Value Find: Stratos International
After a lull for several quarters, things may be about to heat up at little-followed Stratos International (Nasdaq: STLW).
The $111 million market cap niche tech company should wrap up its strategic alternatives review process over the next month or two. Last September, Stratos, a manufacturer of RF, microwave and optical subsystems and components, announced that it was reviewing its strategic alternatives with an investment bank. This move came after large Stratos shareholder Steel Partners made an unsolicited $7.50 per share buyout offer for the company. Steel has a 15% stake in Stratos and has been in the stock since January 2005.
Chicago-based Stratos was formed through the November 2003 merger of Stratos Lightwave, an optical subsystems and components provider, and Sterling Holding, which had its roots in the RF and microwave interconnect business. A one-time tech darling, Stratos fell hard after the tech bubble burst and dropped off Wall Street’s radar. Stratos CEO Philip Harris inherited a badly struggling, unfocused and unprofitable company when he came aboard in December 2004.
Under Harris, Stratos has made an impressive turnaround the past three years, settling legacy litigation, drastically improving its corporate governance and shedding unprofitable operations. The company, with $90 million in annual revenue, has cut over $7.5 million in annual operating expenses under Harris, and has evolved into a solidly profitable and nicely growing niche tech play. The telecom/enterprise and military segments today each represent about 40% of Stratos’ total revenue, with industrial, medical and video making up the remaining 20%. The largest customer is General Dynamics (NYSE: GD), with 10% of total revenue. Stratos tries to stay away from commoditized products.
The stock has been a strong performer over the past few years, up 70% since Harris took the helm, compared with a 14% gain for the Nasdaq. Over the last year, though, the stock has been locked in the $6 to $8 range, and since last fall has been stuck around the $7.50 level after activist hedge fund Steel made its buyout offer. On its March conference call to review results for the third quarter ended Jan. 31, 1007, Stratos management said it expects its review process to be “resolved” in the fiscal fourth quarter. This suggests there could be an announcement from Stratos by the end of this month or soon thereafter.
For its most recent quarter, Stratos posted revenue of $22.3 million, up 16% annually, and net income of $1.5 million, or $0.10 per share, compared with a loss of $1.1 million, or $0.8 per share, a year earlier. Gross margin improved from 36% to 39%, and operating expenses declined by $0.36 million. Earnings before interest, taxes, depreciation and amortization (EBITDA) ticked up slightly sequentially to $2.6 million in the fiscal third quarter compared with $2.5 million in the second quarter. Stratos has now cranked out eight quarters in a row of positive EBITDA and has been net income profitable for the past two quarters. Stratos’ fiscal Q4 results should be out in early June.
The company’s balance sheet remains strong with $31.3 million, or $2.16 per share, in cash on hand and just $1.2 million in Series B preferred stock. Capital expenditures are modest at about $1 million per year. In early April, Stratos announced plans to sell excess real estate for $7 million, which after paying off the property’s note and fees, should result in several million dollars more in cash on its balance sheet. Stratos is also sitting on roughly $38 million in potentially valuable net operating loss (NOLs) carry forwards. These NOLs have started shielding Stratos’ taxable profits.
Stratos doesn’t provide guidance, but it looks as if the company could generate $95-$100 million in revenue for fiscal 2008 and that it could post EPS of $0.55 or more next year. Stratos’ quarterly depreciation and amortization (D&A) will decline by $0.5 million starting in the fiscal first quarter of next year. In an investor presentation last month, Stratos management suggested the $81 million enterprise value firm could be worth $12 per share if it traded in line with its peer group on an enterprise value to revenue basis. This target seems aggressive, but a fair value of $10 per share seems reasonable.
Stratos isn’t a small cap name that has raw “homerun potential” in our view, but it does look like an undervalued, quality small cap play with several catalysts on the horizon and good downside protection. In addition to Steel Partners, activist investor Bryant Riley quietly became an 8% holder of the stock last November. Even if Stratos isn’t acquired at a nice premium over the coming months, the company looks poised to deliver improved profitability over the next year, which should translate into a higher stock price.
Bottom-line, Stratos looks like a good “value find” for lower-risk oriented investors.
