Description

This is more a bet on a jockey as well as the expected market reassessment of the transformed company rather than a valuation case, i.e. one of those 'financials-light' investment theses with lots of unknowns. Most probably not the best pitch for value investors, however, I think the situation is very interesting and could potentially be very lucrative.

Zoom Telephonics, a marketer/designer of networking equipment (particularly Motorola WiFi routers), is undergoing corporate/business transformation and positive announcements are likely imminent. Over the last year, activist Jeremy Hitchcock with a good track record in networking products/industry has fully changed/taken-over the board and management of the company and also acquired a controlling stake (52%) with recent purchases made at a premium to current prices. ZMPT is in discussions to merge with a private IoT networking and security software provider Minim (also partially owned and founded by Hitchcock). The announcement on merger discussions is expected shortly. This merger along with the other planned product/service introductions is expected to transform ZMTP from a simple branded-networking-hardware designer/marketer into a very sexy sounding 'IoT platform', 'Whole Home WiFi', 'Smart Home', 'Cybersecurity', 'AI-Driven IoT Intelligence', 'Recurring Revenue' company (feel free to add any further buzzwords that make today's investors salivate and drive share prices upwards). I do not think that this potential upside (or the expected 'hype') has so far been reflected in ZMTP share price which continues to languish around historical levels. Q3'20 results from the hardware operations are also expected to be very positive reflecting higher networking equipment demand driven by covid as well as the removal of tariff expenses (10% improvement in gross margins) after the manufacturing was transferred from China to Vietnam.

Key risks: The whole investment thesis is mostly based on the expected ZMTP/Minim merger and on the previous track record of Jeremy Hitchcock, who has so far built and successfully sold (at $600m to Oracle) only one single company. Neither details on the merger nor Minim financials have been provided yet. Merger might not happen. It is not really clear whether Minim business has any traction and whether investors will view the combined company as positively as I am expecting. Q3 results of ZMTP operations might disappoint. Finally, ZMTP is listed on pink sheets with limited trading volume. Yesterday shares shot up +10% (was +20% at one point) with no news that I am aware of.

Background

Zoom Telephonics has been written up on VIC couple of times already (here and here) and I recommend going through these articles for more historical background. In a nutshell, back in 2015 ZMTP won the 5-year rights to use the Motorola brand name in connection with consumer cable modem products. Manufacturing was outsourced to China, and the company was mostly dealing with the design, distribution and marketing of its network equipment (i.e. asset-light business). Motorola branded routers were always among the best selling on Amazon and ZMTP revenues increased from $10m-$12m annually during 2008-2015 era to $18m (2016), $29m (2017), $32m (2018), and $38m (2019). Despite strong revenue growth, the company was still operating below break-even. When the bottom line results started improving, ZMTP was hit by U.S. - China trade war and the tariffs on the outsourced manufacturing products. This caused 2019 gross margins to contract from 38% to 29% (excluding tariff expenses, 2019 bottom line was at break-even):

While we were pleased with our top line performance in both the fourth quarter and full year, our bottom line was negatively impacted by the significant burden of China tariffs which led to a net loss again in Q4FY2019. Similar to what we experienced in Q3FY2019, we would have been profitable in Q4FY2019 with $164 thousand of net income, but again the tariffs changed that.

Then covid hit with retail store closures and supply chain disruptions. This affected the company on both revenue and expense sides (e.g. some products had to be shipped in by plane).

Now manufacturing has been shifted from China to Vietnam and going forward (starting with Q3'20 already) there should be no tariff expenses resulting in gradually growing gross margins and improved bottom-line profitability. From Q2 conference call:

At this time, we're manufacturing products in regions, which are not currently affected by tariffs imposed in the United States. You will see the impacts of our financial results reflected over the next two quarters, as our margins will increase.

