By SpearPointLLC :
Re: Outlook for GSE Systems, Inc. ( GVP )
Stock Currently Undervalued
- GSE Systems ("GVP" or the "Company") represents a deep value investment opportunity with materializing growth potential and profitability. Its current market price of $1.62/share 2 does not reflect fair market value, in our opinion, and is significantly lower than the $3.95/share we believe the Company could garner in a theoretical sale of the Company (see discussion below).
- GVP's current enterprise value of $16.2 million 3 trades at an EV/Rev (( TTM )) of 0.29x.
- Net cash as of September 30, 2015, was $12.83 million, or $0.72/share.
- We project 2015 revenue will be $57.8 million, up 52% year-to-year, and 8% year-to-year on a pro-forma basis.
- At a reasonable valuation of 1x projected 2015 revenue (plus net cash), the Company would be worth approximately $3.95/share, or 144% above today's market price.
New Management Focusing Business on Growth and Profitability
- The Company announced a reduction in expenses that should result in annual pre-tax savings of $5.0 million going forward. To put that in perspective, the Company's total operating expenses in the quarter ended September 30, 2015, were $4.05 million (excluding restructuring charges).
- Management is committed to reducing wasteful spending and to achieving profitability in the core business.
- The replacement cost of the Company's core technology is extremely high.
- The Company has announced several significant wins:
- On August 28, 2015, the Company announced a $35 million three-year contract with a major U.S. power generation company.
- On November 2, 2015, the Company announced over $4.6 million in additional new contracts.
- In our conversations with the new management team, they bring a "start-up" mentality to a Company that happens to have $50+ million in revenue.
New Management Aligned with Shareholder Value Creation
- New Management and board changes
- The Company has replaced the CEO and Chairman of the Board this year as well as added an impressive COO.
- New compensation package aligns shareholder interest with management. Clearly, new management and Board are focused on $6.00/share.
Other Positive Factors
- The Company has very high switching costs across its product lines and customers are generally tied to the Company for long periods of time.
- The nuclear and hydrocarbon power solutions provided by the Company require very deep levels of expertise and knowledge and are not easily replicated.
- The Company is an attractive M&A target for some of the larger players in the industry, especially as it approaches profitability and returns to growth .
Overview - The Case for Value at GSE Systems, Inc.
Over the last few quarters, GVP has initiated sweeping management and operational changes, which in turn have led to a leaner and more focused Company we believe is already creating growth and driving to profitability 4 . The Company delivers very sophisticated, mission critical products and services to the nuclear and hydrocarbon industries, requiring high levels of industry-specific knowledge and expertise. This creates significant switching costs for existing customers and relatively high barriers to entry (or in Wall Street's latest parlance, "moats"). Competitors cannot just show up and say "let us run your nuclear plant". The global macro environment is showing improvement and experiencing a spate of M&A activity, as larger players seek to improve their position in anticipation of future growth. These factors, combined with vastly improved business fundamentals and a high energy, visionary and articulate management team, drive us to believe GVP is poised to deliver growth and shareholder value creation in the coming 24 months.
Things were not always so. At Spear Point, we focus on deep-value small-cap stocks, generally with a strong balance sheet but underperforming operations. We then take a position in a company and proceed to work with management and the Board to unlock the value of both the balance sheet and operations. This sometimes takes the form of a contentious public debate, but more frequently, it involves behind-the-scenes discussions with the Board and management. Our relationship with GVP falls squarely into the latter.
In our latest 13D filing on May 27, 2015, Spear Point and other investors participating in Spear Point's group reported holding a total of 6.93% the common stock of GVP 5 . Since that time, the Company has made significant changes in both the Board and key management. In addition, the Company has taken meaningful steps towards creating growth and profitability. With these changes in place, we are confident the Company is on a path to better days. Therefore, we have decided to dissolve our group, as we currently have no plans to engage with the Board and management to promote change and see our filing as a potential distraction.
GVP should Benefit from the Improving Macro Environment
Following the Fukushima disaster on March, 11, 2011, the nuclear industry was left for dead. The Company was particularly hard hit by the loss of customers in Germany and Japan. Since that time, however, concerns about the global reliance on hydrocarbon-based power as well as concerns of population growth, poverty reduction, and greenhouse gas emissions have shifted interest back to nuclear. On November 12, 2015, the Nuclear Regulation Authority stated various Japanese power companies have filed with the NRA to restart 26 Japanese reactors 6 . All of this should buoy GVP's business in the coming years and somewhat represents a return to "normal". That said, there are many people betting on a nuclear renaissance. According to an article in Forbes dated October 2, 2015:
We encourage anyone interested in GVP to watch this video featuring Bill Gates 7 . The bottom line: if Gates and his team are right, we believe GVP will be a great long-term beneficiary of these trends, either as a standalone business or as a strategic acquisition for the 800 lb gorillas participating in the industry (e.g. Honeywell ( HON )).
