Communication Systems Inc. (JCS, Financial) recently caught my eye as it was trading very near to its three-year lows. I decided to dig a bit further to check if it was worth investing at the current price. It closed at $11.22 on Sept. 27, 2012, giving it a market cap of $98 million.
CSI is principally engaged through its Suttle and Austin Taylor business units in the manufacture and sale of modular connecting and wiring devices for voice and data communications, digital subscriber line filters, and structured wiring systems and through its Transition Networks business unit in the manufacture and sale of media and rate conversion products for telecommunications networks. Through its JDL Technologies business unit, CSI also provides IT solutions including network design, computer infrastructure installations, IT service management, change management, network security and network operation services.
The segmental revenue and operating income for the last two years looked like this:
As we can see, Transition Networks is the largest segment in revenue and operating income terms. Let’s look at this first.
Transition Networks
This segment contributes most to the operating income of the company, making up more than 90% of the company’s operating income over the last four years. The operating margin has also increased over the last four years for this segment. This looks promising.
Transition Networks’ products are used in a broad array of markets, including enterprise networks, service providers’ networks and security and industrial environments such as in manufacturing processes. The segment derives the majority of its business from one-time network upgrade projects. More than 80% of Transition Networks revenues came from the North America region in the last three years.
Of Transition Networks’ products, media converters made up more than 70% of the segment revenue for the last four years. The sales of media converters have gone up from $47 million in 2008 to $73 million in 2012. Therefore a large proportion of the company revenues come from this one product. That seems like far too much reliance on one product, although given the increasing revenues and margins over the last four years, the company seems to have managed this well.
Transition Networks faces a large number of competitors for the high-volume products; low cost competitors from China and Taiwan are strong in Asia, EMEA and South American markets, but have not had much success in the North American market for media converters. Since most of the company’s business comes from North America, this seems to be a good thing.
Suttle
Suttle offers a broad range of critical components for premise and outside plant networking. Suttle’s customers include communication companies, electrical contractors, original equipments manufacturers (OEMs). More than 70% of Suttle revenues have come from telephone companies in the last three years.
JDL
This segment provides information technology (IT) solutions focused on network design and integration IT service management, network security, desktop virtualization and managed network operation center services. This is a high-margin business and contributes more to the operating income as compared to Suttle, despite lower revenues. Unfortunately, most of this business in the last two years comes from a single customer.
Austin Taylor
Austin Taylor is located in the UK and is a provider of telephony and data networking products to telecommunications companies, distributors and installers throughout the UK, Europe and the Middle East. This segment has been losing money over the last four years and it may be better for the company to shut this down. The company has decided to consolidate this segment with the Suttle segment from Jan. 1, 2012.
Operating Performance
The company’s operating performance looks as below according to data from vuru.co. As can be seen, the company has managed to increase its operating income at a higher rate than the increase in revenue in the last 10 years. Over the last 10 years the operating income has increased at 16% p.a. as against a revenue increase of 3% p.a. This compares to the last five years when operating income has grown by 11% p.a. as against revenue growth of 3.5% p.a., signalling a reduction in operating leverage.
ROA has been around 5% to 7% over the last few years except the last two years when it increased to around 9%. ROIC has been around 7% to 8% over the last few years except the last two years when it increased to around 10%. These returns do not seem exceptional.
The company has managed to convert most of the net income to FCF over the last 10 years. FCF has been positive over the last 10 years and averaged around $7 million a year. Capex has been around 2% of revenue indicating that this is not a very capital intensive business. However, capex has been more than the depreciation charged over the last few years. Working capital requirements have been around 55% to 60% of revenue over the last 10 years. Inventory as a percentage of revenue has been decreasing over this period. Cash conversion cycle has been improving over the last 10 years from more than 170 days in 2002 to around 130 in 2011.
Balance Sheet
The company has a sizable cash balance ($32 million as at June 30, 2012 — more than 30% of market cap) and very little debt (only a mortgage on some property they acquired as part of an acquisition of a building). Over the last 12 years, they seem to have managed to strengthen the balance sheet.
Management
The chairman, Curtis Sampson, who is also the founder of the company, holds more than 18% of the shares. Overall the insiders hold more than 21% of the shares. This is a good sign as their interests are aligned with the other shareholders.
Another good sign is that management compensation also does not look excessive.
Dividends and Buybacks
As mentioned above, the company has been paying a large part of its earnings in dividends. It has been increasing its dividend since 2005 with around 50% payout ratio. The current dividend yield is around 5%. The company has also done buybacks worth $7 million in the last five years — specifically in 2007 and 2008. The shares were cheaper during these two years compared to their historical prices based on the P/E ratio. This again suggests that the management made good use of the cash at the opportune time. Overall, the number of shares outstanding has only increased slightly over the last 10 years.
