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Will Regulatory Headwinds Turn into Tailwinds For CUI Global, Inc. (CUI)? [Reasons For Tracking]

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By Maj Soueidan, Co-founder GeoInvesting

In our June 1st 2018 email I offered a quick summary as to why we felt Cui Global, Inc. (NASDAQ:CUI) would be our next Reasons For tracking (RFT) article.  I interviewed management on Friday, May 25, 2018 after market close, but the interview was cut short due to Memorial Day commitments that management had to attend to. I recently conducted a follow up interview to tie up a few loose ends. I have a general idea of the potential risks and rewards associated with investing in CUI.  Buying CUI entails substantial risk. The company has a deep history of losing money, and some chips need to fall into place in order for the company to turn a profit (most notably, a stabilization of the political climate in Italy regarding the formation of a government) so that a growing list of opportunities in its energy division can start to be monetized, including a large partially executed contract that had to be temporarily halted. However, it looks like “warring” factions in Italy are finally making progress after recently swearing in a new government.

If headwinds abate, big near-term upside is a real possibility. I am not ready to form a long-term opinion on the stock at this time, but as disclosed on June 1, 2018, I bought a little CUI with funds I set aside for speculative names. It is my hopes that short-term catalysts can put the company in a position to start reporting consistent profits. Some of my concern lies in the uncertainty I have with the time frame that I think profitability can be achieved, which I have estimate could occur either in 2018 or 2019. Furthermore, a bullish thesis assumes that many game-changing circumstances materialize.

To value CUI is currently a tough task since some unknowns are present that could shift the story meaningfully to the positive or decidedly to the negative. 

Background

Divisions

CUI revenue is generated through two business units.

Power and Electromechanical (P&EM) - Acquired in 2008; comprised 80% of revenue in 2017. Two divisions are in this business unit:

  • Power solutions - External and embedded ac-dc power supplies, dc-dc converters and basic digital point of load modules and offering a technology architecture that addresses power and related accessories.
  • Components - Connectors, speakers, buzzers, and industrial control solutions including encoders and sensors. These offerings provide a technology architecture that addresses power and related accessories to industries as broadly ranging as telecommunications, consumer electronics, medical and defense.

 Energy - Acquired in 2013; comprised 20% of revenue in 2017 (2/3 Europe, 1/3 U.S.)

The Energy segment subsidiaries, collectively referred to as Orbital, have developed a portfolio of products, services and resources to offer a diverse range of personalized gas engineering solutions to the gas utilities, power generation, emissions, manufacturing and automotive industries.

Currently, around 60% of CUI consolidated revenue is generated in the U.S. The remaining 40% comes from Europe.

Shares Underperform

Some pause is probably warranted when analyzing CUI.  CUI has underwent several business pivots since the recording of the first available filing at SEC.gov in 2001. The first 7 years since this filing consisted of asset purchases of visual display and thermal management technologies.  These technologies never generated meaningful revenue for the company and were eventually shuttered or sold.  Furthermore, it seems that the current CEO of the company, William Clough, was with the company during a portion of this period and was part owner of one of the technologies that CUI purchased.

“William Clough was appointed President and Chief Executive Officer September 13, 2007 at which time Mr. Clough stepped down as Executive Vice President of Corporate Development.”

“CH/WayCool Tech (eventually purchased by CUI) is a private company controlled by Mr. Brad Hallock, currently a shareholder and a director and Mr. William Clough who currently is a shareholder, corporate secretary and corporate counsel.”

If you are interested, I have included a timeline of events at the end of this RFT, highlighting notable CUI business developments up to the present time.

Along with  consistently losing money, shares of CUI have underperformed, “aided” along by the filing of an S-3 in March 2017 when the stock was trading near $6.00 a share.  The company let the S-3 hang for 7 months before offering 6.4 million shares near market prices of $2.80.   Management acknowledges this offering was poorly executed.  

 

But, reasons exist to actively track CUI, at least for the next year and a half or so.  As it will be discussed, P&EM has a stable revenue base and is profitable. CUI consolidated loss is primarily due the underperformance of its energy division which could be on the cusp of experiencing positive catalysts.

Reasons For Tracking CUI

1. Finally Acquires Revenue Generating Businesses

In 2008, the company acquired the initial assets that make up the P&EM business segment. 

This segment is a commodity-based/cyclical business, which means conditions can change dramatically and very rapidly.

In 2013, CUI purchased the 30 year old company Orbital Gas Systems, Ltd. that makes up its energy unit.

