Too early to add Vislink

Betrayed by the numbers again

To recap: Vislink (VLK) looks like a bargain. Much of its current-asset value is cash, which is a good thing because the value of cash is certain. But the liquidity of cash, the ease with which it can be spent, is a worry because Vislink is spending and the cash balance is falling. This year it’s bought back shares, acquired Gigawave, a small complimentary company, and kept itself afloat while making a loss. As I said last week, if Vislink survives, the money is probably well spent.

Vislink is now half the business it was as HERNIS, the marine and energy CCTV business it sold in 2010 and the reason it has so much cash, made nearly half its turnover and half its profit in 2009.

Historically, the company has earned a Return on Equity of just 6%, which at the current deflated share price offers investors a more tempting typical annual return of 13%. The trouble with that measure is past profitability may have been inflated by adjustments to the accounting. Cash flows have not been impressive in recent years, and if we include good will write offs and one-off costs, neither have basic profits. Vislink also experienced unusually high demand for its broadcast equipment between 2005 and 2009 when US broadcasters were compelled to change their equipment.

Last year, I’d probably have added Vislink’s shares to the Thrifty 30 regardless. Then I needed to add companies because I was still populating the portfolio, and I was more blasé about the problems very cheap companies might be facing.

But today I’ve got Armour hanging over my head. Armour, which makes consumer electronics for homes and vehicles, is in a desperate looking situation. It’s racking up losses and debts, and as the company has raised money from shareholders its chairman and majority shareholder has increased his control.

I added the shares because they looked very cheap, aware that they could always get cheaper, but I didn’t anticipate Armour would do so badly. Now its market capitalisation is so low, there doesn’t seem much of a reason for it to stay listed and I’m fearful it might not. Meanwhile as votes concentrate, the process of delisting becomes easier.

My experience with Northern Recruitment, SCS, OPD, and SatCom shows that minority investors often do badly in such circumstances. They either feel compelled to sell at a ludicrously low price, when a company delists, or the company is so mismanaged it goes bust leaving shareholders with nothing. The company might still turn itself around to the benefit of all shareholders, but I’d like to do what I can to avoid another Armour.

There’s a big difference between Vislink and Armour, though. Vislink doesn’t have a funding problem, and if it’s profitable again in 2012, it probably won’t have one. But I’m more cautious now and determined to interrogate the statistics at my disposal to probe the similarities.

Vislink and Armour are both making losses. They share the same biggest shareholder, Amour’s chairman Bob Morton, who was chairman at Vislink between 1993 and 2007. But most significantly from my point of view, Vislink could be at the same point in its decline as Armour was when I added it to the Thrifty 30.

Armour’s F_Score was five out of nine then. Vislink’s is five now.

Since the F_Score is designed to differentiate between companies getting into trouble and companies getting out of it, I’m going to look a bit more closely at what that statistic means.

Nine out of nine is the top mark, and indicates a company is very strong, so F_Scores of four and five out of nine are middling. With Armour I turned a blind eye to the indifferent F_Score, but I’m not going to do that this time. Perhaps you’ll understand why if I explain in words, with the scores in brackets.

An F_Score of five can mean that a company is losing money (0), is more unprofitable than last year (0), has lower profit margins (0) and lower asset turnover (0). In other words, everything about profitability can be negative and deteriorating, but the company could be assumed to be ‘getting itself out of trouble’ if it scores five out of five in the remaining factors. A score of five is over half way to a perfect nine.

To score five after failing the four profitability tests, the company must not have raised money from shareholders (+1), borrowing must have fallen (+1), return on cash flow from operations must be positive (+1) and higher than return on assets (+1) and finally its current ratio must be higher (+1).

[For definitions of each factor see my original article on the F_Score].

That’s the statistical situation Vislink is in. For confirmation look at the blue line above, and the light blue bars. Profit margins and asset turnover have turned negative, leading to a collapse in profitability (green lines).