Valuation
So far so good. All in all, the historical operating performance seems okay, if not spectacular. Now for the most critical part: Is there value in the stock at the current price? I prefer to look at the FCF of a company as part of the valuation process, as this is the cash that is available to shareholders and cannot be easily manipulated by the company. Based on a FCF of $11 million for 2011, the FCF yield is 12%. The FCF yield becomes even more impressive if we exclude the sizable chunk of cash and investment (around $4.4 per share) and is around 19%. That does look good.
Over the last 10 years, average FCF has been around $7.5 million. This is certainly lower than the 2011 FCF. The next thing to check is: Is the FCF in a definite upward trend explaining the lower average number compared to the number in the recent years? That does not seem to be the case — in fact, the FCF has been quite volatile over the last 10 years. The main question then is whether the 2011 FCF is sustainable.
According to the 2011 annual report, the 2011 sales included $32.8 million or 22.8% of overall revenue from a one-time large network upgrade project with a Fortune 500 company that was completed in 2011. The company does not expect ongoing orders from this customer in 2012 and beyond to exceed 5% of their revenues. That is a straight hit of $26 million to revenues. Also, the fact that JDL derives most of its revenue from a single customer makes me nervous. In order to be conservative, I would therefore prefer to exclude this revenue from their ongoing sustainable revenue as well — especially as they used to have a single main customer for this segment a few years ago and then lost them unexpectedly a couple of years ago. This takes out another $12 million from revenues.
Assuming a net income margin of 6% (historically this has been more around 5% to 6% except the last two years) on the reduced revenues of $105 million gives a net income of around $6 million. Their net income has been around $6 million to $7 million in the last five years apart from the last two years of record profitability
— so my assumption does not seem way off the mark. Assuming depreciation equals capex and there is no additional working capital requirement, FCF equals net income. This gives me a FCF yield of 6%. If I exclude the cash and investments, this increases to 10%. That’s not bad — but certainly not great either.
The results for the six months ended June 30, 2012, bear out these revenue and EPS decreases: EPS for the six months to June 2012 has decreased to $0.12 as against $0.78 for the six months ended June 30, 2011. So the net income for 2012 may turn out to be even lower than the $6 million I have assumed above.
At this FCF yield, the stock does not look like a convincing buy and does not provide me with enough margin of safety, especially as their ROIC figures are not spectacular.
I have therefore decided to pass on investing in this company at its current price.
Disclosure: As of this writing, I do not have any positions in Communication Systems Inc. (JCS).
Disclaimer
This research was produced by M. Joshi (the “Author”). Information and opinions presented in this research have been obtained or derived from sources believed to be reliable, but the Author makes no representation as to their accuracy or completeness. The Author accepts no liability for loss arising from the use of the material presented in this report. The Author may have long or short positions in (please refer to the disclosure above), or may buy or sell any of the securities, derivative instruments or other investments mentioned or described in this research, either as agent or as principal for their own account. This research is prepared solely for information purposes and it does not constitute an advertisement. This document is not, and must not be construed as, a solicitation or an offer to buy or sell any securities or other financial instruments in any jurisdiction. By writing this research, the Author neither provides personal recommendations to, nor receives and transmits orders from, nor executes orders for, recipients of this research. This research should neither be passed on, nor reproduced in whole or in part under any circumstances without the Author’s express consent. This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation which would subject the Author to any registration or licensing requirement within such jurisdiction. The financial instruments described in this research may not be eligible for sale in all jurisdictions or to certain categories of investors.
CSI is principally engaged through its Suttle and Austin Taylor business units in the manufacture and sale of modular connecting and wiring devices for voice and data communications, digital subscriber line filters, and structured wiring systems and through its Transition Networks business unit in the manufacture and sale of media and rate conversion products for telecommunications networks. Through its JDL Technologies business unit, CSI also provides IT solutions including network design, computer infrastructure installations, IT service management, change management, network security and network operation services.
