Research Frontiers REFR
September 12, 2003 - 5:04pm EST by
eagle866
2003 2004
Price: 13.80 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 173 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

Summary & Background
REFR is a $172m market company with negligible balance sheet value and non-existent earnings power value. It produces nothing, except press releases which for over a decade have hyped the stock by talking about upcoming product introductions & impending riches. REFR has been a public company for 38 years working on commercializing a technology developed by Polaroid founder Edwin Land in the 1930’s. This technology is called “suspended particle devices” (SPD), which is basically microscopic particles suspended in a film between 2 sheets of glass. When a voltage is run through the film it affects the particles and allows the amount of light passing through to be controlled. For years REFR has talked about potential uses for SPD in products like “self-dimmable” car sunroofs & mirrors; windows & skylights of homes, buildings & aircraft; and sunglasses and goggles where you can control the amount of light coming in. Over the last 10 years REFR has never produced fee revenues exceeding $575,000 in a single year, and operating losses have aggregated $38.7m.

Key Valuation Statistics as of August 15, 2003:
Stock Price = $12.50
Enterprise Value = $151.5m
Price/TTM sales = 548.13
Price/Book = 27.6
Since it has never had any earnings, no earnings measures are relevant

Balance Sheet Value
As of the end of 2Q’2003, REFR’s balance sheet showed $5.6m in book value, of which $4.9m was cash. It has $183,000 of fixed assets. So, you can see that it has relatively little by way of tangible assets. It has no manufacturing capabilities, produces nothing, and relies on signing up licensees to use its technology to produce the basic SPD chemicals, the SPD encased film, and the end products (windows, mirrors, etc.). Other than this REFR has 27 US & 170 international patents, the value of which is highly questionable considering that SPD-based products have never generated significant revenues in over 70 years of attempts. Even if one assumed that every dollar REFR spent on R&D over the last 10 years were worth $1 of asset power today, that would still be only $17.1m (11% of its current market cap). What about other forms of intellectual capital? Of its 13 employees, 6 are technical; I’m not big on official designations, but of this 6, one is a physics undergrad, a chemistry graduate degree holder and two others are doctorates in Chemistry! And, oh, they have 3 MBA’s! Given their poor track record of no products being produced from their research, I think the market is highly overcapitalizing this brainpower ($26m/technical employee!). Actually, REFR’s biggest asset may well be its $15.2m NOL ($1.20/sh), but its value is highly uncertain considering the company has never made a cent.

Earnings Power
There are numerous negatives in this area for REFR. Over nearly four decades of trying, the company - notwithstanding its regular pronouncements of impending end products - has yet to commercialize SPD-based products in even a minor way. Hence while logic indicates there is no significant end demand for these products, history seems to confirm it. Even if there were end demand, it appears that it would be very low and that would imply even lower revenues for REFR (it earns royalty revenues of 5-10% of end product sales). Finally, even if there were minimal sales of SPD-based end products there is no reason to believe they would be profitable for the licensee or for REFR since there are numerous competing technologies to SPD – to name but a few; photochromic, electrochromic & liquid crystal devices.
In order to support its current $156m market cap, REFR would have to produce after-tax earnings of at least $11m. Given its average operating costs of $6.2m over the last 3 years, and assuming these were to rise to say $8-9m if this business were really successful, it would still need to generate $27m in revenues in order to simply produce $11m in after-tax earnings. So, a 5-10% royalty rate means that $270-540m of SPD end products would have to be sold annually. Pretty tough considering REFR “recorded a small amount of royalty income related to sales of licensed products” as part of its $86K of revenues in 1Q’2003.
Reading through REFR’s press releases on its web site, one notes that it spends a great deal of time talking up its license agreements with various companies, and given the number of announcements one would think that there are many licensees, but in fact not only do the bulk of REFR’s meager revenues come from minimum licensee fees, but 76% of them come from only 4 companies. One licensee which REFR has promoted endlessly is SPD Inc (a subsidiary of Hankuk Glass), which has supposedly built a huge manufacturing facility in Korea and is pumping out tonnes of product. Yet, the total equity investment of all partners in this company is a miniscule $8.2m. It’s hard to imagine this facility generating the kinds of sales numbers discussed above. In June 2001, two months after SPD announced it had acquired its facility, REFR’s CEO Robert Saxe made the following statement; “Based upon projected timetables and sales goals of Research Frontiers’ licensees for SPD film and end-products, the Company expects to earn royalties from sales of licensed products early next year, achieve its first quarterly profit next year, and achieve its first full-year of profit in 2003, but possibly in 2002. Thereafter profits are expected to escalate rapidly.” No such luck.

How does REFR finance itself?
REFR has a significant burn rate & even at the end of the most recent quarter it said that “based upon existing levels of expenditures it would not require additional funding for the next 16 months.” In fact, shareholders’ equity has declined from $14.7m at end of 2000 to $5.6m at end of 2Q’2003. But REFR has been able to continue operating through new equity issuances; however these were not done through the public markets, but rather through a strange put option they obtained from a London investment firm, Ailouros Ltd. Under this agreement REFR can put upto $1.5m of stock to Ailouros each quarter at an 8% discount to the market price. Over the last 3 years Ailouros has spent $20.6m buying 1.28m shares (10% of currently outstanding) from REFR, yet it does not ever show up as a 5% holder in the proxy, indicating that it has quickly turned around and sold the stock. Even more surprising than this form of financing is the fact that a company in such obvious need of capital would spend as much as it does on share buybacks – REFR has spent $13.8m repurchasing stock over the last 3 years, more than twice as much as it spent on R&D. It is interesting to contrast this point with management’s assertion in the latest 10-K that “the company has devoted most of the resources it has heretofore expended to research and development activities.” These buybacks are not so surprising, however, when one considers Ailouros’ motivations and the fact that in 2001 management’s bonus compensation was calculated as 1% of the increase in the company’s market capitalization!

Management
From an incentive standpoint, management is extremely well motivated, with 2.4m shares under option at an average of $12/sh. However this is also highly dilutive to existing shareholders since the exercise of these options would result in 20% new shares being issued. Management actually appears to be grossly overcompensated; in addition to the aforementioned generous option grants, over the last 2 years the top 2 guys, CEO Robert Saxe and President/COO Joseph Harary, received $1.45m in cash compensation. This was 4X total company revenues and represented 50% of total non-R&D expenses!!
While there have been numerous purchases of REFR stock by insiders in 2003, the aggregate dollar amount is not significant – $813,000; and over 80% was by a single board member, Victor Keen. Keen is a senior member in a law firm & I imagine it is not a significantly large amount for him. I am more impressed by insider purchases if they are large relative to the buyer’s wealth. More insightful maybe is that while the total number of shares & options held by directors and officers has held flat at 2.7m over the last 2 years, the number of shares directly owned has declined 25% to 690,000 shares (5.5% of shares outstanding).

Catalyst

None, other than significant overvaluation. In terms of caveats I’ll pinch a comment from VIC’s board on KKD; “Someone asked Buffett at his annual meeting this year why he doesn't short stocks. His reply: ‘there's no way to tell when the fever is going to end.’” The same applies here. Also, there is a 20% short interest in REFR. This kept me from shorting the stock for a while because I didn’t want to get caught in a short squeeze. So I held off recommending it till it had really bounced, and well the market obliged. REFR almost quadrupled from a little over $4 in March to $16 four months later. Volume surged, but the short interest has stayed flat. This looks like a better time to get in.
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