by Travis Johnson, Stock Gumshoe | July 19, 2013 4:01 pm
This month I’ve been strongly considering whether or not a uranium-related investment makes sense — one of the reasons that my ears perked up when I was reading about Andy Obermueller’s tease of Cameco earlier in the week. Uranium should hit a pretty strong bull market as the end of the US/Russia warhead dismantling accord comes at the close of this year and reduces some of that inexpensive uranium supply for electricity generation … and the marginal supply increases from new mines are mostly from more expensive mines, which would mean that costs should rise. I don’t know if we’ll see “uranium mania” like we did back in 2006, when the price went up dramatically and dragged all the uranium explorers along with it, but we should see prices rise over the next couple years.
But though I came close to recommending some combination of Denison Mines (DNN — I hold a few call option contracts on that one), Uranium Participation (U.TO or URPTF on the pinks, a fund managed by Denison that simply owns uranium as an investment and trades at a discount) or big Cameco (CCJ), I decided that I want to wait. The increase in pricing for nuclear fuel is likely but not guaranteed from these levels, and there is a lot of potential low-cost supply in Canada and, perhaps more importantly, in Kazakhstan that I don’t understand very well. Frankly, with Japan now taking the first steps to re-starting their nuclear reactors I may be missing the boat by holding off now — but I think I’ll wait and see if we have some sort of bad news around nuclear power to shake it down a bit further. Maybe I’ll change my mind on that, but for now I’m holding off.
And you know that I did make one change in my personal portfolio and in the Gumshoe Universe this week, ditching Sandstorm Metals & Energy (SND.V and STTYF) after some careful consideration. It’s just not cheap enough for the level of risk they still have, not with their heavy reliance on one mine and their continuing run of either bad luck or bad decisions.
But what’s worth buying now? The overall market is not cheap, so I’m personally most attracted either to those picks that still trade at a deep discount to the market or those who have a good chance of outsized growth that’s not particularly economically sensitive — firms that I’ve covered in the past and own like Xerox (XRX), Rosetta Stone (RST) or Ligand (LGND), though LGND has run up so fast that I’d really like to catch it on a dip for any further investment. Intel (INTC) is also one that I like to add to every time it falls a bit, and sell covered calls against when it starts to rise again, but there’s no real urgency to that. Xerox stands out as the real value still, growing well and growing the dividend and doing massive buybacks, but we know that story pretty well already — though I think many investors don’t yet understand how big their healthcare management and IT consulting business can be with the huge health insurance churning ahead (10% of XRX revenues are already healthcare-related). So XRX is probably the holding I’m closest to increasing right now personally, but what can I cover for you that’s not still fresh in our minds from recent months?
Well, I’m going to go with a teased stock from a few months back — Aware (AWRE), which was pitched by Frank Curzio for his pricey Phase 1 Investor newsletter. Aware is a biometric stock, primarily a software designer and holder of lots of patents on biometric image and data capture and analysis. That means they’re in at least a decent spot in a growing sector of the technology and security businesses, and the price has come down slightly and they hold a massive pile of cash and have huge insider ownership … along with, potentially, the catalyst that they could be bought out at a nice premium or pay out more substantial special dividends along the way (they sold a slate of patents to Intel last year and paid out a big one-time dividend as a result).
The stock was pitched on May 20 as being the seller of the “ultimate app” … and I told you at the time that I was tempted right off the bat on this one, though I haven’t bought personally (I may still, though not within the next three days per my trading rules). That’s largely because of the nice combination of downside protection offered by their cash position, the relatively unknown nature of this small $100 million stock (which has no analyst coverage), and the insider ownership — I hadn’t yet looked in much detail at the actual business.
The financial stuff has not changed. The shares are slightly lower than they were in May when Curzio teased ’em, they dipped below $5 this morning as I was writing but I don’t know what the closing price will be on the day. There is a small bit of stickiness to be dealt with here, though, because it so happens that AWRE is going to report earnings next week — perhaps, if the estimate of Yahoo Finance is correct, as early as Monday. The earnings results are unlikely to cause a huge bump in the shares of AWRE, since their operating earnings have not generally been shocking and there aren’t really any analyst numbers to “beat” or “miss” and they don’t hold quarterly conference calls, but the stock could certainly move if they say something interesting about the future in their press release or if earnings look much better or much worse than recent quarters. For that reason, I’d suggest that folks who want to invest in AWRE after looking into it take a cautious approach and split that initial investment, buying half before the earnings and half after. I’d like to get the shares near or under $5 to keep the downside protection strong, but we’ll see how the week shakes out.
Since the downside protection is a big part of what appeals to me here, let me explain that first. This is a company with a market capitalization of about $110 million, so it’s certainly tiny (be careful with that, even our small merry band of Irregulars is large enough to impact the share price of a company this small if it so happened that a large number of you decided to buy all at once — I don’t expect we’ll cause the shares to spike, but if we do then be patient — it shouldn’t last long), and it carries a very large cash balance and no debt.