The segmental revenue and operating income for the last two years looked like this:
| Revenues ($ 000s) | 2011 | 2010 | ||
| Suttle | 36,367 | 25% | 36,562 | 30% |
| Transition Networks | 91,450 | 64% | 67,782 | 56% |
| JDL | 12,401 | 9% | 12,712 | 11% |
| Austin Taylor | 3,288 | 2% | 3,016 | 3% |
| 143,506 | 120,072 |
| Op. Income ($ 000s) | 2011 | 2010 | ||
| Suttle | 1,102 | 6% | 3,043 | 19% |
| Transition Networks | 20,894 | 119% | 14,497 | 93% |
| JDL | 3,156 | 18% | 4,110 | 26% |
| Austin Taylor | -1,460 | -8% | -1,101 | -7% |
| Other | -6,177 | -35% | -4,934 | -32% |
| 19,526 | 17,625 |
As we can see, Transition Networks is the largest segment in revenue and operating income terms. Let’s look at this first.
Transition Networks
This segment contributes most to the operating income of the company, making up more than 90% of the company’s operating income over the last four years. The operating margin has also increased over the last four years for this segment. This looks promising.
Transition Networks’ products are used in a broad array of markets, including enterprise networks, service providers’ networks and security and industrial environments such as in manufacturing processes. The segment derives the majority of its business from one-time network upgrade projects. More than 80% of Transition Networks revenues came from the North America region in the last three years.
Of Transition Networks’ products, media converters made up more than 70% of the segment revenue for the last four years. The sales of media converters have gone up from $47 million in 2008 to $73 million in 2012. Therefore a large proportion of the company revenues come from this one product. That seems like far too much reliance on one product, although given the increasing revenues and margins over the last four years, the company seems to have managed this well.
Transition Networks faces a large number of competitors for the high-volume products; low cost competitors from China and Taiwan are strong in Asia, EMEA and South American markets, but have not had much success in the North American market for media converters. Since most of the company’s business comes from North America, this seems to be a good thing.
Suttle
Suttle offers a broad range of critical components for premise and outside plant networking. Suttle’s customers include communication companies, electrical contractors, original equipments manufacturers (OEMs). More than 70% of Suttle revenues have come from telephone companies in the last three years.
JDL
This segment provides information technology (IT) solutions focused on network design and integration IT service management, network security, desktop virtualization and managed network operation center services. This is a high-margin business and contributes more to the operating income as compared to Suttle, despite lower revenues. Unfortunately, most of this business in the last two years comes from a single customer.
Austin Taylor
Austin Taylor is located in the UK and is a provider of telephony and data networking products to telecommunications companies, distributors and installers throughout the UK, Europe and the Middle East. This segment has been losing money over the last four years and it may be better for the company to shut this down. The company has decided to consolidate this segment with the Suttle segment from Jan. 1, 2012.
Operating Performance
The company’s operating performance looks as below according to data from vuru.co. As can be seen, the company has managed to increase its operating income at a higher rate than the increase in revenue in the last 10 years. Over the last 10 years the operating income has increased at 16% p.a. as against a revenue increase of 3% p.a. This compares to the last five years when operating income has grown by 11% p.a. as against revenue growth of 3.5% p.a., signalling a reduction in operating leverage.
| $000s | 2002-12 | 2003-12 | 2004-12 | 2005-12 | 2006-12 | 2007-12 | 2008-12 | 2009-12 | 2010-12 | 2011-12 |
| Revenue | 107,300 | 102,411 | 110,779 | 109,709 | 115,440 | 121,243 | 122,700 | 109,792 | 120,072 | 143,775 |
| GP | 28,552 | 29,462 | 36,484 | 36,870 | 38,587 | 42,886 | 46,692 | 41,848 | 51,200 | 58,895 |
| GP margin | 27% | 29% | 33% | 34% | 33% | 35% | 38% | 38% | 43% | 41% |
| Op. Income | 3,940 | 4,020 | 7,364 | 6,805 | 5,025 | 10,263 | 10,584 | 10,219 | 15,614 | 17,515 |
| Margin | 4% | 4% | 7% | 6% | 4% | 8% | 9% | 9% | 13% | 12% |
| Net income | 2,691 | 2,717 | 4,763 | 4,469 | 4,495 | 7,511 | 6,612 | 6,044 | 9,715 | 9,798 |
| Margin | 3% | 3% | 4% | 4% | 4% | 6% | 5% | 6% | 8% | 7% |
ROA has been around 5% to 7% over the last few years except the last two years when it increased to around 9%. ROIC has been around 7% to 8% over the last few years except the last two years when it increased to around 10%. These returns do not seem exceptional.
The company has managed to convert most of the net income to FCF over the last 10 years. FCF has been positive over the last 10 years and averaged around $7 million a year. Capex has been around 2% of revenue indicating that this is not a very capital intensive business. However, capex has been more than the depreciation charged over the last few years. Working capital requirements have been around 55% to 60% of revenue over the last 10 years. Inventory as a percentage of revenue has been decreasing over this period. Cash conversion cycle has been improving over the last 10 years from more than 170 days in 2002 to around 130 in 2011.