Three of the positive factors, changes in the current ratio, debt levels, and the number of shares in issue, have no bearing on Vislink’s operations. They’re measures of how adequately Vislink is funded and, not surprisingly, its very well funded having sold HERNIS. The profit on the sale has protected shareholders from the losses the business is making, which is why the gold and orange bars indicating shareholder wealth have not fallen, yet.

The remaining two factors in the F_Score are measures of profitability in cash terms, rather than accounting terms. I’m not inclined to put my faith in them. A stricter measure than cash flow from operations is free cash flow, which also incorporates investments most likely to be required to keep the business going. According to my calculations free cash flow has been marginally negative for the last two years.

I need to see the company becoming more profitable again, or at least less unprofitable, I need to hear the results of the new interim-chief executive’s operational review, and I probably need to hear from the permanent ceo when the board appoints him. before I put my faith in another bargain stock which has yet to demonstrate convincingly it’s getting out of trouble, rather than further into it.

Vislink expects to be operating profitably by the end of this financial year, and if it is, that may be the time to add it to the portfolio

Did Vislink’s tender offer create value?

The mathematics of buybacks

Last week I wrote:

Buying back shares creates value if the shares are cheap.

And since Vislink’s share price values the company at less than its current-asset value, I assumed the buyback probably had added value. Because it makes no assumptions about future profits, current-asset value is just about the most conservative valuation methodology you can apply to a company. Under most circumstances such companies are cheap.

Best to check though. The buyback was in May after all, and it turns out the company paid 20.25p per share, more than they cost now.

This worksheet shows the maths of buybacks and the not very dramatic result. Vislink’s buyback didn’t create or destroy value assuming the true value of the shares is the current-asset value:

It just maintained the status quo, a current-asset value per share of 19.9p.

After the buyback, the current asset value was £22.6m, £5m lower than it was because the company spent £5m buying shares it subsequently cancelled. So there is less value spread over fewer shares (113.9m after the buyback compared to 138.6m before it), but the relationship between the two remained constant because according to my estimate, the shares were actually worth very close to what the company paid (19.9p per share, compared to 20.25p per share).

Just to show buybacks can create (or destroy) value though, let’s say Vislink was worth more, £40m instead of £27.6m, at the time of the tender offer, but its market value was the same, about £28m:

After the buyback the company is still worth £5m less because of the cost, but the shares it bought were worth more. The difference between price, the per share market value of the shares (20.25p), and my new estimation of intrinsic value per share (28.9p), is forfeited by sellers and belongs to the remaining shareholders after the buyback. Their shares are worth nearly 31p, when they were worth about 29p before. Value is created (at least for some).

Had the company’s shares been overvalued, value would have been transferred from shareholders who stuck with the company to those who sold, and so, from the point of view of the remaining shareholders, value would have been destroyed.

Terry Smith is perhaps the UK’s most outspoken critic of buybacks. Most of them destroy value, he says, and are instigated by managers intent on boosting measures like earnings per share, which make profits look better by spreading them across fewer shares.

But profit can be a very misleading way of judging whether a company adds value. As Smith says in a presentation you can download from his website, you can double the amount you ‘earn’ from interest in a savings account by doubling the amount you’ve saved, but you’ve not created value. If your leave your annual ‘earnings’ to compound in the account its totals will, if graphed as a series of bars on a chart, show perpetual growth not unlike the graphs companies plaster on their annual reports.

Likewise companies can increase profit by investing more money, but the value a company creates depends not on the absolute level of profit the company earns but from the profit relative to the amount of money invested, the return on capital, or profitability. If profitability is low enough, the company could be destroying value, and our money would probably earn a better return in that savings account.

Managers should be thinking about profitability, not profit, then, and investors should be thinking about value, which incorporates our expectations of a company’s profitability, not earnings.

But investors who look little further than the next results announcement are fixated by earnings per share because rising earnings are seen as a sign of health and likely to increase the share price, at least in the short-term. So investors reward managers with hefty bonuses related to growth in earnings per share, even if it will damage the long-term profitability of the company, hence the attraction of earnings increasing buybacks to managers, even when they’re expensive.