The red line on the chart shows the level of tariffs each quarter, rising steadily between Q2 2019 and Q1 2020, as our business grew, and dropping down to just over a $1 million in Q2 2020, reflecting the beginning of our impact of our transition of manufacturing from China to Vietnam. We expect to see this curve continue to drop in Q3 and Q4 2020, as we sell through the inventory manufactured in China and limit our manufacturing in China to only the initial product production runs of new products.

The table below outlines the financial performance during 2019 and H1 2020. Note that revenue growth is indicated QoQ, whereas actual YoY growth has been far higher: +50% in Q1'20 and +26% in Q2'20. ZMPT is currently trading at 17x Adjusted EBITDA (excl tariffs and supplemental air freight) - and while that does not sound like a bargain, keep in mind that revenues are growing at 25%-50% pace and that there should be a strong operating leverage for this type of business. I would expect this growth from the hardware networking equipment to continue in the upcoming quarters mostly as a continuation of the previously observed trend as well as incremental networking equipment demand resulting from covid-19 (i.e. customers needing better routers for home-office, Netflix time and etc).

The second-quarter earnings release had some very bold statements on future outlook (emphasis is mine, part of these might be related to the potential merger with Minim which is discussed in the next section):

We are working to capture the growing market of home connected, WiFi, cyber security, and IoT products. Over the next few quarters, you will see our long-term plan unfold. We are launching in two major categories with Whole Home WiFi and our software platform MotoManage. Not only will we have a better relationship with our customers, but we will also be able to deliver software services sold as recurring revenue.

With our expanded manufacturing footprint and the upcoming launch of the new products, we are now positioned to double manufacturing capacity. While this has created a short-term increase in expense, we feel that the continuity of supply for our customers has set us apart from other producers.

The key takeaway from this is that current networking hardware operations with continued growth already support the enterprise value ($53m) of the company. Any other strategic initiatives (e.g. merger with Minim) or changed market perception as ZMTP transforms from hardware re-seller into a software/hardware IoT company are likely to result in incremental share price appreciation.

In terms of stock market performance, ZMTP shares jumped to $2+ (where it also trades currently) upon the announcement of the Motorola agreement in 2015 and remained around that level for the next 3 years. Then at the end of 2018 with Chinese tariffs and investors losing patience that the company will ever show profitability shares started drifting lower to below $1/share. Finally, shares recovered post-covid after Q1'20 results showed 50% revenue growth YoY and Motorola licensing agreement was renewed for another five years till 2025. Although shares trade at the same level as 5 years ago, it is worth noting that the market cap (and the share count) has doubled due to continuous capital injections (2015, 2016, 2019 and 2020) to cover losses of unscaled operations and invest in further growth.

Jeremy Hitchcock

After recent buyouts of other shareholders, Hitchcock now has a controlling stake (52%) in ZMTP and acts as executive chairman. His previous endeavor (Dyn) proved to be a story of entrepreneurial success.

Hitchcock founded Dyn when he was a student at Worcester Polytechnic Institute in 2001. Dyn was an Internet infrastructure company positioning itself as cloud-based Internet performance management and DNS provider (more details on Dyn). Dyn grew to 500 people and raised $100 million of growth capital since 2010 and finally was acquired by Oracle in 2017 for $600m. By the time of the sale, Dyn had 3500 enterprise customers including  Netflix, Twitter, Pfizer and CNBC.

My main takeaway from Hitchcock's success with DYN is two-fold:

• He knows Internet infrastructure/networking business inside-out;
• He knows how to scale the business and then sell it.

This interview provides some additional insight:

KC:  Why did you decide to raise venture capital funding after bootstrapping the company for so long?

JH:  By 2012, we were 100 people and at that point, we were running a significant portion of the Internet and how people were using information every day. Our customers were the Alexa 1000 - companies like Twitter, Netflix, Zappos, Etsy, etc.

We started thinking longer term about the growth of our business and started to build a legitimate Board of Directors that could help us with members like Jason Calacanis.

By raising outside capital, we could continue to grow and scale the business. Plus, some of the founders were looking to take less of an operating role in the business, so this was a good way to segue the business to the next phase.

