Description

Radyne Comstream (RADN) is a profitable technology company with no debt and lots of cash (28% of market cap). It has been buying back shares. Its valuation is reasonable, but doesn’t immediately scream bargain. Nonetheless, RADN is likely to have to have some sort of change of control or restructuring in 2005 due to the upcoming expiration of slightly out of the money warrants. Downside is fairly low if the change of control doesn’t occur.

RADN is a supplier of capital equipment for the satellite communications industry, and also provides equipment for Digital and High Definition TV (HDTV). Its products are used in applications for telephone, data, video and audio broadcast communications, private and corporate data networks, Internet applications, and digital television for cable and network broadcast. Customers are the television broadcast industry, international telecommunications companies, Internet service providers, private communications networks, network and cable television and the United States government. About half the customers are non-US. RADN has the #1 or #2 market share in their major segments, Satcom Modems and Earth Station products, TV and HDTV encoders, and Point to Point microwave modems. For what it’s worth, RADN expects these markets are expected to grow significantly in the next few years.

It is of course possible that these segments (especially HDTV) could suddenly become sexy. That hasn’t escaped my notice, but it’s not a Value argument, so I won’t discuss it further. The fact that RADN is a market leader in growing market segments does provide some margin of safety, however. Also, their markets are only now beginning to recover from a multiyear capex slowdown.

Until February, 2004, RADN was majority owned by Stetsys (a subsidiary of Singapore Technologies Pte Ltd) Stetsys sold their 9.7 million shares to few dozen other companies in a private placement. However RADN, at its current size, should not be a publicly owned company. Sarbanes-Oxley compliance alone costs almost 1% of revenues. RADN should either (a) get bigger quickly (which could well happen considering the markets it is in), (b) go private, or (c) be bought by another company. A fourth alternative is (d) declaring a large recurring dividend and then a special dividend or buyback financed by debt, (similar to what Reinhold recently did – posted twice on VIC, not by me unfortunately).

2.1 million Warrants with a strike price of $8.75 expire on Feb 7, 2005. These slightly out of the money warrants represent a potential dilution of 13% once the common goes above the strike, and have been depressing the stock price. Their expiration may be the catalyst which causes alternatives (b), (c), or (d) to happen.

Next year, reported earnings will show a tax accrual closer to normal (approx 37%). It looks to me like the NOL will run out in late 2005 - early 2006, and so will benefit cash flow until then.

Some numbers: EBITDA = $9.6 million (YTD annualized). Diluted shares = 16.9 million. Market Cap = $125 million. Net Cash= $35 million. EV= $90 million. EV/EBITDA=9.4. Reported 9 month earnings of $10.5 Million included a $4.1 million tax benefit from the reduction of the tax valuation allowance. Gross Margin = 52% and is expected to remain high for at least the next 2-3 quarters. Annualized Net Earnings (assuming 37% tax) = $5.5 million with a normalized Profit Margin = 10.3%. If you subtract $20 million of their cash as excess then normalized ROE = 18.5%. Depreciation and Amortization are slightly higher than Cap Ex.

Redesign of many of their products has improved margins. In addition, RADN has decided to refrain from bidding on low margin system integration jobs. While this has reduced sales, Gross Margin have greatly benefited with a 2004 YTD GM% of 52% vs 42% in first 9 months in 2003. So, while revenues for the first 9 months declined by 4%, Gross Profit increased by 18%.

Q3 was disappointing. Sales declined by 20% but Gross Margin remained high at 52%, up from 45%. The decline in sales appears to have been a blip caused by orders that came in early October, rather than late September. In October, management estimated 2004 revenues in the $54-$57 million range, which would mean $14-$17 million for Q4. The CEO said he expected a “great” Q4. Q4 results will probably be announced after the warrants expire. Bear in mind that management expectations recently have been overly optimistic.

Executive compensation is reasonable. There’s no disclosed related party transactions. The CEO is 68 years old, about the time a man starts thinking about retirement. The executive employment contracts have the usual change-of-control clauses. I’m not aware of any Poison Pills.

In August, RADN bought back 341k shares at an average price of $6.89. Management has been under pressure (publicly expressed in the July earnings conference call by their then biggest shareholder, Third Point) to consider a sale of the company to someone like Comtech or Andrews. According to Third Point, there have been rumors of interest by other companies. Management only owns about 2% of the shares. Wellington now appears to be their biggest shareholder with about 1.1 million shares. Management wants to use the excess cash for share buybacks and niche acquisitions, so there’s some tension there between management and at least one of the major shareholders. Still, it would be pretty foolish for the company right now to buy back enough shares to push the stock price above $8.75, causing the dilution from the warrants. The same would be true for any possible takeover attempt. This impediment will disappear in less than 2 months.

The warrants appear to be overpriced at $0.56, with an implied volatility of 85-90%, versus a historic volatility of closer to 50%. One possible strategy would be to short the warrants (depending on availability) and buy the common either to reduce the acquisition price or just as an arbitrage.

The major risks are an unwise acquisition and possible management reluctance to consider reasonable acquisition offers. I think the margin of safety is reasonable, however.

Catalyst

Expiration of slightly out of the money warrants, eliminating potential dilution, and increasing odds of a takeover, buyback, or other restructuring.