“Orbital Gas Systems, Ltd. (Orbital-UK) is based in Stone, Staffordshire in the United Kingdom and Orbital Gas Systems, North America, Inc. (Orbital North America), which initiated operations in 2015, is based in Houston, Texas.”  (2017 10K)

Orbital is attempting to capture market share in a mature natural gas market by offering innovative products to help its customers operate more efficiently, improve billing, and meet new regulatory standards. Europe is a key target market for Energy, where CUI has generated minimal sales, but hopes to accelerate the penetration of its higher margin products. 

While CUI is still losing money on a consolidated basis, both units are generating meaningful revenue.  If you take a look at CUI revenue performance since 2008, you will notice that P&EM has grown its revenue, albeit not in a straight line.  Energy saw an initial growth spurt, leveled out, and then experienced a sharp decline.

2. Revenue Growth In 2018 Could Accelerate

P&EM Revenue

As you can see, P&EM did resume some sales growth in 2017, which continued into Q1, growing 25% to $17.02 million.  Its backlog as of the end Q1 2018 (March) was $26.1 million vs $20.2 million at December 31, 2017, which offers hope that revenue growth will continue in 2018.  But since this segment is a cyclical business, I do not expect it to post consistent double-digit growth.

The upside wildcard play for P&EM is its new ICE technology platform that includes a switch product (software CUI has licensed) and it block product (proprietary hardware). The offering helps data centers harness power more efficiently than competing solutions. For example, management claims the platform tracks how data centers are utilizing power to determine the optimal usage of power at peak demand times. It is at these peak times that current solutions lead to an over usage of power. Management believes that the ICE solution can lead to power usage cost savings of 25%.

Currently, ICE is at a proof of concept stage, and one very large customer has placed a small initial order for an ICE system. The data center market size is estimated to grow to $46.5 billion by 2022, so ICE is obviously a large opportunity for the company, one that we will eagerly track heading into 2019.

Energy Revenue

2017 Energy revenue fell 35% to $18.8 million.  While Q1 revenue grew 17% to $4.9 million, they are still well below peak levels.  But interestingly, Energy backlog at the end of Q1 2018 was up 40% to $17.7 million compared to Q1 2017 and up from $20 million at December 31, 2017.  Ironically, this is the side of the business that has the most upside.

Reasons For Let Down in Revenue Growth of Energy Division

Product testing and certification processes by potential customers have been the culprits against ramping up revenue in Europe. But it the company has submitted some bids against some large tenders that could materialize any day.

The situation in Italy is little different.  On September 3, 2015 CUI (and its distribution partner) was awarded a contract from Snam Rete Gas (SRG, 70 year old natural gas transmission company in Italy,) for at least 3,300 of the company GasPT metering devices, for which SRG placed an initial purchase order for 400 units (which were delivered on time in 2016).  But,

 “A regulatory issue unrelated to the technology delayed the next phase of the project through 2017.”

The regulatory issue has to do with political instability in Italy.

“Staying in Europe, we remain at a standstill regarding our Italy contract. Because no government has been formed in Italy since the March general election, the regulatory body has been unable to move for on its proviso to consolidate ownership and/or management of all major off-takes on the Italian network. We expect to remain in a holding pattern at least until a new government is formed.” May 7, Q1 Earnings Call.

Management has indicated in their 2017 10K and on its Q1 2018 earnings call that it expects shipments to resume in 2018. And, as we mentioned in the beginning of this article, the political climate may have improved.  The next step on the regulation front would be for Italy to reinstate an energy regulatory commission that has not been in place since late last year.  Although I am not hanging my hat on a quick resolution, CUI should be in good position to move towards eclipsing past peak energy segment revenues, sooner rather than later as SRG installs the remaining 350 GasPTs and places additional purchase orders when it gets the green light from regulators.

Pages 5 through 8 of CUI’s 10K filing do a great job laying out the challenges and opportunities that have been facing Energy.

3. Attractive Energy Product Portfolio

Despite the lack of growth in Energy, the three-product portfolio appears to have some moat-like attributes discussed in CUI’s 2017 10K, and is the division I am most excited about:

GasPT® - Making sure natural gas meets quality guidelines by measuring the physical properties of the gas, and saving gas operators money through more accurate metering of its customers’ gas usage.

 “At present, there is no equivalent product competition. There are instruments like gas chromatographs (‘‘GC’’) that technically can be considered competition, but they are slow, complicated to use and as much as five times the installed price of the GasPT.”

