Peerless Systems is a Rare Profitable Net Net and my Pick to Click

Some stocks are just made of money

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Peerless Systems (PRLS) is my Pick to Click

To summarize the characteristics of Peerless Systems, it would be something like this.

Positive Aspects

Generates positive free cash flow

Has 90% margins
No debt
Buying backs shares like there is no tomorrow

Trades at less than its NCAV
CEO was previously a value fund manager and owns 20%

Negative Aspects

Its licensing business will wind down sooner than later resulting in no revenues
Looking to change the business into a closed end investment management
Investment in a public micro cap not working out well

Let me show it another way.

PRLS Profitable Net Net

Peerless Systems is a net net selling below both NCAV and NNWC.

NCAV is $4.58. The current price is an 18% discount to NCAV.
NNWC is $4.30. 12% discount to NNWC.

Extremely cheap in terms of valuation.

Why is Peerless Systems So Cheap?

Everything becomes cheap for a reason.

Peerless generates revenue by licensing its technology for imaging solutions in the digital image space. Manufacturers of printers, photocopiers, scanners and other digital image OEM’s have to pay Peerless.

The problem is that the printer business has been in decline for a while. People just don’t print as much as they used to. It’s easier than ever to store documents digitally and to share with others online.

Multifunction printers were hot several years ago, but the industry has been consolidating and Peerless understood that it didn’t stand a chance competing against OEM’s directly and with cheaper labor overseas. In 2008, Peerless sold the majority of their technologies and has been milking the last few remaining licenses it holds.

There is no growth prospect and the core operation is going to become obsolete.

But that also brings opportunity.

Is there Any Upside with Peerless Systems?

It’s not the typical 100%+ upside that many net nets offer.

For a company in decline, the last quarter saw revenues increase by 79%. Yes it’s just one quarter and yes the numbers are small ($0.6m to $1.1m) so it’s easy to dismiss it. However consider the way Peerless Systems sells its licenses.

Most of the revenue until now came from selling block licenses. A block license is where you are given a set quantity of licenses to use. E.g if you buy Microsoft Office, you can only install the software onto one machine. If you want to install it on 10 computers, you need to buy a bigger, more expensive license.

In the recent quarter, some accounts have moved to a pay per unit license agreement.

This is good and bad.

Good because single licenses are more expensive and brings in higher revenue. Thus the 79% increase in revenue compared to the last comparable quarter.

Bad because customers are not committing long term.

Because the company has eliminated expenses down to $0.3m, most of the money from revenue will drop to FCF. If more customers switch from the block license commitment to paying per unit, the short term will see some good FCF generation. This gives Peerless even more time to find the best use for their cash and to turn their business in another direction because at the moment, cash burn is a surplus.

I’ll get to valuation later.

How Can I Lose Money?

Before discussing what Peerless is worth, or what it isn’t, I want to focus on the downside.

Protect the downside and the upside will take care of itself.

Seth Klarman

Can you lose money with Peerless? Of course.

This investment is a bust if Peerless burns through its cash and there are 3 main ways that Peerless Systems “burns” cash.

Cost of staying public – approx $100k a year for auditing and tax fees.
CEO compensation – $445k in 2013, $653k in 2012.
Loss on its stock investments – All of its marketable securities (which is 11% of cash and equivalents) are held in a microcap called Moduslink (MLNK)

Peerless Systems will likely keep all three so that means the real cash burn is going to be in the range of $500k – 800k a year. The market value of the stock is a non realized amount so it isn’t a cash burn. I will ignore it in this scenario.

If Peerless did absolutely nothing, the cash burn will be around 800k at the upper range. With a current cash balance of $10m, Peerless could technically stay afloat for 12 years. Being able to survive for 12 years on breadcrumbs may sound impressive, but remember that in such a situation, every passing year will see its value decrease.

That’s how you can lose with Peerless. It all comes down to how the cash will be used.

Value Investor CEO in Charge

No big progress has occurred since the sale of its licenses in 2008, but the CEO is on the shareholders side.

Timothy Brog is a former value fund manager and owns 20% of the company. His interests are definitely aligned and his strategy has been to reduce expenses and increase shareholder value.

Expense Reduction

Peerless Systems Share Buybacks

2009 shares outstanding: 17.7m
Current shares outstanding: 3m

With the low liquidity, about 10% of the shares are being bought back each quarter in the mid $3 range, well below book value and NCAV.