As the potential for global nuclear power industry growth emerges, M&A activity has begun to accelerate. For example, on November 17, 2015, Atkins plc announced, as part of its plans for global expansion in its energy technology group over the coming years, that it agreed to acquire the Projects, Products and Technology segment of EnergySolutions ("PP&T"), an international nuclear engineering services business for $318 million 8 . For the year ended December 31, 2014, PP&T reported revenue of $281.4 million. Therefore, the transaction is valued at 1.13x revenue.
Earlier this year, using the tactic known as a "reverse merger", France's Schneider Electric ( SBGSY ) ( SBGSF ) (PARIS : SU) merged its industrial technology assets with a U.K. software company Aveva 9 (LSE : AVV) to create a new publicly traded, broad-ranging industrial technology company with significant nuclear and hydrocarbon power plant customers.
We are not suggesting GVP is "in play" or that Spear Point has made our investment in the hope of the Company getting acquired. We believe the Company has regained a fundamentally sound operating posture and is poised for growth and profitability in the coming years. This should eventually drive significant shareholder value in and of itself. However, at +$55 million in revenue and a healthy bottom line, GVP could find itself being pursued by any number of larger companies looking for an undervalued, strategic acquisition that would be immediately accretive to the buyer. Assuming a theoretical strategic transaction at a 1x multiple on projected 2015 total revenue of $57.8 million, plus net cash of $12.83 million, GVP would be sold for $3.95/share. This represents a 144% premium to the close of $1.62/share on November 20, 2015. So, to restate, Spear Point believes GVP has turned a corner operationally, and combined with energetic new leadership, is poised for organic growth and profitability. We also like the idea of a "call option" in an M&A scenario, as the market continues to consolidate globally.
Despite these valuable strategic factors, as well as the significant improvements of the Company's top and bottom lines detailed below, the market continues to value the business at a paltry $29.0 million market capitalization and an enterprise value of $16.2 million 10 .
New Management Driving Towards Profitability and Growth
In August 2015, the Company named Kyle Loudermilk President and CEO and Chris Sorrells as the Interim COO 11 . Within the first three months, the new management team announced sweeping changes to the business, designed to aggressively move the Company towards greater profitability and implement Company-wide best practices. According to the Company, these changes should result in $1 million in pre-tax savings in the fourth quarter of 2015 and will result in annual pre-tax cash savings going forward of approximately $5.0 million 12 .
On August 28, 2015, the Company's Hyperspring division announced a three-year on-call services contract for up to $35 million from the Tennessee Valley Authority ("TVA"). Hyperspring provides professional plant support services to a variety of power generation facilities throughout the U.S. and continues to perform nicely.
In the nine months ended September 30, 2015, Hyperspring accounted for $15.7 million in revenue, or an average of approximately $5.2 million per quarter. This compares to $13.0 million of revenue through the first nine months of 2014 13 , or $4.3 million per quarter. This represents growth of 21% year over year and we expect the fourth quarter to be near the same growth trajectory. Therefore, we estimate Hyperspring will generate revenue of approximately $20.9 million for the full year 14 .
For the first time since 2012, the Company's other reporting unit, Performance Improvement Solutions (or "PI"), should also post growth for the full year. In the nine-month period ended September 30, 2015, the PI division had revenue of $26.9 million compared with $24.8 in the year-ago period, or an increase of 8.5% 15 . For the full year 2015, we project PI will report $36.9 million in revenue, bringing the Company's projected total combined revenue to $57.8 million. This would be the highest annual revenue number the Company has posted since the $55.7 million reported in 2000. This number is skewed by the acquisition of Hyperspring in November of 2014. As the following chart shows, on a pro-forma basis, growth in total revenue would be a much more modest 8%.
GVP Pro Forma Revenue by Business Segment*
*The 2014 column details pro forma revenue had the Hyperspring acquisition occurred on January 1, 2014. The 2015 column details actual revenue by business segment through September 30, 2015 PLUS Spear Point's business segment projections through December 31, 2015.
Not only has the Company reversed revenue declines and begun growing again, the new management team has moved to streamline the cost side of the business. On August 29, 2015, the Company announced a series of cost reductions designed to streamline operations and improve profitability. As noted earlier, the Company stated these actions should result in annual pre-tax cost saving of $5.0 million per year. Not an insignificant amount when you consider Total Operating Expenses in the quarter ended September 30, 2015, were $4.053 million (not including a $1.6 million restructuring charge).