In a portfolio of undervalued shares, though, buybacks should be good news and Smith has the evidence. He sites a study of 1,239 US companies who did buybacks between 1980 and 1981 compared to a reference portfolio of randomly chosen companies. Although buyback companies beat the reference portfolio every year for three years after the buybacks, the most expensive 20% of buyback companies did worse than the reference portfolio. The cheapest 20% of buyback companies, those with the lowest price to book values, beat the reference portfolio by 34% over three years.

Vislink has a very low price to book value, and at least it looks like it didn’t destroy value in its buyback. If, when I come to look at its ten-year record, I decide it’s worth more than its current-asset value the buyback may be another factor encouraging me to add the company to the portfolio.

Vislink transmitting mixed signals

Having reaffirmed my commitment to deep value, buying shares at very cheap prices so long as I reckon companies have a profitable future, I’ve picked the company at the top of my newly cleaned-up bargain shortlist as the next company to research.

Vislink (VLK) makes satellite systems, wireless cameras, and microwave radio transmitters and receivers for broadcasters mainly, and law enforcement agencies. These products enable the transmission of live video and radio.

The market values Vislink at just 73% of the value of its current assets (mostly cash) less all liabilities on 31 December 2010, but the situation has changed since the end of its financial year, and there’s less cash now.

New chairman and interim chief executive John Hawkins is reviewing the business, which was restructured just last year through the sale of HERNIS Scan Systems, a company that makes CCTV for oil and gas installations. The sale explains all the cash and so far Vislink has used it to repay its debts, buy loss-making Gigawave (£3.75m in instalments) and buy back lots of shares in a tender offer (worth £5m).

Paying off debt reduces risk. Buying back shares creates value if the shares are cheap, and that’s true if the company recovers from here. The same might be said of Gigawave. Vislink says it can return Gigawave to profitability this year, and if it does it’s probably a shrewd investment.

But we don’t yet know if Vislink’s new and future investments will be money well spent, the man in charge while the company searches for a permanent ceo is a bit of an unknown quantity, and his record at Thrifty 30 graduate Anite until 2003 does not inspire confidence. He was ousted as chief executive after an acquisition fuelled boom turned sour and controversy about the size of his pay packet, money, perhaps, not so well spent.

I take some heart from this statement in the annual report:

Following the announcement of further cost reductions at the start of 2011 the Group intends to continue to contain its operating costs. No further immediate expansion is planned; our regional sales offices are appropriately staffed and the major planned investments in information technologies have been completed.

The rest of the report reveals Vislink is loss-making, the result it seems of belt-buckling by broadcasters and public bodies during the recession and the end in 2009 of a US Government programme requiring broadcasters to convert to digital equipment and relocate radio transmissions to a higher frequency. Its middling F_Score of five out of a possible nine belies a decline in the most important statistic, return on assets, from –2% to –10%.

HERNIS, the bit Vislink sold, made a profit of about £2.7m in 2010, but it and the £21m profit Vislink made on the sale, are excluded from the adjusted loss because it’s no longer part of the business.

It looks as though Vislink has sold a profitable (and presumably more marketable) division to save its unprofitable (and presumably less marketable) businesses. That may not be as mad as it seems. Perhaps it couldn’t find any buyers for its other businesses. If it could not get a fair price for the rump but is convinced it has a future, then keeping the undervalued assets actually makes sense (to a value investor like me). And finally, I’ve experienced this before. Johnson Service did the same thing, and it’s still with us.

An update in May, before payments of just over £2m for Gigawave, revealed Vislink’s cash balance had fallen £5.5m from net cash of £22.2m in December to £16.7m, and it was still loss-making although it aims to be operating profitably by the end of this year.

The strategy is to reduce the number of products and services, while increasing its geographical spread. So Vislink’s moved out of marine safety, but intends to sell more in Asia, Africa, and the Middle East (already 40% of sales are from outside North America and Europe). To be very good at a few closely related activities, package products up with expertise and consultancy, and expand globally, is part of the generally successful hidden champions strategy, so I approve, although to do that profitably is little more than an aspiration at this stage.

