Arc Wireless (ARCW) – Possible Net-Net Value Play

ARC Wireless (NASDAQ: ARCW) is a possible net-net value play.

What first got me interested in this one was that the stock was trading at a discount to liquidation value. A net-net value play in the truest sense of the word? Let’s see…


Seeing numbers like this can get you a little excited.

These numbers are all from their most recent 10Q. I applied a discount to the receivables and inventory as is customary (due to lack of liquidity/collectability) per Benjamin Grahams methodology.

The way these numbers shake down, you get $3.66/share in net current assets against a market price of $2.65.

It doesn’t happen that often where you find a true “net-net” – meaning the company is valued by the market at less than its estimated liquidating value.

For a “died in the cloth” value investor, net-nets are a thing of beauty.

A closer look indicates ARCW has been a company in rapid decline over the past 5 years. It looks like a horse that needs to be put out to pasture. Given this company’s history and business model, it gets easier to see why it’s being given up for dead.

ARCW sells broadband wireless antennas that…apparently nobody wants anymore. They were sporadically making money prior to fiscal year 2006…when everything went south.

Situations like this can be interesting. Sometimes the board and management know the game is over and take appropriate action to return capital to shareholders. If you can get into a situation where there is some uncertainty over future actions or when the company is stuck in limbo, you can make a decent return. Instead what usually occurs are instances where the board and management will suck every dollar out of the company with various frivolities until the company files Chapter 7.

One thing you really have to look at – perhaps the most important thing- with a net-net is the way in which value will be uncorked. This usually happens one of two ways:

1.    The business has still has earning power which has been totally discounted to zero by the market, in which case if the company keeps earning money the earning power will be priced in again, as the share price will reflect this ongoing value.
2.    The company unwinds itself gradually and value is returned to shareholders by an orderly liquidation – special dividends, liquidating distribution, sale of technology and other assets, etc.

The first (#1) situation is by far the most common and most profitable (at least it has been for me). With the second case, it is rare that the company’s board and managers will “know when to say when” and return value to shareholders. Usually, a catalyst such as a small investment company or hedge fund manager coming in a 13-D type situation and agitating change is one of the best ways for shareholders to realize value.

A big concern with #2 situations, as we have with ARCW, is the net-net surplus value being eroded due to incompetence, malice or just plain ignorance on behalf of management and the board.

So, one of the first things you have to look at is the burn rate of cash.

The most recent 10Q (as reported in May) shows ARCW is burning through about $330k per quarter. What is especially concerning about this is they have spent money buying plant and equipment and acquiring patents. These expenditures show management’s belief in “keeping the fire burning.”

At this rate – all things equal – ARCW will burn through $1.3 million this fiscal year.  If this pace keeps up, the net current asset value per share will be $3.23 one year from now. This then leaves us with 18% discount, given the current market price of $2.65/share.

Burn rate is definitely a concern with ACRW.

Next we have to find other potential destroyers of value.

Looking at the “Related Party Transactions” should always be mandatory in due diligence, but in the case of a net-net it is very important.

Why?

Because often net-nets are small companies and can have closely held stock. Management may be trying to pull a fast one on shareholders by extracting value away from the company and into the interest of officers and directors.

With ARCW, I have substantial concerns in this regard.

It was disclosed that the CEO of ARCW, through various entities, controls 22% of the common stock. With this power, the CEO has had the company engaged in various transactions with outside entities controlled by himself.

Of particular note is the “financial advisory and business consulting” agreement the company has with Quadrant Management. Quadrant is controlled by the CEO of ARCW. The agreement calls for Quadrant to make $250k per year minimum until 2013, or 20% of any increase in operating income the company may earn.

I can only interpret such an agreement as the CEO receiving $250k per year from the company, regardless of performance.

These little side agreements should be closely scrutinized by shareholders of every company. It is an often used way for management to make money at the expense of shareholders….and a BIG reason why looking at the percentage of the company owned by management is not always indicative of them being focused on building shareholder value.

For instance, let’s say the CEO of a company owns 20% of the stock. This means he gets 20% of the profits after taxes, which on the surface should provide incentive for him to make the company profitable.

But, instead of working hard to make the company money and share in only 20% of the spoils, why not get a whole lot more?

Here’s how:

If, for example, a company had a pretax profit of $1,000,000 and a 50% tax rate, the CEO owning 20% of the common stock would make $100k on the stock.  But…what if instead the company signed a consulting agreement with a firm owned by the CEO, for $250k/year?

That would leave pre-tax profits of $750,000. With a 50% tax rate, the CEO would make $75k on the stock….PLUS the $250k from the “consulting agreement.” That’s a total compensation of $325k (not including normal salary and benefits).

This is an example of the classic “principal/agent” problem at its best.

In the case of ARCW, the case is not this egregious…but I don’t like the consulting arrangement at all.  It’s clearly not paying off in terms of improved company performance.

If ARCW would liquidate now, the CEO (owning 21% of the stock) would make a little over $2.2 million.

Seems like it may be a good idea to start winding things down, right?

Why keep things going and make $250k per year (from the consulting contract) for the next 3 years ($750k) when you could make almost 3 times that amount?

Is there another reason to keep the fire burning?

It could be because ARCW also purchases $200k/month ($2.4million/year) in inventory from another company that is controlled by the CEO, called RIL.

The question is: are they getting a good deal from RIL, relative to any other supplier? And, does it even matter where they heck they are getting their stuff, as they don’t have any kind of order backlog or semi-decent prospects of increasing sales?