Hitchcock's current ventures are Minim as well as his very active involvement in Zoom Telephonics.

My bet here is that he will be able to replicate Dyn's success in growing Minim and that ZMTP will be part of that story. It's likely the main reason for Hitchcock's controlling investment in ZMTP was to merge it with Minim and in this way bring his private company public. This also seems to fit Hitchcock's promise made in the latest earnings release "Over the next few quarters, you will see our long-term plan unfold".

Minim

At the end of September, both companies entered into an exclusivity agreement regarding a potential business combination. It was revealed that 43% of Minim are owned by Hitchcock and his affiliates, so it is a bit less than his ownership in ZMTP, which makes it far less risky for a potential transaction to siphon value away from ZMTP minority shareholders. Later this agreement was extended till the 6th of November, so apparently, negotiations are still ongoing.

Minim was started in 2017 and is positioned as Wi-Fi and Internet-of-Things security platform to execute Hitchcock's vision of home network devices communicating efficiently, free from the interference of Internet slowdowns and cybersecurity attacks. Some more details on how the company aims to achieve that:

Minim’s core technology involves “fingerprinting” connected devices (using machine learning) and developing behavioral models of communications. Presumably that approach would help detect security threats and fix vulnerabilities in more effective ways than the status quo, but that remains to be proven.

“The key premise is that the home or office network must have a Minim-enabled wireless access point (router),” Hitchcock writes. “We have a lightweight [software] agent that gets installed on the router so that we can observe network flows and sync with our cloud. With this, we can fingerprint devices, adopt per device policies that virtually patch, isolate traffic, etc. We’re bringing enterprise-grade networking technology to the home and small office, but we’re making it simple.”

The company offers a “care portal” for Internet service providers that Hitchcock says gives them “an unprecedented, accurate view of connected devices and their behavior in homes—so they can troubleshoot better and reduce on-site support.” He adds that “there are big incentives” for service providers, telecom companies, and IT services providers.

Minim also has a mobile app that lets people “do their own self-care in homes and offices, perhaps even preventing the service call,” Hitchcock says. “Manage your devices, get usage insights, check out your signal strength, manage parental controls,” and so on.

Minim sells its services/software to Internet service providers and as of 2019 it had contracted with 50 ISPs and has been deployed to 100k homes. While I have no idea what it means in terms of revenues, there is clearly some traction for the services.

The company has raised $2.5m in 2018 from venture capital funds, but not from the same funds that supported Dyn, not clear why. Hitchcock should have sufficient capital to finance Minim himself as he has done with Dyn for over a decade. He has explained the capital raise in the following way:

I wanted to de-risk and challenge myself with outside guidance. I love the idea, the concept, the market, and everything about Minim, but adding in others’ capital makes you accountable in a way that safeguards your own money and time. Plus, they make you think bigger, all the time.

Minim continues to grow. At the time of the capital raise, the company had 15 employees. During 2019 Minim acquired Aerez (+5 employees) - a connected device platform that served small wireless Internet service providers (WISPs). At the beginning of 2020 the company employed 32. Linkedin currently lists 37 employees with further open positions advertised.

ZMPT and Minim started partnering back in Jul'19 and Minim software was integrated into some ZMTP Motorolla routers. Minim is also working with other hardware providers (here, here and here), but it is not clear how extensive these relations are and how well do products with Minim software sell-through.

Google and Apple app stores show very limited traction for Minim app, however, I am not sure if much can be judged from that as Minim products so far mostly target ISPs rather end-customers.

Overall, it's hard to tell how successful Minim actually is and how valuable it should be. I tend to view it as a start-up company with a star management operating in a sexy and fast-growing industry (IoT) with some developed products and some clients already in the pocket.

It is also not clear whether merger with ZMTP is strategically rational, but at least on some level the combination of network hardware and software providers seems to make sense. Most importantly, this transaction would position ZMTP very differently in the eyes of investors.

