Marking the target — Veramark in my sights

As it is the case for all postings in this blog, my standard disclaimers apply for this posting.  However, since this posting discusses investments, I urge you to review the disclaimers laid out in the About section with extra diligence. Moreover, even if you have already reviewed these disclaimers in the past, you need to review them again, as they are subject to change without notice.  Do it now, and remember that whatever I say in this blog posting is simply my opinion — it is not science, it is not advice, and it is not an attempt to make you act in any way whatsoever.

LandscapeOnce in a while I go to a local Meet-up, which in my neck of the woods happens to mostly be dominated by swing traders, the alchemists of the financial world, leaving me a bit lost and disgruntled when the meeting is over.

Occasionally, however, a triple-zero speculator appear at these meetings, looking just as lost as I feel, which makes for great fun, and, typically, confirms my bias against — or, perhaps more accurately, disdain for — triple-zero speculation.

This bias, of course, is a horrible thing, so when faced with triple-zero speculators I attempt to maintain my humility by keeping in mind that the way I look at triple-zero speculators is probably reflected pretty accurately by the way that NYSE, S&P, and even micro-cap traders look at me, since I prefer to operate in the micro-micro cap land where a per share price of $5 is considered good and a capitalization of below the triple-digit million is appealing.

Mind CTI — An investment lesson

As I described in a recent posting centered on Mind CTI, I focus on micro-micro capitalization companies because I am able to find stable, overlooked companies and equities in this range, and because the exclusion rules for most institutional investors means that I do not have to worry about a particular group of competitors (investment is, at the end of the day, a competitive sport.) In other words, I play in the sandbox because I have a fair level of certainty that no larger kids are going to come around and kick me out.

My investment in Mind CTI is a textbook example of my approach to investment in micro-micro capitalization companies. I followed Mind CTI for many years before I invested, and, frankly, for a number of these years it did not look like Mind CTI would be a good investment. At some point, however, I could see that, from a pure fundamental valuation point of view, things were poised to improve markedly and very quickly and, so, I threw my full weight behind the related equity, MNDO, attempting to catch the infliction point. The results were very good, and, as I wrote in my posting about a hypothetical investment in Mind CTI:

[M]y calculations are raw, but the upshot is that if you had invested $100,000 at the $0.65 (or so) per share price level in 2009, and since 2009 had reinvested 50% of the post-tax dividend yield from MIND into acquiring additional MNDO shares between 7 and 30 days after the ex-dividend date (retaining the remaining 50% of the post-tax dividend for, if you will, shopping-around money,) then your portfolio of MNDO shares would by February of 2011 be worth an astonishing $730,000 or more (at a price of $3.35 per share) and you would have collected more than $81,000 in shopping-around money.

The important point about my entry into Mind CTI’s equity was that (1) from an operational viewpoint, it was clear that Mind CTI was doing very well, (2) that the company was profitable and had good free cash flow, and (3) that the confluence of events that made the company’s equity cheap were very well understood by me.

Hoping to apply the same approach I had stalked MER Telemanagement Solutions and its Nasdaq exchange traded equity, MTSL, for more than five years, but, unfortunately, a play was not possible because the company’s anchor client underwent an event, raising doubts about the sustainability of the company’s fundamentals, and because speculators flooded the equity, something that I wrote about here, here, and here.

Both Mind CTI and MER Telemanagement Solutions are in the telecommunications business and dabble in the expense management domain. Another player in telecommunications expense management domain, a fairly crowded space, is Veramark Technologies, a Rochester, New York, based company. I have stalked Veramark Technologies for almost ten years, and I think that time may finally have come for for me to step into its equity, VERA.

On a sidenote, although it is not really germane to the investment thesis that underlies our interest in Veramark Tehcnologies and VERA, it is interesting to note that Mind CTI, MER Telemanagement Solutions, and Veramark Technologies’ histories are interconnected in a number of non-trivial ways.

Veramark Technologies

3946086952_7cee33472e_oThe story of Veramark Technologies is long and, for many years, frankly, not very distinguished, including elements of what, to my mind, is best characterized as mismanagement and a general lack of respect for the common shareholder. Moreover, through much of its history, Veramark Technologies has been saddled with a pension arrangement that has been almost crippling for the company from both an M&A and balance sheet perspective, and appears to mostly having been instituted as a perk for the one of the company’s earlier Chief Executive Officers.

The dispositions and actions of the company over more than a decade did not go unnoticed with investors mostly seeking refuge, and the company’s equity being relegated to OTC. Because these dispositions and actions are not only integral to a new potential investor’s understanding of Veramark Technologies and its equity, but also holds valuable general lessons for anyone who are considering any investment into publicly traded company, I will in a later posting attempt to provide more background on the decade. Stay tuned!

