Description

INVESTMENT THESIS      

Plantronics, Inc. (“PLT” or the “Company”) is a telephone headset and communication software provider that recently acquired peer Polycom from PE sponsor Siris Capital. We believe this transaction was a desperate response to stave off negative industry trends and presents an attractive short opportunity primarily due to the following reasons: 1) CSCO’s 2017 acquisition of BroadSoft disintermediates PLT and intensifies competition; 2) the merits of the Polycom merger are predicated on an acceleration in revenue growth despite flat-lining independently and ambitious cost savings yet PE sponsor already significantly cut costs and underinvested in the business; 3) the deal added nearly four turns of debt to the balance sheet; and 4) management has never done an acquisition before and has never operated with significant leverage. PLT is up 20% since the acquisition of Polycom was announced indicating that few appreciate these facts. The stock is presently GC and there is very limited sell-side coverage despite the $2.7B market cap. This is a pretty straightforward setup so we have intentionally kept the write-up brief.

BACKGROUND & TRANSACTION

Plantronics derives 70% of its revenue from headsets used in offices, call centers and on UC systems (unified communications) with the rest coming from consumer headset sales. The Company’s revenue declined 1% in 2016, grew less than 3% in 2016 and declined 3% in 2017 to $881M.

Polycom sells conferencing phones and hardware to enterprise customers (72% of revenue) and supporting services (28% of revenue). In mid-2016 Polycom was taken private by Siris Capital at a valuation of $2B or approximately 9.5x EBITDA. Siris went on to cut over $100M in operating expenses or approximately 20% of SG&A from the business. After owning it for just one and a half years Siris sold it to PLT last month for $2B (8.4x EBITDA). Polycom has been facing secular headwinds prior to the deal with revenue declining 11% in 2016 and grew less than 2% in 2017 to $1.1B.

INDUSTRY DYNAMICS

Although the UC market as a whole has been growing, both PLT and Polycom have stagnated as competition primarily from Logitech in video conferencing on the lower-end and Cisco on the higher-end have taken share. Competitive pressure from Cisco is now rapidly intensifying and hitting PLT/ Polycom on both sides of the business. Historically BroadSoft has been a major distribution partner for Polycom with its hardware having a 75% attach rate to BroadSoft’s software sales. Following Cisco’s acquisition of BroadSoft last year, however, the rationale for that strategic partnership no longer exists as Cisco has its own hardware. Primary research indicates Polycom is already losing distributors as a result. Presumably these developments drove Siris to punt Polycom when it did, taking over 80% of the consideration in cash. The excerpt from an industry blog below sums up the Polycom-BroadSoft-Cisco dynamic well.

Cisco and BroadSoft have always been recognized as expensive “brand name” companies, and this is unlikely to change. Cisco will use the merger to push hard on integrating BroadSoft’s products with Cisco products, so you can probably say “bye-bye” to using Yealink, Logitech and Polycom SIP phones with BroadSoft. Considering that about 75% of current BroadSoft lines currently use Polycom phones and that Polycom invested heavily in BroadSoft-specific integrations while ignoring smaller softswitch makers for some time, this could get interesting. We can predict that a couple of years from now, BroadSoft resellers will be selling primarily Cisco endpoints, and Cisco will practically be giving away free SIP devices to accelerate their own growth. (Source)

Further, Cisco recently released a line of headsets which directly compete against the higher-end Plantronics’ noise cancelling offering, a product that had historically been paired with Cisco’s phones. Other large players are entering this already highly competitive space as well. In June Microsoft announced its entrance into enterprise teleconferencing with a line of Windows Collaboration Displays as an extension of its Surface tablets. The combined Company’s competitive challenges are only magnified by the lack of investment Siris made in Polycom and the constraints on R&D spending its debt load places upon it. Meanwhile the entire industry is under secular pressure as web-based and smart phone-based teleconferencing has become increasingly the norm versus the large conference room format that requires +$25k in hardware.

Levered Balance Sheet & Unattainable Cost Savings: On a pro forma basis the Company now has a leverage ratio of approximately 4x. A business facing growth headwinds and led by a management team that has never integrated an acquisition nor operated a business with such leverage itself is a recipe for trouble, if not disaster for equity holders. PLT has guided to $75M in annual run-rate cost synergies within 12 months of the transaction closing. This equates to close to 4% of pro forma revenue and appears very ambitious particularly considering all the costs Sirus already stripped out of Polycom and the Company’s need to increase, not reduce, its investments in product development just to keep up. Management has provided no details regarding how it intends to achieve these results and in such a short time frame. Sell-side estimates have taken them at their word with consensus estimates assuming full realization of guided cost savings with revenue growth increasing at a mid-single digits rate over the next year.

VALUATION & CATALYSTS

The setup here bears similarities to a prior successful short, Computer Programs and Systems (CPSI). In that situation CPSI’s management team had also never done a deal before or operated with leverage yet took on a significant amount of debt to acquire a secular declining peer. In pretty short order they failed to realize the aggressive synergies they initially provided as the target’s prior PE-owner had already stripped the company down.

PLT is currently trading at 10x pro forma EBITDA. On an absolute basis this is a rich multiple for an old tech hardware business facing an eroding top-line, product obsolesce and increasing competition. Near-term earnings misses should result in PLT re-rating to below 8x EBITDA in-line with it purchase multiple of Polycom and that of its closest peer Avaya (AVYA) which is trading at 6.8x EBITDA. This represents a 40-50% return on the short.

In the medium-term, there is a decent probability PLT follows the path that befell Avaya which in early 2017 was forced into bankruptcy due to an unmanageable debt load. Under such a scenario the value of PLT’s equity would be wiped out.

ACCOUNTING RED FLAGS& OTHER CONSIDERATIONS   

• For seven consecutive quarters, inventory has been growing well ahead of revenue. In each of the last four quarters inventory has grown in the high teens while revenue growth has been flat. This could suggest inventory obsolescence and potential write-offs to come.
• Similarly A/R has also grown well ahead of revenue for seven consecutive quarters, suggesting aggressive recognition/ pulling forward of sales.

RISKS  

• Cisco missteps and potential slower adoption of BroadSoft customers.
• New sell-side initiations promoting the story.

Catalyst

1) Missed cost savings guidance

2) Earnings shortfalls as secular headwinds and competitive pressure further manifest themselves

3) Dividend cuts