In an attempt to make something out of the company, Peerless is also transforming the business into a closed end fund.

in the second quarter of fiscal 2012, we determined to attempt to transition our primary business to the asset management industry. In the third quarter of fiscal 2012, Peerless Value Opportunity Fund (“PVOF”) filed a registration statement to conduct an initial public offering of its common shares. Locksmith Capital Advisors (“LCA”), a wholly-owned subsidiary of Peerless, has entered into a management agreement with PVOF to act as its investment advisor.

It will likely be focused on small value plays such as ModusLink. The only thing is that ModusLink doesn’t seem to be working out well so far. As with all investments, a year or two is too early to judge an investment so I won’t conclude anything about the MLNK investment yet.

We continued to hold a significant investment in ModusLink during fiscal 2013. ModusLink experienced a number of disruptive events during the year, including a review of strategic alternatives which had no positive results, an inquiry from the SEC, an internal investigation which determined that certain client contracts had not been “properly aligned with best corporate practices,” a delay in filing various periodic reports with the SEC, a restatement of prior financial statements, various letters from NASDAQ notifying ModusLink of its noncompliance with NASDAQ Listing Rule 5250(c)(1) due to the company’s delayed filing of its periodic reports, and the departure of its top two executives.

If Peerless Systems is able to register as Peerless Asset Management (PAM), this will serve as a catalyst. Until it happens though, it’s just an idea.

What is Peerless Systems Not Worth?

Let’s kill the investment.

Just assume the worst has happened.

No more sales
All the customers have left
The licenses are useless and its technology is out of date

MLNK goes bankrupt and market securities is written down to zero
Peerless can’t collect any of its receivables

Other than the company burning down, how could it get any worse?

Imagine this happening tomorrow, all at once.

What’s it worth?

$0.00?

How about $3.35, which is only 11% below the current price. The world has basically collapsed on Peerless Systems, but its value is only 11% lower?

Here’s the adjustments I made to the balance sheet to reflect the above.

PRLS adjusted balance sheet

That’s how cheap it is. So what I do know is that it isn’t worth the current price of $3.76.

It also isn’t worth $3.35 because it’s profitable on the top and bottom line and is seeing some short term growth to further cushion the cash vault.

What is Peerless Systems Worth?

The stock price is made up of two parts.

Stock price = Fundamentals + Speculative

where speculative is just another way of saying growth.

On the fundamentals side the balance sheet is super clean and healthy with no cash burn. Tangible book value is equivalent to NCAV and so I can safely say that the starting point is $4.58.

On the speculative side, it gets tricky because I’m trying to measure the value of operations that I know will decline.

Professor Damodaran provides 3 ways to value distressed companies that will liquidate.

Estimate the present value of the expected cash flows in a discounted cash flow model, and assume that the distress sale will generate only a percentage (less than 100%) of this value. Thus, if the discounted cash flow valuation yields $ 5 billion as the value of the assets, we may assume that the value will only be $ 3 billion in the event of a distress sale.

Estimate the present value of expected cash flows only from existing investments as the distress sale value. Essentially, we are assuming that a buyer will not pay for future investments in a distress sale. In practical terms, we would estimate the distress sale value by considering the cash flows from assets in place as a perpetuity (with no growth).
The most practical way of estimating distress sale proceeds is to consider the distress sale proceeds as a percent of book value of assets, based upon the experience of other distressed firms.

For Peerless Systems, option (1) and (2) are the same. Option (3) is the same as selling it at NCAV value.

Performing a DCF with a starting FCF value of $0.6m with 9% discount rate and 0% growth yields a value of $6.05. If the company is to be liquidated, 100% of the value is unlikely to be recognized. Taking 80% of the fair value makes it worth $4.84 in a distress case.

But Peerless is not in distress. It doesn’t have any debt that it can’t pay back and it is unlikely Peerless will abruptly cease to exist. So it will be worth more than $4.84.

I’m going to keep the limit to $5.00

More art than science here.

I’ve got my range then.

Low value: $4.58

Mid value: $4.84
High value: $5

I still have a 18% margin of safety on the low end and 25% margin of safety on the high end. The upside isn’t through the roof, but when you think about the downside protection, Peerless Systems is a stock well worth considering.

Click the image below to download the PDF tearsheet and DCF valuation sheet.

Additional Reading

Peerless Systems SEC Filings

Disclosure

Long PRLS