Description

Remec is a 12-18 month story that offers nice upside with what I believe to be limited downside. The stock was written up in mid-‘05 by Sparky during the sale of its core business line(s) and I would encourage you to read the excellent write-up. The story has changed as the business lines have been sold, distributions have been made, and the company is now essentially a shell with cash, modest other assets, and some liabilities related to a couple of lawsuits and potential tax items. Complete liquidation and return of all capital is now the stated goal of the entity. Management is essentially an attorney and an accountant who appear to have been very conservative in terms of guidance and reserve accruals, and there is no reason to believe that fact has changed. NAV has gone up in each of the last two quarters. With a stated NAV of $1.82 per share, I believe there is enough cushion to provide for nice risk adjusted returns.

Below is a summary of the current litigation and my summary for each:

Cardinal Litigation: Based on my reading, this situation has very low likelihood of an adverse event for Remec. My understanding is that Remec acted as a contract manufacturer of circuit boards for Cardinal. Certain elements of the circuit board were faulty and Cardinal sued Remec, Tyco and Thomas & Betts. Tyco and Thomas & Betts were the manufacturers of the primary inputs into the circuit board. Cardinal has argued that the product was faulty due to defects in the inputs to the product (nothing to do with the manufacturing process). As a result, it appears Remec did its job, manufactured the product well, and was lumped into the lawsuit because it touched the product. The initial court ruling dismissed the case against Remec prior to the trial. Tyco and Thomas & Betts were found liable and have to pay $16 million. If Remec were ever to be found liable, it would be logical that they could sue Tyco and Thomas & Betts for their liability, as they had nothing to do with manufacturing the inputs to the circuit board. The matter is in appeal.

Likely Liability: $0-$2 Million

Ex-Management Medical Benefits: A couple of ex-employees (I believe they sold a business to Remec) are arguing that they (and family) are entitled to lifetime medical benefits. They put the value of this benefit in current dollar terms at $11 million. Remec is arguing that the contracts do not allow for this benefit if the company is to be liquidated. They also are arguing that the assumptions used by the ex-employees to get to $11 million are egregious. The matter is going to binding arbitration at some point in the next few months. In attempting to come up with a potential liability, it is necessary to consider how the arbitrator will look at assumptions on replacement coverage and future medical costs. I have looked at two scenarios, one with fairly conservative assumptions, the other with a more realistic scenario. I have talked to a medical insurance broker who gave me some pretty good insight. His perspective is that $1,000 per month will give a family a very nice medical/dental/vision policy. A modest uptick for no longer being a part of a group would be necessary here. Additionally, Medicare will kick in for these individuals eventually, substantially reducing cost, and the children will not be on the plan forever. In order to calculate a range and stay conservative, I have looked at a 25-year discount period, with the kids on the plan the entire time, $15,000 per year per family, and no adjustment for Medicare. The analysis is very sensitive to inflation. Kaiser recently came out with a very detailed study showing an estimate of 9-10% future inflation in the cost of medical coverage. I have taken two estimates – one with an inflation rate of 10% per year and another with an estimate of 17% per year. The 10% per annum scenario yields a cost estimate of $1.3 million, the 17% scenario a cost estimate of $3.5 million. Each of these scenarios uses a discount rate of 5%.

Likely Liability: $1-$3.5 Million

Powerwave Liability: This liability is the only one that requires a bit of a leap of faith on the part of investors, in my opinion. Remec has reserved $9.3 million in purchase price adjustment payments and indemnification costs. Powerwave has attempted to assert a right to the full $15 million for which it is indemnified, along with an additional $2 million. Based on history, it is likely that Remec has taken a moderately conservative accrual on its estimate of liability. The most recent Q states:

“On May 17, 2006, in connection with the Asset Purchase Agreement dated March 13, 2005, and amended on July 11, 2005 by and among Powerwave Technologies, Inc. (“Powerwave”) and REMEC, Inc. (“REMEC”) and the related Escrow Agreement dated as of September 2, 2005 by and among Powerwave, REMEC and Greater Bay Trust Company (the “Escrow Agent”), REMEC received from Powerwave a copy of a certificate, submitted to the Escrow Agent on May 12, 2006, certifying indemnification claims potentially in excess of the escrow funds ($15.0 million) by Powerwave against REMEC, together with instructions not to release the escrow funds on the release date of June 2, 2006. REMEC is attempting to resolve these claims informally. “

It is interesting to me that they include this last sentence. It implies that there is a current negotiation going on between REMC and PWAV. Based on the level of conservatism that has gone into previous accruals, it would not surprise me if the $9.3 million is based on a middle ground between REMC’s offer(s) and PWAV’s ask(s). Considering that this is the biggest overhang still on the stock, it strikes me that investors are not properly considering the past history of management’s accruals and the language in the public documents that suggests a discussion is ongoing that would result in exposure well below the additional $7.5 million that Powerwave has asked.

Likely Liability: -$2 Million (less than accrual) - $5 Million

Additional Accrual Reversals?

In addition to the current NAV compared to potential liabilities, one must consider the likelihood that management has over-reserved for other items on the balance sheet. The two most significant areas of reserves outside of the aforementioned matters include tax exposure (reserve of about $7 million) and costs in liquidation (about $4 million). The tax reserve is likely a reserve in case there are any future disagreements with tax authorities. Based on history, I feel one must consider this a pretty soft accrual, i.e. it may come back onto the balance sheet. This could conceivably go the other direction and actually be a net negative down the line. However, given the history of these guys I doubt that. Additionally, considering the substantial cash reserves still held by the entity, the interest income ($2.5-$3.5 million per annum) will probably pay much of the expenses in liquidation and help with any severance. There also may be other items I’m not considering that have been handled very conservatively.

Potential Positive Adjustment: $0-$10 Million

    Valuation

    Below is my analysis of potential likely outcomes. This is not an extreme worst case, although I think it’s somewhat close. On the downside, I have assumed additional accruals of $7 million beyond the current balance sheet which I viewed as a catch all for anything else that might come out of the woodwork on the expense side. However, one risk here is that a big liability comes out that is unforeseen by management to this point.

Considering that most of these issues are to be resolved in the next twelve to eighteen months, and the history of this situation, I think a likely outcome range of down 8% versus up 62% is attractive.

Catalyst