The incentive could be this:

Say the gross profit margin RIL is making on their sales to ARCW is 40%. That means (on average), every $2.4 million in annual sales to ARCW equates to $960k in gross profits for RIL. Not too shabby.

If we add up and include the “outside incentives” of the CEO of ARCW (consulting contract + inventory purchases), we get approximately $1.2 million per year in financial benefit.

The question of whether to start unwinding things or not is now flipped on it’s head: why would you voluntarily liquidate and unwind the company for $2.2 million now, when you can milk it for $1.2 million per year ongoing?

It looks like ARCW’s cash horde could simply be a treasure chest to pillage.

Considering the CEO (beneficially) controls 21% of the common stock, most of which was acquired prior to the 3rd and 4th quarters of 2008, I conservatively estimate their cost basis at or around $3.50 to $4/share.

With 671,000 shares beneficially owned, this equates to a cost basis of $2.3 – $2.6 million.

Given what they have already taken out of this business and what is possible in the near future,  it’s easy to see why the status quo could remain indefinitely. The ROI for them goes up month after month like clockwork. The status quo would be completely detrimental to shareholder interest.

But…this status quo only holds up if there is a continuing genuine demand for the company’s products to drive at least some sales. It does look like this demand is there, but very minimal.

Possible Catalysts for Value Realization

All might not be lost for taking a long position in ARCW.

Recently, a 13-D (statement filed with SEC once a person or company acquired 5% or more of outstanding commons stock) was filed by an individual investor (Greggory Schneider). This investor stated on the 13-D form: “Mr. Schneider believes the stock is grossly undervalued, having a liquidation value of $3.50/share without valuing the company’s business. Mr. Schneider may engage in conversations with management about how to maximize shareholder value.”

This position and statement on the 13-D is interesting. Is there room for more activism? Will Mr. Schneider get more shares and agitate for change?

Maybe Mr. Schneider knows more than I do about the wireless antenna business…but I think it is a big stretch to say there is a value in this company’s “ongoing business.” Even stripping out the $250k/year paid to the CEO’s company for “consulting,” ARCW will still burn about $1 million this fiscal year.

Perhaps Mr. Schneider sees value the company’s intellectual property (licensing possibility?)…but you’d have to really be an expert in this industry to know that. I cannot bank on it for my analysis.

Since present management controls 21.7% of the common, it stands to reason somebody like Mr. Schneider could get up to the 10% or even into the 15% range of common stock ownership and get a board seat. Although, this type of action may not be welcomed with open arms by management and the board.

There is also a 14% holder on the books (Mr. Rini), but his holding appears passive.

The other big holder of stock is Randall Marx at 5.4%. He’s the former CEO and does not hold a board seat. His stock is probably left over from when he was involved with the company. I’m guessing he wishes he would have sold a few years ago.

Roughly 40% of the company’s outstanding common stock is tied up in 3 entities/individuals. This leaves a 60% float up for grabs. A tender offer is possible that could bring about value realization.

The next factor to look for is any kind of “poison pill” or “change in control” agreements which could bleed shareholders dry in the event a shareholder friendly investors gets board seats and starts to liquidate this company.

Their current CFO has a contract to make $245k/year. But that ends in fiscal year 2012. There are no ‘change in control’ agreements which compensate management (often egregiously) if there is a change in control of the company.

I couldn’t find any other evidence of poison pills that would prevent shareholder value from being unlocked.

Other Risks

Other factors to evaluate carefully in ‘net-net’ situations are legal/regulatory problems and off-balance sheet liabilities.

Sometimes a company will find its stock beat down because of an announced lawsuit which could impact the business. Many times these share price beat-downs are overblown.

ARCW is currently fighting with some of its customers in collections, but there aren’t any material legal issues or regulatory issues disclosed at this time.

What’s not overblown enough, however, are off balance sheet liabilities. These occur most frequently with long-term leases, pension and other post retirement employee benefits, purchase _ funding commitments and warranty costs.

As of the most recent 10-K, ARCW doesn’t have any off balance sheet liabilities, save for their commitment for the “consulting services” to a related party of the CEO for $250k per year.

Verdict

I see a long position in ARCW possibly making sense right now IF the possibility arises that an investor aggressively comes in (a 13-D situation) and agitating for a special dividend and unwinding of the business. There is zero going concern value. Present management has indicated they really don’t want to do anything to kick start the earning power (if it was even possible given their business model).

With ARCW right now you have a maximum upside of 27.5%. It’s likely that even if the board voted right now – and shareholders accepted – a plan of liquidation, the upside would be perhaps 15%-20%. This is because probably $1-1.5 million or so would get eaten up in ongoing expenses (legal, tax, compliance, etc.) and liquidation costs. And the time frame for an orderly liquidation would be indefinite. Shareholders would probably get a one-time special dividend (I think they could probably do $3/share or so) and then the company would begin unwinding. 12-18 months is what I’m guessing the likely scenario would be. But it could be much longer.

It is entirely likely cash will continue to be burned and that ARCW will limp along until all the cash has been milked out – with shareholders receiving little to none.

I hope this is not the case.

At this time I need a little more cushion to think about going long ARCW.

If I could pick it up around $2.25/share or so I could feel better about having a higher margin of safety on the purchase. If I do take a position, I would likely try to acquire a large position (circa 5% or more depending upon trading spreads) and communicate directly with management and the other shareholders to bring about value realization.

Those considering a small long position in ARCW would do well to pay close attention to every 8k filing and press release issued by the company, in addition to the regular financial reports. If a bigger fish comes in, the value might be realized.

Disclosures: I do not have a position in ARCW at the time of this writing and I do not plan on taking on in the next 72 hours.



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