AWRE has $72 million in cash on the balance sheet right now, after paying out a big one-time dividend early in the year, and no real other assets or liabilities worth mentioning — they have some property, plant and equipment, which is probably just their offices, and no real liabilities or debt, so the book value is about $88 million. So the stock trades for a small premium to book value, about 1.3X the book value of $3.75 per share. Put otherwise, there is about $3.25 of unencumbered cash sitting in their bank accounts, so the actual operating business, their intellectual property and their customer relationships and whatever else, is valued by the market at just $1.75 per share. We can say that with some confidence, because although it’s a small company it’s also profitable. They have a lot of cash, but unlike so many other little companies we see they’re not burning through it — in most quarters, they’re adding to it.
Now, it’s not all that profitable, to be fair. For the past few quarters, operating income (which doesn’t include their big patent sales last year) has come in roughly between $1.5-2 million per quarter. That gets confused when you deal with the large patent sales, the sales tax implications, and the other one-time transactions over the past year, but from my reading it appears that they should be on a pretty consistent run rate of earnings at between 25-40 cents per year. That means we don’t have a shockingly low Price/Earnings ratio (that would be a PE of between 12-20 at current prices), but if you back out the cash position it’s more like a PE of between 5-7.
They have consistently reported operating revenue between $5-7 million over the last ten quarters, though that revenue has often declined a bit during that time, so this is certainly not a guaranteed grower — and it’s also in transition. The big patent sales were part of their strategy of refocusing the company more precisely on their biometric work, getting rid of their networking patent portfolio that has brought in a significant portion of revenues over the years and de-emphasizing their DSL work.
So what does the business actually do?
Well, they are still in the DSL service assurance business — they sell a software tool that lets providers diagnose, test and monitor DSL networks and delivery of service to customers. They had formerly also sold hardware into the DSL business, but they dropped the hardware business in 2012 to focus on higher-margin sofware sales and services. Over the past year, from the first quarter of 2012 to the first quarter of 2013, the DSL service assurance business dropped from about $743,000 in revenue to $637,000 and, in the last quarter, reported an operating loss of almost $200,000.
And as that winds down they are focusing on biometrics, which is a rapidly growing part of their business. Over that same time period the Biometrics and Imaging division went from revenues of $3.67 million to $4.7 million, and generated $2.4 million of operating earnings in that first quarter this year — more than enough to cover corporate overhead and the losses of the DSL division and generate an operating profit.
Here’s how they describe these core businesses in their latest quarterly report (you’ll have to read the full version of the 10-Qs and other filings over in the SEC Edgar database if you want details, they don’t include much info in their press releases):
“Our active business operations are focused on: i) biometrics and imaging software and services; and ii) Digital Subscriber Line (“DSL”) service assurance software and services.
“Biometrics & Imaging. Our biometrics products consist of software and services used in biometric systems, and our imaging products consist of software used primarily in medical imaging applications. Biometrics systems are used in applications such as law enforcement, border control, national defense, secure credentialing, access control and background checks. We typically sell our biometrics software and services to: i) systems integrators that incorporate our software products into biometrics systems that they are developing on behalf of their customers; ii) OEMs that incorporate our products into their biometrics hardware and software solutions; and iii) directly to government agencies that are deploying biometrics systems. Our imaging software is primarily sold to OEMs and systems integrators that incorporate our software into their medical and imaging products.
“DSL Service Assurance. Our DSL service assurance products consist of DSL software products that are used by telephone companies to improve the quality of their DSL service offerings. We sell our DSL service assurance software products through OEMs and directly to telephone companies.”
What they have essentially done over the last year and a half or so is focus the business — they sold major patent portfolios and generated that big cash position they now enjoy, and they dropped the unprofitable DSL assurance chip/hardware business to focus on software and related services, which are, generally speaking, much higher margin… and clearly, the DSL Assurance division is being phased out and de-emphasized since it’s already shrinking and it generates no operating profits, the profits all come from biometrics and medical imaging software.
Importantly, though, they also seem to be trying to build this biometrics/imaging business through more patent licensing and software sales — they didn’t sell any of the patents that are related to these core divisions, and I don’t know if they’d be happy to see takeover bids for the company right now but they are not apparently shopping those biometrics or DSL assurance patents. They say, in fact, that they are currently using their R&D spending to develop new software (and presumably to patent new ideas) in both of these core segments.
For more detail on the more important part of the business, the biometrics software and patents, we turn to the Annual Report:
“Biometrics & Imaging. Our biometrics software products leverage imaging and biometrics technologies developed by Aware over the past 20 years. We sell a broad range of software products that are used in biometric systems worldwide for fingerprint, facial, and iris modalities. Primary applications of biometrics systems include law enforcement, border control, secure credentialing, national defense, access control, and background checks.