This McKinsey report provides overview of where IoT industry is moving. This also shows how investors might potentially view Minim as a public stock.

Device-enablement platforms—connecting devices, cloud providers, and applications for optimal processing in IoT settings—are a notable source of growth and value. In a nutshell, device-enablement platforms improve financial performance across cost, revenue, and operating efficiency, especially for midmarket companies.

Our research indicates that as device-enablement platforms become more important, in part due to uptake among small-to-medium-sized enterprises and small- and home-office users, their corresponding revenue pools will continue to grow at an average CAGR of 24 percent, 48 percent for the IoT use cases

Timeline of Governance and Ownership Changes

Over the last year Hitchcock increased his stake in ZMTP from 0 to 52% and also fully changed the board/management of the company. He acquired his current stake in 4 lots:

• May'19 at $1.1/share - as part of $5m equity raise by the company;
• May'20 at $1.52/share - as part of $3.4m private equity investment;
• Aug'20 at $1.95/share - buying out largest independent shareholder Manchester Management;
• Oct'20 at $2.5/share - buying out 3 directors including ZMTP co-founder Frank Manning;

The last two purchases (at $1.95-$2.5/share) account for more than half of Hitchcock's position in the company.

Full details of ownership and governance changes:

• 3rd May'19. ZMTP raises $5m equity at $1.10/share, $4.1m of which comes from Jeremy Hitchcock. Other investors included CEO (at that time) Frank Manning and three more insiders. Subsequently, Hitchcock and Jonathan Seelig (founder of Akamai - $18bn tech firm, who apparently did not participate in the raise and he later resigned from the board in Jul'20) joined the board. After the raise, Hitchcock owned a 23.1% stake.
• 21st Oct'19. Due to lackluster share price performance and some governance issues, Hitchcock called for a special meeting of the board.
• 15th Jan'20. Due to continued concerns and lack of progress after the previous meeting, Hitchcock continued the dialog with the board regarding changes to the composition of the senior management and together with three other directors called for another special meeting.
• 21st Jan'20. Frank Manning retired as CEO and gave the seat to Joe Wytanis (previously president). Manning stayed as advisor and director. Hitchcock became the chairman. New "acting" CFO was appointed (Ms. Hamilton), which later (26th Feb) became a CFO.
• 8th April. Hitchcock calls for a special meeting to consider debt and financing options. Also, intends to increase the board from 7 to 9 members.
• 14th April. Hitchcock named an executive chairman (instead of just Chairman before)
• 11th May. CEO Joe Wytanis steps down. The CEO search committee, led by Hitchcock will look for a new CEO (no updates on this since and not clear why CEO is necessary if Hitchcock is executive chairman).
• 27th May. ZMTP closed a $3.4m private equity investment at $1.52/share (market price was $2.04/share) from Mr. Horowitz and Frank Manning. After closing, two new members joined the board (expanded from 7 to 9 members). Hitchcock's stake increased from 17.8% to 21.5%.
• 13th July. The largest independent owner Manchester Management has decreased its stake from 20% to 16.8%. It also received a notice that Hitchcock wants to acquire the remaining stake at $1.95/share.
• 4th August. Hitchcock purchases the remaining stake from Manchester Management at $1.95/share. The increased stake stands at 37.6%.
• 4th September. Hitchcock announced that he is in talks with 3 directors of ZMTP (Manning, Kramer, and Donovan) regarding the acquisition of their 3.7m ownership stake. It was assumed that after the acquisition is closed, the three directors might resign.
• 26th September. Zoom and Minim entered into an exclusivity agreement regarding the business combination. It was disclosed that Hitchcock owns 43% of Minim.
• 13th October. Hitchcock acquired shares of 3 ZMTP directors and increased his stake to 51.8%. The transaction was done at $2.50/share (30% premium to market price). Subsequently, two co-founders (Manning and Kramer) as well as another director (Donovan) resigned.

Catalyst

Merger with Minim

Q3'20 results