-GAAP operating income was $12.4 million vs. $15.3 million prior year.  We are hopeful these cost programs will continue to positively impact Q3 and Q4 results and buffer depressed revenue from core customers.

Summary Financial Information:

Invest in Affiliates                                      $23               $21           $31            $35            $29

Below are some recent quarterly results:

• (1) Non GAAP operating income excludes charges related to depreciation, amortization of intangibles, stock-based compensation, restructuring, and non cash charges. The Company believes that its non-GAAP measure of operating income provides investors with a useful supplemental measure of the Company's operating performance by excluding the impact of non-cash charges and restructuring activities.

ModusLink's largest shareholders are as follows (shares in thousands):

Disclaimer

Disclaimer:  We own shares of MLNK.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst