Communications Systems Unloved Restructuring Story Portends To 70% Upside

Communications Systems: Unloved
Restructuring Story Portends To 70%
Upside
|Must Read May 31, 2016 7:30 AM ET
by: Lester Goh
Summary
• Due to declines in fundamentals, investors appear to have given up on
Communications Systems, evident by the Company trading at a discount to
book.
• However, management is not resting on their laurels. R&D has been
increased and Communications Systems is refreshing its product portfolio to
reinvigorate growth. A rationalization of operations is also underway.
• Fair value of ~$11, implying ~70% upside.
• Estimated liquidation value of ~$71m exceeds the Company's current
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market cap, suggesting substantial protection on the downside.
To say that Communications Systems (JCS) ("JCS", "CommSystems", or "the
Company") has underperformed would be an understatement.
Since 2011, the top-line has declined by ~25%, or ~$36m, gross margins have thus
contracted roughly 1200bps from ~41% to ~29%, operating margins have similarly
retreated, and the Company is currently more or less breaking even on a free cash
flow basis when one adjusts for the lumpiness by averaging results over multi-year
periods.
The bear case is predicated on such a pattern continuing.
Unsurprisingly, investors have apparently given up on JCS, evident by shares
trading at a discount to book. However, it seems like shares are too cheap at the
moment and appear to be pricing in a draconian scenario, something that I disagree
with, upon deeper analysis. The JCS story is not a slam-dunk, but its not exactly
shabby either.
Management has clearly gotten the message the market is sending, and they are
not resting on their laurels. By inferring from the actions that management have
taken (and are taking), it is quite clear that the Company initially thought that its top-
line would recover without much effort on their part. In light of business
developments in recent years, this particular line of thought is likely non-existent at
the current time.

As an example, operating expenses remained rather elevated since 2011 even in
the face of declining sales (i.e. current expense levels are likely able to support
revenue levels in excess of $145m), which was due to overly mature product
offerings.
Back-To-Basics: Refreshing The Product Portfolio + Rationalize Operations
Broadly, executives appear to be tackling the aforementioned issues by being laser-
focused on R&D in order to introduce new products which would hopefully
reinvigorate growth. R&D spending has tripled from ~$2.8m in 2013 to ~$8.3m in
2015 and has begun to bear fruit.
While these numbers may appear minuscule in absolute terms - this is certainly so
when you consider that the 800lb gorilla in the space is Cisco, I gather that JCS can
thrive by focusing on niches whose total market size is too small for giants such as
Cisco to bother entering. So JCS can do well by focusing their limited resources
largely on a small subset of customers or on markets with broad applications with
mostly homogeneous customer demands.
For the former, this is evident when you consider that the Company's Suttle
segment primarily caters to large telecoms such as Verizon, AT&T, and
CenturyLink. As for the latter, this is apparent in the Transition Networks segment.
It is clear that significant progress has been made on this front - see here, here,
here, and here - in recent years. More examples of new product development,
qualifications, and certifications can be seen in their recent investor presentations
(specifically, this 2015 presentation - slides 7, 8, among others).
Importantly, management is targeting 29% new product revenue relative to total
revenue in 2016 (presently 14%), growing to 36% in 2018. By all indications, this
seems highly plausible (more on specific segments later).
In the Company's segments that involve manufacturing (i.e. Suttle & Transition
Networks), JCS either outsources ~33% to contract manufacturers (Suttle), or fully
outsources (Transition Networks). Thus, gross margin leverage derived through
manufacturing would be present, but not prolific. New products which naturally carry
higher margins would further augment gross margin expansion.

