Nice read from SA...
Small But Mighty: Network-1 Security Solutions
Jan. 12, 2018 1:40 PM ET
4 comments
About: Network-1 Technologies, Inc. (NTIP)
Robert Leonard
Value, small-cap, special situations, long/short equity
Summary
•An overreaction in the market has lead to a significant discrepancy between price and value for Network-1.
•Network-1 is greatly undervalued with no debt and a lot of cash.
•Although Network-1 is small, they continue to prove their patent protection abilities by winning cases against behemoths.
•Minimal downside potential, with over 100% upside potential.
The current valuation of Network-1 Security Solutions (NTIP) makes this company very attractive in today's market environment of generally elevated equity prices. Undervalued equities are difficult to find right now, but Network-1 appears to be a diamond in the rough.
Photo Credit
Network-1 Security Solutions is a micro-cap ($56 million) firm that focuses on developing, licensing and protecting intellectual property assets for corporate and academic patent owners, as well as individual inventors. The firm currently owns over fifty patents in total, covering three main portfolios: Power Over Ethernet, Mirror Worlds and Content Monetization. The Power Over Ethernet portfolio includes technologies that allow the transmission of power through local area network cabling, rather than running new power cables. The Mirror Worlds portfolio covers technologies enabling search and indexing, displaying, and archiving of documents in a computer system (Network-1 Portfolio Descriptions). The Content Monetization portfolio includes technologies relating to the identification and tagging of online content, allowing businesses to act based on these identifications. This portfolio also covers technologies relating to the identification of plagiarism and copyright infringement through online media.
The management team has been a part of the organization for a significant period of time; Corey M Horowitz has been a board member since April 1994, Chairman of the Board since January 1996, and Chief Executive Officer since December 2003. Executive Vice President Jonathan M Greene has been working with Network-1 since December 2004, and Chief Financial Officer David C Kahn has been with the company since January 2004. The management team's interests are also closely aligned with that of shareholders, as they currently own about 14% of the company.
Morningstar
Financial Fundamentals
Although not linearly, the company has been a strong financial performer. They have seen their revenues grow from about $1 million to a normalized level of about $19 million in 2017 (according to their TTM) - providing them a compounded annual growth rate of about 44% for their revenues. Their gross margins have been declining over the past eight years, but are still a healthy 60%. One of the most important financial and valuation metrics of a non-industrial company is its book value growth and price-to-book-value. Network-1 has been able to obtain a compounded annual growth rate just over 45% for their book value, since 2009. In the past nine years (2009-2017), Network-1 solutions has had positive free cash flow in all years but three. In the three years in which they had negative cash flow, the amounts were rather minimal in comparison to other years positive cash flow and the cash level on their balance sheet.
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Morningstar
The most exciting part of Network-1 isn't their income statement, it is their balance sheet - more specifically, their cash position. Since 2012, they have been able to maintain a relatively stable and healthy cash position, with very little to no debt. After a very successful 2016, they have been able to more than double their cash position, bringing their total cash to over $50 million. For a large-cap company like Apple (AAPL), this amount would be insignificant, but for a micro-cap company like Network-1, this amount is very large. Remember, their market cap is only about $56 million, yet they are holding over $50 million in cash on their balance sheet. According to their September 2017 10Q filing, they have amassed $53,329,000 in cash and cash equivalents. While significantly adding to their cash position over the years, they have aggressively bought back more than 19% of their stock since 2011.
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Morningstar
None of their important financial metrics follow a smooth linear path, but they are all stable, if not increasing - the same goes for their free cash flow. Over the past five years, from 2012-2016, they had one year with negative free cash flow. Although it appears 2017 will be another down year for their free cash flow, it is not official yet, and looks to be rather minimal. In general, the company has strong free cash flow generation and is producing cash annually.
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Morningstar
Valuation
What makes this company intriguing is their intrinsic value in relation to their current stock price. Even using conservative figures to arrive at a valuation, this appears to be a great opportunity in today's market environment.
With a market cap just above $56 million, the cash on their balance sheet is almost equal to their market cap. With total cash and cash equivalents of $53,329,000 on their balance sheet, and 26,000,000 shares outstanding, that gives them about $2.05 in cash per share. The current stock price is about $2.30 - meaning you can buy the rest of the business for just $0.25!
If we remove the total liabilities outstanding from their cash holding, that leaves Network-1 with a net cash position of $50,213,000, or $1.93 per share - meaning you still only pay about $0.37 for the rest of the business, with all liabilities paid off.