There was a significant and much needed change in the executive management a couple of years ago, and since this change, the company’s fundamentals and operating situation have slowly and gradually improved, resulting in consistently and markedly improving top- and bottom-lines — except for a recent misstep related to the litigation of Veramark Technologies by a third party in relation to intellectual property. The litigation was resolved through a settlement in 2011, but it did put a significant financial burden on Veramark Technologies throughout its fiscal years 2011 and 2012, delaying the company’s return to profitability.

The company’s revenues for fiscal year 2011 totaled $13.9 million — a year-over-year increase of 6%, but its net income was negative, amounting to a net loss of $1.2 million for the fiscal year, equal to earning per share of -$0.12. Absent the litigation and settlement cash expenses ($863 thousand in the fiscal year,) non-cash charges in relation to an effort to minimize the long-term impact of the pension agreement ($912 thousand,) and certain other charges, the company would have had positive net income of $555 thousand for the year, equal to $0.05 per share.

On December 31st 2011, Veramark Technologies had a backlog of $12.6 million, up from $9.6 million from December 31st, 2010, of which approximately $7.6 million was expected to be recognized as revenue during 2012.

In spite of a cash payment of $250 thousand in fiscal year 2012, finalizing the settlement, the first three quarters of Veramark Technologies’s fiscal year 2012 have been strong. Aggregated net income for the quarters was $475 thousand on revenues of $11.3 million, up from $10.1 million in the first three quarters of fiscal year 2011. Aggregated free cash-flow for the three quarters was -$75 thousand, i.e. $175 thousand net of the settlement.

Total orders received during the three quarters increased marginally on a year-over-year basis, and, importantly, gross margin for the three quarters was 58% of revenues.

Finally, absent the pension liability, the balance sheet is now as clean as it gets — albeit it not strong, with the company having very limited amount of cash and similar current assets.

In my view, it is highly likely that the company, at the end of the 2012 fiscal year will record positive cash flow, record revenues, and record backlog, marking an infliction point for the company, and possibly causing the company’s equity to be noted.

In fact, at this stage, it would, I think, take a macro-economic event, malfeasance, or near-criminal stupidity on behalf of the company’s management for Veramark Technologies to not be able to record significant progress for the 2012 fiscal year, and the company should be well positioned for an ascent in revenues, earnings, and market capitalization throughout fiscal year 2013.

Assuming that the net income for the fourth quarter of fiscal year 2012 turns out to be $0.03, a $0.01 improvement over the third quarter, for earnings per share of $0.07 for the fiscal year, and assuming an average per share price of $0.55, then trailing twelve months’ P/E will be approximately 8. If the per share price holds at the $0.55 level and the company achieves $0.03 in EPS per quarter for the next fiscal year, the P/E for the 2013 fiscal year will be approximately 4.5, a bargain by any measure.

This may be good…. We will see what happens next.

Caution

3641567660_081338508f_oThere are, of course, potential issues with Veramark Technologies and its equity as an investment object: (1) the company’s stock compensation plan has generated more than one million shares that are exercisable at an average weighted exercise price of $0.71 per share, (2) the company’s pension obligations will continue to suck cash out of the company for many years, dragging on net income and constituting a considerable obstacle to any M&A related activities, (3) the liquidity of VERA is limited, so assuming any significant position will require skillful buying to prevent the price from raising in a typical bid-against-yourself scenario and extracting oneself from the position before the market embraces the equity will be difficult, if not impossible, and (4) we cannot predict when the market will embrace the equity, and so an investor must have infinite patience (a typical problem, which I have written about at length in my investment related postings.)

Let me say this again, focusing, in particular, on the option related risk. The company’s shares, which are currently trading at a price of approximately $0.75 per share, could potential see a dilution of one million shares at an average strike price of $0.71. While the current per share price means that this is not much of a problem (flooding one million option/shares at, say, $0.75, with a strike price of $0.71, will infuse approximately $710 thousand into the treasure, making this near-wash,) a significant appreciation in the per share price will dramatically change the situation

The liquidity issue is manifest in the meager trading volume for VERA. In fact, absent a recent significant accumulation by Peter H. Kamin, an institutional investor, there is near zero liquidity in VERA.

This being said, I do believe that there is now a significant opportunity around VERA, and given the flood of liquidity that I saw around a somewhat similar chain of events for MER Telemanagement Solutions’ MTSL equity, I think it is possible that the liquidity issue will not be a long-term problem.

Having drawn a parallel between MTSL and VERA, it is, I think, prudent to point out an important difference between the MTSL equity and the VERA equity, namely that the number of issued shares for VERA is much higher than the number of issued shares for MTSL and the free float for MTSL is extremely limited. In fact, the limited free float for MTSL has caused — and continue to cause — an acute shortage of available shares leading to a sustained speculative bubble in MTSL, which has yet to implode. With more than 10 million shares outstanding and a reasonable free float, the same phenomenon is unlike to manifest itself for VERA. You can read more about the free float issue in my posting about how to recognize speculation in equities.

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