JCS does not appear to hold any quarterly conference calls, and the Company has
also only recently started discussing the sales contribution of its new products and
the fact that it is likely to grow at rapid rates going forward. Notably, it does not
break out new product contribution in its regulatory filings.
As a result, it seems likely that the market has not fully understood the implications
of the refreshment of the product portfolio would have on the firm's growth and
margins - recent share price action certainly supports this assertion.
Rather, it seems as if investors have sold almost solely on headline results (i.e. top-
line decline, gross margin contraction, etc), not bothering to dig deeper. Seeking
Alpha also has next to no coverage on the Company, with only 3 articles being
penned to date, further suggesting that my thesis isn't well-known. Street coverage
is similarly sparse, something that should not be surprising seeing as JCS does not
hold quarterly conference calls - they simply issue quarterly press releases detailing
results.
Apart from new product development, management has also recently embarked on
initiatives to change the business structure (which notably included the hiring of
Roger Lacey, former SVP for strategy & development at 3M) as well as rationalize
operating expenses. In my view, bears are likely skeptical with respect to the extent
of the potential restructuring benefits, whereas I hold the opposite view.
As an example of expense rationalization, the Transition Networks segment has
seen its SG&A decline by ~$3m, with costs being taken out from areas such as
supply chain, sales & support, admin, among others, as seen below. Management
also issued a press release to give investors an update on their progress.

Source: 2016 Shareholder Presentation
As the above slide alludes to, there is still much to be done to rationalize the
Company's operating expenses. The question is, how much?
Management sees 1100 bps of margin improvement through OneCSI (their
restructuring initiative), and historical numbers suggest this is a reasonable
expectation, particularly as the Company's segment mix have not changed much
over the years, apart from a small ~$1.4m bolt-on in 2015 and other mostly
immaterial changes (they sold the Austin Taylor facility after ceasing operations;
Austin Taylor generated minimal revenue relative to the Company's total).

2015 revenue numbers are approximately $108m. JCS achieved a similar amount in
sales in 2006 and 2009. In those years, SG&A amounted to ~26%-29% of sales,
down from the current number of ~38%. At the 27.5% mid-point, this implies post-
restructuring operating expenses of ~$30m, down from the current figure of ~$41m.
The Company also purchased and began to implement a new ERP system during
2011-2012 to standardize all business units on a common platform. ERP for
Transition Networks went live in 2013 and Suttle, 2014. This should allow for
operating efficiencies across JCS.
On the gross margin side, there is room for expansion as well. Here are some
numbers:
Source: Company filings
In the bolded years (2006, 2009, and 2012) gross margins ranged between ~33%
and ~40% respectively on ~$105m-~$115m of revenue, as compared to the current
gross margin of ~29%. I believe that the above margin range is reasonably
attainable as it was achieved on revenue levels similar to the current run-rate of
~$113m.
Segment mix remains fairly similar with the present period (Suttle & Transition
Networks still account for the majority of total sales), so there is little reason to not
expect post-restructuring gross margins to be in the same ballpark.
Segment-By-Segment Analysis
As I alluded to earlier, the Company has four segments: Suttle, Transition Networks,
JDL Tech, as well as Net2Edge - the latter being created only recently.
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Revenue 115m 121m 123m 110m 120m 144m 104m 131m 119m 108m
Gross
Margin %
33.4 35.4 38.1 38.1 42.6 41 39.8 34.2 35.4 29.3

Suttle
Lets say you're a cable company. You use many electronics and miles of cabling to
make the end-user connection possible. Your worst fear is that if one of these
components fail - failure results in expensive truck rolls, deterioration in brand
perception, and other unsavory outcomes.
Suttle, among other things, makes the structured wiring which improves the
reliability of these components, reducing the total cost of ownership (less
maintenance required), and improving asset (the cabling) life. JCS mentions that
their products can reduce TCO, CapEx, OpEx, and truck rolls by >50% - so clearly,
there is a significant value-add.
Thanks to the increased investment in R&D, Suttle is emphasizing the development
of solutions, instead of individual products - it even renamed its website to
suttlesolutions.com. Suffice to say, this bodes well for sales growth and gross
margins.
Business over the years has been mostly rosy, with sales growing in excess of 20%
in the years 2013 and 2014 due to new products, increased telecom deployments,
and growth in high-speed connectivity.
2015 saw a bump in the road where the segment experienced disrupted orders as
customers curtailed spending, which also resulted in pricing pressure.
Going forward, however, sales should recover - clearly, 2015 was a industry-wide
issue, not a Suttle-specific issue - if you look at the capital spending plans of major
telecoms (AT&T, etc), they are all projected to massively increase.
This increases in capital spending is driven by growth, not maintenance - growth
tends to be more robust, thanks to the exploding demand for data, voice, and video,
as a result of increased smart device penetration. 1Q '16 already reflects this, with
Suttle's sales rising ~11% and backlog jumping ~47%.
Transition Networks

