EMCORE Corporation (EMKR)

[chmcnfunds]

Emcore: Trading Near NCAV With A Free Option On The Operating Business, But Binary Risk Remains


Mar. 17, 2016 10:08 AM ET| About: EMCORE Corporation (EMKR)
Martin Vlcek Martin VlcekPremium Research »?Follow(1,435 followers)
Contrarian, growth at reasonable price, macro, small-cap

Summary

EMCORE trades very close to its net cash and cash equivalents and even closer to its net current asset value.

Sum of the parts valuation shows the stock has ~45% upside.

However, a pending binary outcome of a litigation arbitration poses a significant tail risk.

Overall, the risk/reward is attractive.

I've been following and trading EMCORE (NASDAQ:EMKR) for over a year but the stock and its operating business and industry outlook have been very well covered on Seeking Alpha, so I didn't feel the need to add anything. However, now the stock price has fallen so low and so close to the value of EMCORE's cash on its balance sheet and its net current asset value (NCAV) that I have to add my two cents.

Investment thesis

The stock trades very close to its cash and cash equivalents, and even closer to its NCAV. This would be nothing special due to the opportunity cost of having our money locked in this investment. But there are several other hidden values that make this investment essentially a free call option with substantial upside. If we ignore the opportunity cost of money, the option is virtually free. But even if we consider a reasonable required rate of return, EMCORE is still an attractive investment in terms of its risk/reward, because the sum of the parts valuation shows the stock has ~45% upside, depending on how we value the business and the net operating losses (NOLs), as well as the binary outcome of the Sumitomo arbitration result.

Cash level

At the end of 2015, the company had $115.52, or $4.46 per share of cash and cash equivalents. The stock now trades ~13% above its cash level. If you add Accounts receivable and subtract Accounts payable (near-cash equivalents), the picture improves even more and the company trades just 7% above this measure of cash and near-cash equivalents.

NCAV

At the end of 2015, the company had $150.24M in current assets and $23.33M in total liabilities. So Benjamin Graham's famous NCAV stood at ~$127M. The current stock price of $5.08 makes the company worth ~$133M. So EMCORE trades less than 5% above its NCAV.

I believe that unless the company starts losing cash on its operating business, the current stock price level around the $5 mark will prove to be a very strong fundamental support zone due to the NCAV shown above. The reasonable downside here is very low unless the economy tanks.

Value of the operating business

So far, it looks like investors are essentially buying a $1 bill for $1.07, which is not a good deal, especially if you consider the opportunity cost of not being able to use this money for other investments. But there are other hidden benefits we haven't discussed yet. First, investors are getting a free option on any future positive free cash flow that the operating business can generate. Nevertheless, we are talking about a low margin, competitive space, if the business can generate a ~2% positive net FCF margin on stagnant sales of ~$100M. At a 10% required rate of return, this FCF stream would be worth ~$20M, adding ~15% to the total value of the stock. Yet the company's sales are rising.

The value of the net operating losses (NOLs)

The company has ~$575M in accumulated deficit on its balance sheet. Although only a part of the tax loss carry-forwards is immediately available for use without restrictions and a significant portion is locked out abroad, still, there is tremendous value. If I simply used a very conservative 20% tax rate on all of the NOLs, they would be valued at ~$115M. When discounted at a 10% required rate of return over ten years, I would come up with a present value of roughly $65M, or $2.5 per share. This value is reasonably close to the estimate of ~$2 per share from a fellow Seeking Alpha contributor.

EMCORE is definitely not a "no-brainer" buy. There are several risks involved

In the shorter time frame, the company acknowledges there is a risk of a large litigation loss to the tune of up to 40% of the current market cap from an arbitration with Sumitomo (see page 18 of the 10-K). As of February 4, 2016, "the arbitration has been completed and the Company is awaiting the arbitrators' final decision."

In light of the Annual meeting's decision not to pay out the special ~$3 per share dividend at this time, I believe one of the factors why the company decided to wait is the uncertainty about the potential litigation fines. The company believes the claims are without merit but given the recent stock price weakness and Becker Drapkin selling most of their large EMCORE position, the ticker tape action speaks for itself: the knowledgeable insider market participants seem to price in at least some risk of the litigation not being favorable to EMCORE, or some other adverse event.

The postponement of the decision on the one-time dividend doesn't have to be related to the Sumitomo litigation. It could also mean the company simply wants more time to make a decision or that they are considering other uses of the cash, such as a buyback (which would be very positive for shareholders) or a merger with some profitable company in a similar business.

This would allow for a more rapid utilization of the NOLs (positive), but the merger would also result in a larger risk of the operating business as the results would matter more when the cash portion shrinks. This would increase the risk profile of the stock, but could also mean significant upside depending on the merger conditions (price paid) and profitability of the newly acquired business.

In the longer time frame, one of the main concerns is that risk of a "melting ice cube" due to possible negative net cash margins from running the real business and also from the fixed overhead represented by management salaries and bonuses. Indeed, the recent Annual meeting approved an expanded total number of stocks available for compensation.

The most recently reported quarter, ended December 31 2015, showed practically zero operating income from continuing operations. This margin weakness could be seasonal, because, although operating income worsened in relation to the previous quarter, it improved by a massive $5M compared to the same quarter a year ago, when it was significantly negative.

Of course, we also need to factor in that the composition of the business was different. In short, it is hard to extrapolate now due to lots of moving parts. This means there is a risk that the value of the operating business is zero or less than zero in the long run, if the business can't operate above cash break-even. And this is clearly reflected in the stock price and partly creates this buying opportunity.

The catalysts

Obviously, this investment needs a catalyst. Otherwise, the stock may linger around the current price literally for years without any paper or real gains for investors to realize and the "ice cube" may start to melt.

However, the company last year repurchased shares worth roughly $45M. So it is willing to serve shareholders. It could do so again this year once the litigation risk is firmly quantifiable. Or it could still decide to pay the one-time dividend. A takeover of another company could provide a stock price boost as well, depending on the price paid and the risks involved. Due to the NOLs, EMCORE is unlikely to be sold to another company (a large change of ownership).

Wrapping it up

I like EMCORE at the current price and see a ~45% upside and a target price of ~$7.50 per share. I am long EMCORE and those who don't have a position should consider getting long. However, I will wait for the arbitration outcome before deciding to buy more because my position is already quite large.

It is very likely that some investors have an edge over me regarding the Sumitomo arbitration risk, because I have no close information about the case or litigation/arbitration know-how. So the arbitration risk may be underpriced or overpriced by the market. Given the low stock price in relation to its cash level and NCAV, it seems lots of pessimism is priced in. This provides an attractive risk/reward opportunity to buy now.

Disclosure: I am/we are long EMKR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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http://seekingalpha.com/article/3959225-emcore-trading-near-ncav-free-option-operating-business-nols-binary-risk-looms?auth_param=udil:1belcrb:bd561e592e57ffd906e1f95d467dcfde&uprof=46#alt3

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