“By using our GasPT Technology, very expensive gas turbine machines can be tuned to run more efficiently and therefore longer with significantly cleaner emissions. Because of the delay in information from the GC’s (or gas chromatographs; the competition), such tuning cannot be effectively accomplished. This greater efficiency has led the top U.K. utility company, National Grid, to change its entire turbine control strategy, canceling orders for several GC’s and, in 2013, replacing those GC’s with GasPT devices specifically designed for natural gas-fired turbine control.”

“On September 3, 2015, SRG (70 year old natural gas transmission company in Italy) issued a public tender for the installation of at least 3,300 metering devices to change the way SRG monitors its facilities and assets SRG has confirmed that the GasPT device is still the only qualified technology.”

“Along with passing first phase testing by GE-Energy in October/November 2012, the GasPTi device successfully completed second phase testing with GE-Energy in October 2013. The device is now in final phase testing at GE's Oil & Gas Learning Center in Nuovo Pignone, Florence, Italy.”

“At a time when energy providers are moving to take advantage of a government subsidy program to build biomethane terminals, OFGEM's certification holds a potential to catalyze GasPT sales in the UK.”

“The economics of replacing a $250,000 gas chromatograph that needs $8,000 to $10,000 a year in maintenance gas annually with a much less expensive GasPT appeals to all parties.”

Bio-Methane to Grid – Green Energy

Biomethane is a green source of energy.

Biomethane production eliminates the release of a great deal of methane and other harmful gases into the atmosphere.

Without getting too technical, CUI markets a solution that injects Biomethane into the existing natural gas infrastructure more efficiently than legacy approaches that are less cost effective. The key differentiator between CUI solutions and legacy solutions is that CUI analyzes biomethane prior to being injected into the grid, which results in less waste and less emission of environmentally unfriendly gasses.

VE Technology® -

“Orbital holds exclusive worldwide rights to manufacture, sell, design, and market the VE-Probe, VE sample system, VE thermowell and VE Technology® from its United Kingdom-based inventor, EnDet Ltd.”

Gas companies need to sample the gas that is being sent though pipelines in order to ensure it will not cause undue damage to the pipeline. In order to do this, gas companies insert certain equipment into the pipelines.  Under the standard methodology, “outdated” equipment has to be eventually replaced due to wear and tear.  But CUI’s VE works in a manner which prevents wear and tear of CUI equipment inserted into pipelines.

VE and GasPT work together to provide customers with an all in one real-time quality and metering solution (GasPTi offering)

4. Revenue Opportunity In The Energy Division Is Enormous

The potential for some “nasty” revenue growth originates from relationships the company has with major natural gas players in Europe, product certifications it has received, projects in the works and industry size:

Relationships

  • Scotia Gas Networks (SGN)
  • Wales & West
  • DNV GL, a leader within the oil and gas industry
  • ENGIE, the French transmission company
  • National Grid, the national gas transmission company in the UK and one of the most respected specialized gas engineering companies in the world.
  • Snam Rete Gas (SRG) 70 year old natural gas transmission company in Italy

Certifications

  • GPT This new and innovative technology has been certified for use in fiscal monitoring by
  • Ofgem in the United Kingdom,
  • The Polish Oil & Gas Company Department of Testing and Calibration in Warsaw,
  • NOVA Chemical/TransCanada in Canada,
  • the Pipeline Research Counsel International (PRCI) in the US,
  • ENGIE
  • NMi & The International Organization of Legal Metrology (‘‘OIML’’) for SNAM RETE in Italy.
  • In U.S., waiting for certification from GE for gas fired turbines  

Projects In The Works                                                                                                                       

  • GASPT
    •  In the case of SNAM RETE, the Italian gas transmission company, there are ~7,000 customer access points, servicing 7,500 customers. All of those customer access ports would be applicable for the GasPT Technology, which has been certified by SNAM RETE.
      • As mentioned earlier, on September 3, 2015, SRG issued a public tender for the installation of at least 3,300 metering devices to change the way SRG monitors its facilities and assets
    • The device is now in final phase testing at GE's Oil & Gas Learning Center in Nuovo Pignone, Florence, Italy.
    • The company states, “We continue negotiations with ENGIE, the French transmission company, for deployment of the devices to both GRTgaz (ENGIE’s pipeline subsidiary) and Elengy (ENGIE’s liquid natural gas subsidiary) in the near future. ENGIE has agreed to represent the technology to other Western European, North American, and Asian entities in a partnership with Orbital.”
  • Bio
    •  Italy produces as much as 8 billion cubic meters of bio-methane gas per year
    • The company states, “FBM project Orbital has produced an initial, formal bid for the UK project of up to £490,000,000 ($661,000,000 USD at December 31, 2017) over 15 to 20 years.  The UK regulatory agency confirmed that the formal bid falls “within budget guidelines.”  The project is part of DNV GL’s Future Billing Methodology (“FBM”) Project, which, when implemented in late-2019, could call for the deployment of literally tens-of-thousands of the Company’s proprietary GasPT analyzers.”