This segment solves connectivity issues. One of the problems customers face with
regards to network constraints is distance restrictions. A common scenario is as
follows: customers usually use multi-mode fiber within buildings, and single-mode
fiber between buildings.
This makes sense because multi-mode fiber have distance potential of ~550 metres
while single-mode fiber can reach 10,000 meters. Naturally, single-mode fiber costs
way more.
But using both would leave gaps in coverage across an area. Transition Networks
makes the stuff that allows you to integrate single-mode and multi-mode fiber,
eliminating coverage gaps. Sure, you could just add more fiber, but it is much
cheaper to integrate.
The ramp-up in R&D is also benefiting this segment - JCS is targeting >25% new
product revenue as a percentage of total revenue by 2017, up from ~12% at the
current time.
Business activity in this segment may appear uninspiring as sales is more or less
flat in 2014 and 2015, but that is mainly due to government spending; the
government is a large customer here.
2013 saw a ~20% y/y decline in sales, but that was clearly due to the sequestration
which called for broad cuts across many different programs.
With budgets forecast to remain stable, while it is hard to see Transition Networks
growing unless government spending rises substantially, it is also hard to see it
losing large chunks of revenue, barring a repeat of the sequestration.
JDL Tech
As for JDL, this segment is a managed service provider. A typical managed services
agreement goes something like this: JDL helps the customer maintain corporate IT,
resolves issues, and supports the customer's user community. Essentially,
customers outsource their IT to JDL.
In this segment, business is extremely lumpy, and this is reflected in its revenue
dynamics.

Sales jumped 6x from ~$5.4m in 2012 to ~$33m in 2013, due to the winning of a
large Miami Dade County contract. In 2014, sales fell ~75%, as said contract was
completed. And in 2015, revenue jumped ~83%, due to the winning of the Broward
County contract.
Clearly, the model hinges upon winning large, multi-year contracts. However, there
is reason to believe that segment sales will grow nicely, at least over the next few
years.
As discussed, the Broward County contract was won in 2015, which added ~$7m in
incremental revenue. Management issued a press release which mentions that the
total contract value is ~$83m, to be realized over the next half-decade. So there is
~$76m left to go, which should allow sales for this segment to rise going forward.
Net2Edge
Net2Edge was created after Transition Networks acquired Patapsco in 2014 to
combine the acquiree's technology with their Ethernet capability.
One of the pressures faced by carriers is whether to migrate from legacy networks.
In technical terms: how can you move on from TDM or ISDN without your customers
(who rely on these traditional services) moving on too?
Retiring TDM/ISDN networks is not an easy decision to make.
If you retire these traditional services, you lose a meaningful recurring revenue
stream and the loyalty of enterprise customers whose mission-critical functions often
rely on these traditional services.
If you don't retire them, you'll be confronted by limitations and high maintenance
costs - one of which is the lack of skilled personnel; as the workforce ages, those
with the technical expertise to work with TDM/ISDN eventually retire, while the new
recruits lack such expertise - as it is considered outdated, no one's being trained on
TDM/ISDN anymore.
Net2Edge makes the stuff that allows carriers to virtualize their traditional services
over the Ethernet using circuit emulation, enabling carriers to transition to Ethernet
without impacting enterprise customers.

1Q '16 is the first time this segment's results have been broken out separately, and
highlights management's intentions to bring attention to Net2Edge - sales grew
~70% to ~$600k. Forecasting future sales is difficult as the Company does not offer
much detail on the segment. Inferring from the value proposition discussed above, it
is quite possible that there would be a reasonably large addressable market here,
but we'll remain conservative.
Valuation Discussion: Fair Value Of ~$11, ~70% Upside
Once operations have been rationalized and new products start dominating JCS's
portfolio, the Company should be set to be consistently free cash flow positive to the
tune of ~$4m-$14m (or more), as it had been during the 2006-2009 period, where it
had a similar top-line, gross margins, and operating expenses. Averaging the 4-year
period of this FCF range to iron out the inherent lumpiness in business activity
suggests normalized FCF of ~$8m. Thus, JCS is valued at an attractive ~7x
normalized FCF.
These are extremely compelling numbers that do not account for the possibility of a
major upturn in the Company's end-markets (ala 2011); these numbers only factor in
a refreshment of JCS's product portfolio and a rationalization of operations, which
quite closely resembles the 2006-2009 period, in my view. The fact that JCS should
be able to consistently generate FCF, which would lead to an improved balance
sheet, even in a period where revenues are obviously highly depressed does offer
investors some confidence that things shouldn't be that bad in a downside scenario.
With a little bit of revenue growth stemming from Suttle, Transition Networks being
flat, JDL Tech ramping up the Broward County contract, and assuming no
contribution from Net2Edge due to the inherent difficulty of forecasting a segment in
its infancy, total sales could reasonably grow to levels in excess of $125m.
At such levels, it does not seem overly optimistic to expect the Company to be able
to generate $4m-$14m in FCF for a normalized figure of ~$8m in a post-
restructuring scenario. A 12x multiple on this ~$8m in FCF seems fair, assumes
a low-growth scenario using a 10% discount rate, and would imply a ~$11
stock or ~70% upside from current levels on ~8.8m shares outstanding. Such
a target price does not appear heroic given that shares of JCS traded at $9-$12
over the 2006-2009 period, implying that the market assigned FCF multiples to the
stock that are in-line with my expectations over said period.

Estimated Liquidation Value Exceeds Current Market Cap, Implying
Significant Downside Protection
JCS owns a 105,000 square foot building in Minnetonka, Minnesota, and three
plants totaling 109,000 square feet in Hector, Minnesota, where they do all their
manufacturing.
The only data point sourced from the Bloomberg terminal which seemed useful was
U.S. office price psf, of which the rolling 3-month figure in 1Q '16 was ~$263. This
seems far too high to me. Undoubtedly, this figure is heavily influenced by premium
real estate in places such as New York and Manhattan.
Rummaging through CRE data providers did actually offer useful information to help
us reasonably estimate the fair value of the above-mentioned properties.
In Colliers' 1Q '16 office market report on Minneapolis, it cites a transaction that is
likely to fall in a similar price range as JCS's real estate. Southdale Office Center,
formerly majority owned by GE Capital, was sold to Wildamere Properties at $55m.
The office complex was a 446,818 sqft property, implying price paid psf of ~$123.
CBRE estimates average office cost psf at ~$100 total in Minneapolis, which seems
to be a decent gauge of replacement cost.
Averaging the two figures from Colliers and CBRE gives us ~$112 psf. Applying this
averaged figure on the Company's properties totaling 214,000 sqft implies they are
worth ~$24m. With a current market cap of ~$55m for JCS, these properties are
certainly material. JCS's offers a breakdown of PP&E in its 10-K, with buildings &
improvements amounting to ~$9.4m before accumulated depreciation, suggesting
~$14.5m upside to fair value.
The market is likely broadly unaware of the fair value of the above real estate given
that, from what I can gather, management has never discussed the Company's real
estate in their investor presentations.
As of 1Q '16, JCS has ~$15.4m in cash & short-term investments and ~$32m in
working capital. Long-term liabilities are minimal at ~$180k. Summing up cash &
short-term investments, working capital, the fair value of real estate, and deducting
long-term liabilities suggests a liquidation value of ~$71m, compared to the
current ~$55m market cap, suggesting substantial protection on the

