Description
We believe that TCCO is dramatically overvalued and, to steal someone else's quote, "a stock only a trading robot could love." Just ask management.
This writeup is much more brief than our typical idea share. Based on our analysis, if TCCO's prospects continue to improve on last decade's trajectory the stock is worth 40% less. If TCCO's sales fall back to pre-2010 levels, as management has indicated they will, the stock is worth 65% less.
TCCO is a manufacturer of products that encrypt / de-encrypt information transmitted over a variety of communications mediums. TCCO sells their product to the military and foreign governments. Though it's a small company ($25m market cap) it trades a couple of $hundred thousand USD / day and short interest is currently very small.
2010 is shaping up to be a banner year for TCCO and earnings growth is no doubt hitting fundamental quant screens around the world. But when is a company's blow-out year bad for earnings? When it's a one-time event, causes management to ramp up spending as revenue declines significantly, and eats up all the company's NOL's resulting in weak subsequent earnings comps.
TCCO has been bumping along generating between $3.5 and $8.0m of revenue per year since FY04. On these revenues, TCCO generated an average of $0.37 EPS per annum including a couple of loss years. In FY10, TCCO received a large order for their ruggedized DSP 9000 encryption products in Afghanistan and generated over $20m of revenue during the year. In the FY10 (Sep) earnings release however, the CEO commented specifically that "while the continued business in Afghanistan is encouraging, [revenue] in fiscal 2011 is expected to return to the more modest levels achieved prior to 2010." In addition, backlog at the end of 2010 fell to $3.4m, a 56% decline though it did spring back a bit this far into 1Q11 according to management to be down only 25% y/y in Q1 after closing small follow-on orders for Afghanistan.
If revenue numbers went back to FY09 levels, it would seem to imply $0.58 EPS in 2011. However, there are three meaningful adjustments that need to be made to the '09 numbers.
- Management guided that increased R&D spending from 2010 would carry into 2011. TCCO spent $2.6m in R&D in 2010, $0.7m more than in '09. 2009's total EBIT was only $0.4m. This alone would bring '09 to an operating loss.
- More than 50% of '09 EPS was due to a non-cash reversal of the valuation allowance against NOLs. Business strength in 2010 ate through all of TCCO's NOL balance and so TCCO's 2011 earnings will be taxed, we estimate at a 30% rate.
- Basic and diluted shares outstanding have increased 26% and 15% respectively, weighing on subsequent comparisons.
With increased R&D spending, the absence of a tax shield and significant equity dilution, we believe that TCCO's 2011 earnings per share will actually be closer to $0.02 vs. the $0.58 reported in 2009 and the $4.33 per share generated in 2010. That's a 99.6% y/y decline in EPS from 2010. We model sales of $8m, gross margin of 63%, $2.5m each for SG&A and R&D, flat "other" income and a 30% tax rate which generates $0.02 at 1.9m shares.
Nonetheless, TCCO generated $4.33 per share in fiscal 2010 giving it a trailing 3.1 P/E multiple suggesting that future weakness is factored in. 2011's P/E multiple however, is over 800x in our model. This is a high ratio for a company with a roughly 100% decline in earnings, a 25-50% decline in bookings and increased operating expenses.
The future however, may not look that bad. If TCCO is able to grow revenue 30% in 2011 over 2009, maintain similar gross margins and spend slightly less on R&D than in 2010, they'll generate a fully taxed $0.49 per share. This still represents almost 30x earnings. I believe a tiny business like this with highly volatile (and declining y/y) earnings should command no more than a very aggressive 20x multiple. At 20x the upside case earnings, the stock would command a $9.75 price tag - 30% downside in the stock.
If TCCO actually only generates the $0.02 we expect them to, we believe this stock would drop back to the $5 range expecting that management can de-throttle expenses to bring EPS back up to a level reasonably close to what the business has been generating for the last decade (less taxes of course).
To conclude, we believe that if TCCO's prospects continue to improve on last decade's trajectory the stock is worth 40% less. If TCCO's sales fall back to pre-2010 levels, as management has indicated they will, the stock is worth 65% less.
Of course, as with any short, there's a risk that the stock pops on an announcement of a large order. We believe that if there were a high likelihood of this in the foreseeable future that the CFO wouldn't have sold nearly all of his regular stock on the first date he could (last week when the 10-k was filed with the SEC).
Catalyst
Declining backlog
Earnings degradatin in Qs 1-4 (2011) on a comparable basis
More insider selling (management and directors)