“Our products provide interoperable, standards-compliant, field-proven biometric functionality and are used to capture, verify, format, compress and decompress biometric images as well as aggregate, analyze, process and transport those images around biometric systems. We also offer software engineering services to customers who require assistance with the design and development of biometric solutions. Specific services may involve customization of our software, installation services, or complete system development depending on customer needs and requirements. We also sell software products for medical and digital imaging applications based upon industry standards such as JPEG 2000 and JPIP.
“We sell our biometrics software products and services to a large number of customers. We reach these customers through three principal channels of distribution: i) a systems integrator channel; ii) an OEM channel; and iii) directly to end-users, such as governments, their agencies, and corporate customers.
“Sales of biometrics and imaging software and services represented 76% of our total revenue in 2012.”
The major user and buyer of biometrics-related hardware and software is still the government — mandates for better security, more secure passports, stronger border control all get into biometrics, whether it’s fingerprints or something like facial or iris recognition. Some big companies also buy these kinds of systems, often for high-security installations and the like, but the big customers are governments and their contractors. These customers buy scanners or software packages or systems, or they build their own, and Aware makes discrete sofware packages available that are generally bought by tech companies or systems integrators and re-sold to those end customers for a software royalty as part of a bigger package or a piece of hardware. Some of the applications of their software are listed on the website here — again, mostly law enforcement, border control and access control stuff.
And I expect those end markets to grow, perhaps dramatically if we start to see growing popularity among consumer devices that incorporate biometric security — something that has been technically possible for a long time but that hasn’t been seen by most consumers as a real “need” yet. Who knows, maybe the next Apple iPhone will really incorporate a fingerprint sensor (as has been speculated by many, largely because of AAPL’s takeover of Authentec last year), and maybe that will drive more adoption that will increase the size of the market and trickle down to Aware. I’m not counting on huge growth or new consumer adoption of biometrics here, I think just the growing government security spend will help increase earnings for Aware, given their small size and their current and growing revenues in this segment already, but Apple has been known to create consumer needs and consumer markets where none existed before. (Yes, as you know, I do own AAPL shares as well.)
There is competition in all of these markets, and AWRE is not the only company who holds patents for a variety of biometric capture and processing tasks, but they do have a lot of patents and it’s likely that the patent universe in this segment will get a lot more attention if biometrics really captures investor attention again and the market grows. They claim 103 patents and 88 patent applications, though they also say that they rely heavily on trade secrets and nondisclosure agreements, so clearly not all of their “secret sauce” is patented. They describe the patents as being in the areas of “communications and signal processing technologies, including DSL service assurance, biometrics imaging, and medical imaging compression,” but other than that we have to just assume that some of the patents have some value. Of course, if the big boys start swinging in tis space there are downside risks, too — it could turn out that AWRE is infringing on someone else’s patents, and you don’t want the value of your company to be tied up in legal proceedings (I have seen no indication or threat of that, it’s just another risk that may be worth noting for any small company in a business that’s emerging or growing).
If a big wave of interest in patents does come, the big upside potential is that the large players, either big hardware firms or government security contractors or suppliers (firms like Raytheon, Hewlett Packard, etc.) might start a patent-bidding war for this stuff as other companies have in the past, particularly in the mobile space. If that happens, a takeover of AWRE seems likely, but that’s merely an outside possibility — at the core, this is a small company with a growing and high-margin biometrics and imaging software business that’s still being obscured a bit by a huge cash position and by a smaller, unprofitable segment. When it comes to risk, they are not overly reliant on any single customer — no one customer makes up more than 10% of sales, which is a little bit unusual for such a small company without a big sales force… but biometrics software and systems is a very competitive business right now, and Aware is a small player — if they don’t continue to innovate and develop they could fall behind the competition, and even if they do keep spending on their R&D they might fall behind. The insiders have not been buying but the founding family has strong control of the shares and has monetized that holding both through some small share sales and, more importantly, through receiving the special dividend (along with regular shareholders) following the patent sales.
I would buy shares here in the $5 neighborhood and expect that unless they dramatically change their business the downside should be limited to about 30% — the stock should not approach the cash balance of $3.25 per share unless there’s a real catastrophe, but it could easily rise substantially if they pay out more of the cash in special dividends … or rise probably more slowly if they simply continue to generate decent earnings and limit the losses from the DSL Assurance division. They haven’t proven yet that this reorganization and refocusing will work, but I suspect that they’re on the right track — and with the downside protection and their extremely small size (they have only 73 employees, 46 of whom are in the engineering division and presumably working on R&D), this is a worthwhile speculation. I’ll keep an eye on them to see if that core biometrics software division continues to grow, because that’s the key to any future organic growth in earnings but for now I’d want to buy in the $5 neighborhood and not start worrying about them unless the revenue declines over several quarters or they begin to burn through their cash.
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