downside. Even if we assign a 50% discount to inventories and receivables, which
would shave ~$21.7m off my liquidation value estimate, we would still get a number
near the current market cap.
Moreover, even in a draconian scenario, I'm pretty sure a 50% discount is far too
pessimistic considering that inventory turnover averages ~2.7x - which is not
suggestive of significant obsolescence risk, and that the Company's customer base
is either slightly concentrated in extremely creditworthy customers (Suttle) or highly
diversified (Transition Networks), implying that one would be hard-pressed to see a
significant portion of receivables being uncollectible.
Catalysts & Risks
A significant rebound could very plausibly bring revenues back to the
~$130m-$145m range, which the Company achieved in 2011 and 2013.
Note that customers, especially in the Suttle segment which caters primarily to the
telecom industry (Suttle saw peak revenues of ~$67m in 2014, ~35% higher than
current levels), can create demand extremely quickly, as experienced by Dycom
(who caters to a different part of the value chain) whose backlog has exploded in
recent quarters, as I wrote about before, suggesting that JCS revenues can spike
over a short period of time. Better results should also attract sell-side coverage.
What could go wrong?
Demand could fall of course, but with a restructured operation, I estimate the
Company's breakeven's point to be ~$88m in revenues - 34% gross margins
(representing slight gross margin deleveraging on lower revenues), ~$30m in
operating expenses, minimal interest expense - implying the top-line would have to
fall ~22% on trailing 12-month figures of ~$113m, which suggests a significant
margin of safety.
Stated another way, we would require a huge and prolonged downturn in telecom
capital spending and another large-scale government sequestration to really hurt
JCS - neither of which seems highly likely.

Telecoms are currently upgrading their networks to satisfy exploding demand in
data, voice, and video, and this does not seem to be stopping anytime soon. Sure,
telecom capital spending could experience a hiccup, like it did over the 2014-2015
period, but the overall trend over the next few years should be solidly positive due to
secular trends in penetration of smart devices.
The probability of another large-scale government sequestration is certainly not
zero, but again, it seems highly unlikely; in my experience, betting on a specific
political outcome is a great way to torch money.
While there is the non-zero risk of a sharp drop-off in demand, current segment
trends suggest that this is unlikely - in 1Q '16, all segments grew, manufacturing
backlogs expanded ~30% (with Suttle's jumping ~47%, as discussed) - which are
suggestive of a stable demand environment.
But let's assume the draconian scenario - i.e. the Company's franchises are
severely impaired. Even in such a scenario, downside shouldn't be much with
liquidation value estimated to be in excess of the current market cap. We can
quibble over assigning 10%-50% discounts to inventories and receivables in a
hypothetical orderly liquidation scenario, but even then, the value you get is still near
the current stock price.
Overall, it is my belief that the JCS story is inherently low-risk as it is not hugely
dependent on end-market cooperation driving monstrous growth, but instead reliant
on restructuring operations to mirror 2006-2009 - not a stretch, since this was
already achieved years ago.
As discussed, even if things go wrong, downside isn't much. What about risks to the
upside?
Suttle could grow more quickly than expected as it expands its offerings and as
telecoms ramp up their capital spending further, Transition Networks could bag a
large customer account, JDL Tech could sign up another huge contract, and
Net2Edge could explode. Playing around with assumptions suggest that revenues in
excess of ~$150m is quite achievable in such a scenario. An upside scenario would
certainly boost FCF potential in excess of the ~$8m average.

To summarize, with downside being solidly protected by liquidation value even
assuming draconian discounts to receivables and inventories, and ~70% upside not
out of reach, the risk/reward in going long JCS appears highly asymmetric. Daily
liquidity of $60k-100k is reasonable for small funds and individual investors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate
any positions within 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.
Additional disclosure: Disclaimer: The author's reports contain factual statements
and opinions. He derives factual statements from sources which he believes are
accurate, but neither they nor the author represent that the facts presented are
accurate or complete. Opinions are those of the the author and are subject to
change without notice. His reports are for informational purposes only and do not
offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester")
accepts no liability whatsoever for any direct or consequential loss or damage
arising from any use of his reports or their content. Lester advises readers to
conduct their own due diligence before investing in any companies covered by him.
He does not know of each individual's investment objectives, risk appetite, and time
horizon. His reports do not constitute as investment advice and are meant for
general public consumption. Past performance is not indicative of future
performance.
Editor's Note: This article covers one or more stocks trading at less than $1 per
share and/or with less than a $100 million market cap. Please be aware of the risks
associated with these stocks.

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