I like companies like Vislink, even though most investors think they’re scary. Statistically they make good investments, and I think that’s because once a company has been touched by the spectre of insolvency, the risks are apparent. If management is more conservative, cutting costs as Vislink is, by rationalising its operations, switching manufacturing to lower-cost factories in Asia, withdrawing old products, and restructuring the business along more modest, sustainable lines, then the level of risk is falling at the same time as the share price.

Since the less you pay for an investment the higher your future return (other things being equal) a falling price (higher return) and less risk breaks the bond between the two and offers us the prospect of a relatively low-risk-high-return investment.

That’s the holy grail of value investors, so I’m going to push on and see what its ten year record shows.

Vislink’s digital hangover

Bubble, bubble, toil and trouble…

Looking at Vislink’s charts, two things stand out:

The first the bouts of enthusiasm for the company’s shares (pink price line), in 2000, and 2006/7, and the second is a surge in profitability around the time of the second bout of enthusiasm (light green line, return on total assets).

Since Vislink (VLK) is a technology company, I’m guessing the first bout of enthusiasm was mostly hype connected with the company’s restructuring and relisting during the dot.com bubble. The second bout also looks a bit like a bubble.

Vislink makes and sells wireless, satellite and microwave communications systems used to capture live TV, surveillance systems deployed in military, law enforcement, and disaster recovery operations, and explosion proof CCTV systems installed on tankers, oil rigs, and terminals. It also supplies the technical expertise and project management to install and maintain them.

In 2009 it supplied wireless camera systems so crews on motorcycles could follow the London Marathon, re-equipped a Manila based TV channel’s fleet of newsgathering trucks with high definition microwave transmitters, and sold a CCTV system for a 550km long Russian oil pipeline.

Its biggest market is news and entertainment, and the reason for the rise and subsequent fall in profitability was a temporary increase in investment by US television companies during the switchover from analogue to digital broadcasting.

Apart from those few years, Vislink’s been borderline profitable, and in a state of seemingly perpetual restructuring. Judging by its annual report for 2009, this state of affairs has returned, partly because of recession and partly because the digital upgrade is complete.

To help Vislink diversify and overcome the slow-down in its main market, it has reorganised into four business, News & Entertainment, Law Enforcement & Public Safety, Marine & Energy, and Vislink Services. It has cut staff, reduced manufacturing costs by consolidating its operations into fewer sites, and is focussing on its smaller markets in Asia, the Middle East and Africa, where demand is holding up better.

Although it made a loss this year after exceptional items (as it has on four other occasions in the previous decade, see the light blue basic eps line), the company scores six out of nine according to the F_Score, indicating it’s in reasonable financial shape. Cash flow remained positive, and it’s less indebted than it was in 2008. Overall 58% of the company’s assets are financed by shareholders’ equity (dark green line) as opposed to liabilities, which again suggests financial strength.

Much depends on Vislink’s other divisions, all of which grew revenues in 2009 and increased their share of total revenue at the expense of News & Entertainment:

That’s good news, although the doubling of revenues and tripling of margins in the Law enforcement division (LE&P) was helped by the acquisition of Pacific Microwave Research in 2008, and profits in Vislink Services were buoyed by work related to the digital switch over. News & Entertainment (N&E) and Marine & Energy (M&E) remain Vislink’s biggest markets.

The shares are attractive, considering the company is in reasonable shape, and the price (about 18p) is very low. A multiple of six times average earnings over the last ten years is well inside bargain territory. But average earnings has been distorted by a few bumper years so the measure is not as reliable as it could be.

I’m not adding Vislink to the Thrifty 30. With little more than £8,000, or 26% of the portfolio left in cash, I must be discriminating about adding more companies. I want some money in reserve lest the market crash.

The story is not compelling enough to unseat one of the existing Thrifty 30 companies, or spend cash, and the portfolio already contains Quadnetics, which serves the surveillance market Vislink is pushing into.

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