The following chart depicts two welcome trends - higher revenue and lower cost.
(click to enlarge)
*2015 numbers include actuals through September 30, 2015 and Spear Point's projections of $10 million in Performance Improvement Solutions revenue and $5.2 million in Staff Augmentation revenue for Q4 2015
Management Compensation Aligned with Shareholder Value
On July 30, 2015, the Company released an 8-K filing detailing Mr. Loudermilk's compensation package. His base salary was set at $350,000, plus an annual bonus of 50% of base provided certain goals are achieved for the period. All pretty standard stuff. However, the non-cash compensation component caught our eye.
Per the 8-K:
The filing then presents the following table:
Mr. Loudermilk stands to make a sizable amount should the stock price reach $6.00/share during his tenure, and obviously much more if it continues to climb. However, in return shareholders would see the value of their Company increase to $107 million in market capitalization, a 257% increase from today's value. Of critical importance in our opinion, Mr. Loudermilk does not receive RSUs in the Company until he delivers significant shareholder value. In other words, unlike so many CEOs, he doesn't get a significant stake in the business for simply showing up for work every day . Hats off to the Board for putting together a compensation plan that strives to balance fair compensation with upside potential tied to shareholder value creation.
That was the "steak", now where's the "sizzle"?
The Company clearly seems to have regained its footing and seems to be headed in the right direction. But we believe the new management team has a vision reaching beyond the Company's historical boundaries. GVP was born as a services business targeted at the highly defensible nuclear energy niche business. In the last few years it has looked to hydrocarbon power plants as a source of additional growth. However, over the years, the Company has also developed leading technology solutions for solving its customers' needs (e.g. simulation technology for managing nuclear power plants that rivals the most sophisticated video games). Despite this heavy technology footprint, the Company has always thought of itself and acted like a services Company. This includes the people who were chosen to lead it, the way it priced its services and the way it reported sales.
However, it appears the Company has set its sights on the more lucrative and scalable technology side of its business. In our discussions with management, they expressed a desire to create the industrial technology Company for the power generation industry. Rather than selling services that happen to include technology solutions, the Company intends to invert that equation over the coming years - a technology company that happens to provide services.
Although the difference may seem minor, the potential for value creation is not. Successful technology oriented businesses boast significant recurring revenue streams and become deeply imbedded in their customer's business processes. This gives them strong barriers to entry due to higher switching costs for their customers, and therefore, greater pricing power. Aspen Technology, Inc. (AZPN) and MicroStrategy Inc. (MSTR) are two good examples of this model. Not coincidentally, they also happen to be former employers of GVP's new CEO.
Like a struggling college football team, where a new coach marshals existing "assets" to seemingly create a powerhouse from heretofore mediocrity (e.g. Nick Saban becoming head coach of both LSU and Alabama), we believe the new management team led by Mr. Loudermilk has the potential to do the same for GVP. We are not arguing Mr. Loudermilk is a Coach Saban, but we firmly believe he has the potential to become one. He appears to be disciplined about cost control and spending, focused on areas of competitive advantage where additional value can be created, and is highly energetic and articulate. He also has a vision of building on his successful background to transform GVP from a sleepy services firm to a dominant, niche industrial technology business.
GVP has great barriers to entry, extremely high levels of industry and institutional knowledge, a very large base of current customers, and mission critical software solutions that once installed become extremely difficult to dislodge or replace. And Mr. Loudermilk isn't starting from zero. The Company boasts an existing, high value technology firm hiding within a services shell that in our opinion receives zero value. After meeting him in the Company's offices in Maryland a few months ago, our opinion was he was instilling the best of a "start-up" culture in a Company that happens to have more than $50 million in revenue.
Whereas technology firms with high switching costs and recurring revenue routinely trade at multiples of revenue (e.g. ERP, industrial technology, security technology, etc.), GVP languishes at an Enterprise Value/Revenue multiple of 0.28x ($16.2 million/Spear Point projected 2015 revenue of $57.8 million). The mark of a valuable industrial technology company is relatively high recurring revenue and very high customer renewal rates. We think GVP has extremely high customer retention and it has some measure of high value, recurring revenue. Although the Company has not broken out the recurring component of their annual revenue, COO Chris Sorrells stated in a conversation the Company agrees with our contention that recurring revenue is valuable and could become a bigger part of the value story for GVP in the future as it grows the core technology aspects of its business. As such, we have asked management to consider breaking out revenue type as well as segment at some point in the future.
