Description

There is an old joke that goes - "we lose money on every sale, but make it up in volume." In Telular's case - they almost actually do. Telular lost their largest customer in March, but because of a unique business model that generates very stable, high margin revenue, only their future growth and not their current cash flows should be impacted by this loss. Telular is an underfollowed micro-cap that is owned primarily by quant funds. It trades at seven times free cash flow with 46% of the market cap in cash. In addition, insiders have been buying and they just announced a significant increase in their stock buyback program.

Telular sells a product called Telguard which is designed to fill the void in alarm monitoring created by the increasing number of homes without traditional land lines. Customers who want alarm monitoring systems, but have disconnected their land line must use either cellular technology or internet based technology (VOIP or WIFI). Of the two, Cellular is far more reliable.  Telguard allows alarm system to communicate with the monitoring party via cellular signals.  The number of homes without landlines is growing rapidly and Telular expects to be a beneficiary of this trend.

Telular is not the only producer of this type of product and it is essentially a commodity which is sold at breakeven or a small profit.  Telular is willing to sell Telguard at these levels because with each unit comes a high margin, recurring revenue stream from the monthly fees customers pay to use the cellular service. Telular has a run-rate revenue from this stream (which they call Service) of $25.6mm. The margins on this revenue stream are in the high to mid-50% range. Once a customer installs a Telguard unit, they can use only the cellular service provided by Telular. With captive customers, churn is around 1% per quarter and has been generally stable for the last five quarters although it ticked up slightly in the most recent quarter.

Telular's share price was crushed in March 2010 when they announced that sales from their largest customer, ADT, (30% of sales in FY 2009) were going to be dramatically lower and perhaps at zero. Telular reduced unit sales guidance and the stock fell from $4.60 to $3.10 before rallying this week on the insider buying. ADT added a surcharge in order to dis-incentivize their sales force from installing Telular products. The reason: ADT's new owner, Tyco, also owns a company called DSC which produces a competing product. Barring a sale of ADT by Tyco, I do not expect these sales to come back.

At the midpoint of their new guidance (12k to 20k units per quarter), Telular will sell 16,000 Telguard units per quarter. At the current churn rate, Telguard will lose 6,000 subscribers per quarter (ended most recent quarter with 558k subscribers). Ceteris Paribus, Telular should add 10,000 new subscribers per quarter. At a quarterly ARPU of $11.88 and margins of 57%, Service income should grow $67k per quarter. While this is much lower than the $200-300k increase in Service income they generated prior to the loss of ADT, the stream is not in decline. This is important because it supports the current cash flows of the company. It does not appear there will be any diminution in cash flows and this was confirmed by management guidance in the April 29 earnings release.

Telular has generated free cash flow of around $4.5mm in the trailing twelve months. Given that the service revenue stream will remain intact and that Telguard product sales provided very little contribution, I estimate that free cash flow will remain constant at about a $1mm per quarter run rate (capex is minimal - around $100-200k per quarter). Telular's balance sheet is pristine with $23.8mm in cash (46% of market cap) and no debt. With a TEV of only $28mm, Telular trades at only 7x free cash flow.

Management seems to be smart capital allocators. The CEO, Joe Beatty, is a CFA charterholder and worked as a sell side bond analyst at Nations bank. He has maintained a strong balance sheet which allowed them to opportunistically buy back stock in 2008 and 2009 including through a Dutch auction in 2009 where they purchased 21% of shares outstanding at an average price of $1.97. While Mr. Beatty does not own a tremendous amount of stock (100,000 shares), he does have significant option holdings (327,000 at strike prices of $3.50 and $6.62.) On April 29^th, Telular announced an increase in the stock buyback plan from $1.2mm to $5mm. This would be just under 10% of shares outstanding if they bought all of the stock at today's prices.

What is this worth? You could make the case that a stream of free cash flow that is stable, recurring, and growing slightly is worth 12-15x free cash flow. In addition, the trends in this niche are favorable as more and more homeowners disconnect landlines which argues for the higher end of that range. As a small micro cap with a large cash balance, it will probably never get 15x free cash flow but I think 10-12x is reasonable especially with a management team that is clearly focused on driving shareholder value through smart buybacks. At the low end of this range, the stock would be worth $4.28 (+23%) and at the high end, it would be worth $4.80 (+38%). A more aggressive share buyback and/or growth in units sold would provide further upside.

While this doesn't appear to be a double, it seems to have a very good risk/reward because of minimal downside risk. The cash on the balance sheet is in money market funds and treasuries and represents almost half of the market cap. The subscriber revenue is very secure and they are still growing despite losing ADT. It is important to note that Telular's service churn has been rising slightly from 0.7% in the quarter ended 3/31/09 to 1.3% in the quarter ended 3/31/10. As of now, these increases are not meaningful but if the trend continues, it will be worrisome if churn ever exceeds new activations. There is also risk that their technology becomes dis-intermediated by an internet based technology that is more reliable than current versions. Barring a violent change in the business,though, Telular should continue to quietly generate a nice free cash flow yield and will likely get a higher multiple as investors become more comfortable with the business model post ADT and as management shrinks the share count.

Catalyst

• Bounce back in home sales which tend to lead to more alarm system purchases,
• Further increase in rate of traditional land line shut off,
• Stock buyback  
• Any movement to AT&T's request to the FCC to phase out traditional land lines due to the expense of maintaining the infrastructure for a shrinking user base