Balance Sheet
The company has a sizable cash balance ($32 million as at June 30, 2012 — more than 30% of market cap) and very little debt (only a mortgage on some property they acquired as part of an acquisition of a building). Over the last 12 years, they seem to have managed to strengthen the balance sheet.
Management
The chairman, Curtis Sampson, who is also the founder of the company, holds more than 18% of the shares. Overall the insiders hold more than 21% of the shares. This is a good sign as their interests are aligned with the other shareholders.
Another good sign is that management compensation also does not look excessive.
Dividends and Buybacks
As mentioned above, the company has been paying a large part of its earnings in dividends. It has been increasing its dividend since 2005 with around 50% payout ratio. The current dividend yield is around 5%. The company has also done buybacks worth $7 million in the last five years — specifically in 2007 and 2008. The shares were cheaper during these two years compared to their historical prices based on the P/E ratio. This again suggests that the management made good use of the cash at the opportune time. Overall, the number of shares outstanding has only increased slightly over the last 10 years.
Valuation
So far so good. All in all, the historical operating performance seems okay, if not spectacular. Now for the most critical part: Is there value in the stock at the current price? I prefer to look at the FCF of a company as part of the valuation process, as this is the cash that is available to shareholders and cannot be easily manipulated by the company. Based on a FCF of $11 million for 2011, the FCF yield is 12%. The FCF yield becomes even more impressive if we exclude the sizable chunk of cash and investment (around $4.4 per share) and is around 19%. That does look good.
Over the last 10 years, average FCF has been around $7.5 million. This is certainly lower than the 2011 FCF. The next thing to check is: Is the FCF in a definite upward trend explaining the lower average number compared to the number in the recent years? That does not seem to be the case — in fact, the FCF has been quite volatile over the last 10 years. The main question then is whether the 2011 FCF is sustainable.
According to the 2011 annual report, the 2011 sales included $32.8 million or 22.8% of overall revenue from a one-time large network upgrade project with a Fortune 500 company that was completed in 2011. The company does not expect ongoing orders from this customer in 2012 and beyond to exceed 5% of their revenues. That is a straight hit of $26 million to revenues. Also, the fact that JDL derives most of its revenue from a single customer makes me nervous. In order to be conservative, I would therefore prefer to exclude this revenue from their ongoing sustainable revenue as well — especially as they used to have a single main customer for this segment a few years ago and then lost them unexpectedly a couple of years ago. This takes out another $12 million from revenues.
Assuming a net income margin of 6% (historically this has been more around 5% to 6% except the last two years) on the reduced revenues of $105 million gives a net income of around $6 million. Their net income has been around $6 million to $7 million in the last five years apart from the last two years of record profitability
— so my assumption does not seem way off the mark. Assuming depreciation equals capex and there is no additional working capital requirement, FCF equals net income. This gives me a FCF yield of 6%. If I exclude the cash and investments, this increases to 10%. That’s not bad — but certainly not great either.
The results for the six months ended June 30, 2012, bear out these revenue and EPS decreases: EPS for the six months to June 2012 has decreased to $0.12 as against $0.78 for the six months ended June 30, 2011. So the net income for 2012 may turn out to be even lower than the $6 million I have assumed above.
At this FCF yield, the stock does not look like a convincing buy and does not provide me with enough margin of safety, especially as their ROIC figures are not spectacular.
I have therefore decided to pass on investing in this company at its current price.
Disclosure: As of this writing, I do not have any positions in Communication Systems Inc. (JCS).
Disclaimer
This research was produced by M. Joshi (the “Author”). Information and opinions presented in this research have been obtained or derived from sources believed to be reliable, but the Author makes no representation as to their accuracy or completeness. The Author accepts no liability for loss arising from the use of the material presented in this report. The Author may have long or short positions in (please refer to the disclosure above), or may buy or sell any of the securities, derivative instruments or other investments mentioned or described in this research, either as agent or as principal for their own account. This research is prepared solely for information purposes and it does not constitute an advertisement. This document is not, and must not be construed as, a solicitation or an offer to buy or sell any securities or other financial instruments in any jurisdiction. By writing this research, the Author neither provides personal recommendations to, nor receives and transmits orders from, nor executes orders for, recipients of this research. This research should neither be passed on, nor reproduced in whole or in part under any circumstances without the Author’s express consent. This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation which would subject the Author to any registration or licensing requirement within such jurisdiction. The financial instruments described in this research may not be eligible for sale in all jurisdictions or to certain categories of investors.