Bottom line in our view: GVP has turned the corner on a much needed reorganization and is now led by a visionary management team that appears capable of executing that vision with a sense of urgency. The changes in the last few months alone should drive the Company towards profitability in 2016 and beyond. Furthermore, the hidden gem lies in the fact this is a highly defensible niche technology Company that heretofore has not acted like one and has not been valued like one. By focusing on areas of historical expertise and delivering high value solutions with significant recurring revenue, GVP can become a dominant player as a provider of mission critical technology solutions in the power generation industry and create significant value for shareholders. We would be remiss if we failed to reiterate GVP would make a compelling strategic acquisition for any number of mid-size and large market participants.
Spear Point Capital Partners LLC
/s/ Rodney A. Bienvenu, Jr.
By: Rodney A. Bienvenu, Jr.
Its: Managing Member
2 For this report's purposes, current stock price is the closing price on November 20, 2015, which was $1.62/share.
3 Source: Yahoo Finance Key Statistics page, November 20, 2015
4 CEO Kyle Loudermilk: "Through these areas of focus, we feel that we can serve the global power and process industries most effectively, resulting in profitable revenue streams for the long-term. At the same time, we're exploring new adjacent markets that offer sustainable, profitable growth potential." Earnings Transcript
5 Spear Point Amendment No. 1 to Schedule 13D filed May 27, 2015
7 Another video is from The Wall Street Journal ECO:nomics conference . Although it is from 2002 and clocks in at over 47 minutes, we believe it is well worth the time.
9 Source: Reuters , July 20, 2015
10 Total cash and equivalents of $16.4 million, or $0.91 per diluted share, including $3.5 million of restricted cash. Backing out restricted cash yields a net available cash value of $12.83 million, or $0.72/share. Market capitalization at the market close on November 20, 2015 was $29.0 million.
11 In addition to changes of the CEO and COO, the Company also announced the resignation of long-time chairman Jerome "Jerry" Feldman.
12 Source: Yahoo! Finance
13 GSE Systems press release dated November 17, 2014
14 We note Hyperspring revenue is relatively low margin, however, as it is generally billable hours, the majority of gross profit flows to the bottom line.
15 GSE Systems 10Q for the period ended September 30, 2015, page 37
16 Emphasis ours
Notice and Disclaimer:
References to "Spear Point" or "we," "us" or "our" are references to Spear Point Capital Partners LLC together with its affiliates. As of the publication date of this letter, Spear Point has a long position in and may own options on the stock of the Company and stands to realize gains in the event that the price of the stock increases. On or after the date hereof, Spear Point may transact in the securities of the Company. All content in this letter represent the opinions of Spear Point. Spear Point has obtained all information herein from sources it believes to be accurate and reliable. However, such information is presented "as is", without warranty of any kind - whether express or implied. Spear Point makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results obtained from its use. All expressions of opinion are subject to change without notice, and Spear Point does not undertake to update or supplement this letter or any information contained herein. This document is for informational purposes only and it is not intended as an official confirmation of any transaction. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. The information included in this document is based upon selected public market data and reflects Spear Point's views as of this date, all of which are accordingly subject to change. Spear Point's opinions and estimates constitute a judgment and should be regarded as indicative, preliminary and for illustrative purposes only. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. This letter's estimated fundamental value only represents an estimate of the potential fundamental valuation of a specific security, and is not expressed as, or implied as, assessments of the quality of a security, a summary of past performance, or an actionable investment strategy for an investor. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Spear Point. Also, this document does not in any way constitute an offer or solicitation of an offer to buy or sell any security in any jurisdiction in which such an offer would be unlawful under the securities laws of such jurisdiction. To the best of Spear Point's abilities and beliefs, all information contained herein is accurate and reliable. Spear Point reserve the rights for their affiliates, members, officers, and employees to hold cash, long, short or derivative positions in any company discussed in this document at any time. As of the original publication date of this document, investors should assume that Spear Point have positions in financial derivatives that reference this security and stand to potentially realize gains in the event that the market valuation of the company's common equity is higher than prior to the original publication date. These affiliates, members, officers, and individuals shall have no obligation to inform any investor about their historical, current, and future trading activities. In addition, Spear Point may benefit from any change in the valuation of any other companies, securities, or commodities discussed in this document. Individuals who prepared this letter are compensated based upon (among other factors) the overall profitability of Spear Point's operations and their affiliates. This could represent a potential conflict of interest in the statements and opinions in Spear Point's documents. The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Spear Point's forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties and other factors, most of which are beyond Spear Point's control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
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