Remember, this isn't including any growth in net income, free cash flow or book value. Using very conservative numbers (estimated year 1 free cash flow of $3 million, a growth rate of 1% for the first five years, a growth rate of 0% for the proceeding five years, discount rate of 10%, a multiple of 7.5x free cash flow at the time of sale, and 26,000,000 shares outstanding) to compute a discounted cash flow analysis, the present value of future estimated cash flows of the business add about $2.09 per share of value (this could prove to be even higher if the company continues to repurchase stock).
By adding the value of future cash flows to their current cash holdings, their intrinsic value is $4.02 per share. With the stock currently trading around $2.30, we have a 75% margin of safety - giving a significant margin for error in our estimations and computations.
Another valuation metric that is among my favorites is the Acquirer's Multiple. Although this valuation tool is generally used for industrial type businesses, it still gives a good illustration as to just how undervalued this firm is. The Acquirer's Multiple takes the market cap of a business, adds their debt, minority interest and preferred shares, then removes cash and cash equivalents to get the business's enterprise value. The enterprise value is then divided by operating earnings (similar to EBIT, but without one time/special income). I prefer to use operating earnings instead of EBIT due to the reasons Tobias Carlisle explains in his book The Acquirer's Multiple, "Operating earnings differ from EBIT because the operating earnings figure is worked out from the top of the income statement down, and EBIT is worked out from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries, and sectors possible. By excluding special items - income that a company does not expect to recur in future years - ensures that these earnings are related only to operations … Operating earnings allows an apples-to-apples comparison between stocks with different mixes of debt and equity." (Carlisle 75).
The lower the Acquirer's multiple, the more undervalued a business is. "Think of the enterprise value as the price you pay and operating earnings as the value you get. The lower the Acquirer's Multiple, the more value you get for the price you pay and the better the stock." (Carlisle 67). An Acquirer's Multiple of 0.47 is extremely low, especially in this market environment.
Another valuation metric that is common to use for a firm like this is book value; the firm is trading at about 1x their book value - a very reasonable and undervalued amount in today's market conditions. As seen below, competitors in Network-1's industry tend to trade at an average of 2.4x book value; the average for the S&P 500 is over 3x book value.
The table below also shows other metrics that illustrate the stocks undervaluation. On a Price/Earnings basis, the stock is trading at a significantly lower multiple than the industry average, the S&P 500 average, and Network-1's own five year average.
Morningstar
Also shown in this table is the company's dividend yield; their current dividend yield is a healthy 4%, well above industry peers and the S&P 500 average.
Recommendation
In the market environment we are currently experiencing, and the current valuation of Network-1 Security Solutions, this company is rated a buy, with a price target of $4.00 within 1-3 years. On November 13, 2017 the stock was trading at $4.40, only to be cut nearly in half over the next month on news of a lost lawsuit that had been pending. This does appear to be a bump in the road for the firm, but will likely not have a long-term impact on the business's fundamentals. The firm continues to acquire new business, having acquired a new patent to add to their Cox Patent Portfolio, and recently purchasing an entire portfolio of patents from M2M and IoT Technologies, LLC. According to a Yahoo! Finance report, "The acquired portfolio includes 12 issued United States patents relating to, among other things, the enabling technology for authenticating and using embedded SIM cards in next generation IoT, Machine-to-Machine, and other mobile devices, including smartphones, tablets and computers as well as automobiles and drones. It is estimated that the annual sales of devices making use of embedded SIM technology will exceed 500 million units by 2024 as they are used in an extremely wide assortment of connected devices." Investors will want to continually watch Network-1's new acquisitions of IP/patents, as well as their increasing cash holding. Not only has the company been proving they are able to obtain new intellectual property, but they also have a very solid track record for winning patent infringement cases against some of the world's largest companies. They have taken on patent infringement cases against Google/YouTube (GOOG), Facebook (FB) and Apple (AAPL).
With this firm being a micro-cap, it can take more time for markets to realize it's true value, causing investors to remain patient. If investors can remain patient, this position has over 100% upside potential, with minimal 16% potential downside. While investors wait for the stock to reach its intrinsic value, they will be able to collect a healthy ~4% dividend. Although the stock is already priced for worst case scenario, if things did get worse, the company has net cash at $1.93, putting a floor on the stock price just $0.37 below the stock's current price. "A good price implies a lopsided bet: a small downside and a big upside. The downside is small because the price already assumes the worst-case scenario. This creates a margin for error. If we're wrong, we won't lose much. If we're right, we'll make a lot. An upside bigger than the downside means we breakeven, even if we err more often than we succeed. If we manage to succeed as often as, or more often than we err, we'll do well," (Carlisle 137). As successful value investor Mohnish Pabrai frequently says, "Heads, I win; tails, I don't lose much!"
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NTIP over the next 72 hours.
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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