Industry Penetration

  • “According to the latest industry analysts (including MarketsandMarkets), the global GC market reached $2,583.6 million in 2014 and is poised to grow at a CAGR of 6.9% from 2014 to 2019, reaching $3,605.1 million by 2019. Admittedly, that market is mature and is dominated by ‘‘after-market and accessories’’ sales. In contrast, the GasPT Technology is less expensive, more efficient and dramatically faster than any GC. It provides nearly real-time monitoring with no large enclosure, carrier gas and, most significantly, regular technical support and calibration. Taking those factors into account, it is our intention that the GasPT Technology will rapidly and effectively penetrate a large segment of that $2.5 billion market.” (10Ks)

Additionally, some upside to revenue can come from Orbital North America growth opportunities.

“We’re seeing it grow and we’ve actually been approached by one large company that is asking us to extend the size that building, actually to build a bigger building, so they can give us multiple projects at the same time.” Q1 2018 CC

5. Profitability Could Be Around The Corner

CUI has yet to report a consolidated GAAP profit and reported just one adjusted profit, in 2009. Obviously, this is concerning.  However, it breaks out the revenue and operating profit for each of its two segments in its 10ks which show that for the last three years P&EM has been profitable, with the energy business taking the company into the red. Here is a snapshot of the 2017 operating profit breakdown:

Interest expense is about $500,000 per year. So, if the energy unit can turn a profit, CUI could begin to report healthy EPS.  Except for Q2 and Q3 of 2016, when CUI sold 400 GasPT units to SRG, the bulk of the Energy segment revenues came from low margin integration work (AKA construction and installment of equipment). However, the higher margin product business is where the upside exists, and as discussed, Europe is the current main focus on this front. Q2 & Q3 of 2016 can start to give us a peek at how GasPT product sales made to SRG positively impacted gross margins.

You might ask yourself, “why even bother with the low margin legacy integration business?”  The integration work has helped CUI establish relationships with major customers, which opens the door to cross sell its other solutions. 

Q1 2018 Results

P&EM reported breakeven results for Q1 2018, but that was due to a one-time royalty payment from its licensing arrangement surrounding its ICE product and should be much less going forward.

“The net loss for the quarter includes an approximate $900,000 royalty payment to Virtual Power Systems included in cost of revenues. To remind you, royalties to VPS decreased considerably after the first $1.4 million in revenues of ICE Technology Products. Therefore, future ICE orders will contribute significantly more to future profits.”  Q1 2018 CC

In November of 2017, CUI relocated its Houston warehouse which tripled the size. This move will allow CUI to go after larger integration projects that could require the need for more, higher margin hardware products.

But, kick starting growth in Europe is essential to reach positive EPS on a consolidated basis. The energy business in the U.S. and Europe has been mainly lower margin integration business. This business in the current backlog is also short-term in nature (within a year). Again, the company is gearing up its hardware Energy business in Europe which carries higher margins, and where contracts can span several years.

“Yes, lot of that backlog is lower margin integration work frankly, we will see the I think the larger higher margin product when we see the bigger projects across Europe with the -- their pure product base. Italy is a good example of that, that's a pure product-based sale, we’re not doing any integration, we’re simply delivering to them GasPTs and the associated material that goes with that. Those are going to be the highest margin and those are still pending. I think right now our biggest part of that backlog is the lower margin integration work.” Q1 2018 CC

As far as the U.S. goes, CUI is at various stages of discussion with potential customers regarding the adoption of its hardware products.

Management provided investors with some color on the potential margin profile of the company during the Q1 2018 CC.

Gross Margins P&EM

Daniel Ford (CFO)

Yes. So, I would say it’s going to go up into the mid-30s for this next quarter is what I would expect it to be, if not slightly higher than that and then as we continue through the year it should go back up into higher 30s.

Mike Wallace (Attendee)

So, it could be 30% to 35% to 40% by year-end?

Daniel Ford

Yes.

Gross Margins Energy

Daniel Ford

It’s really about winning higher margin business and so that comes down to what products we’re able to put into it based on what the customers requiring, so that customer often times expects in what they want into the device and we could engineering around that. But we are pushing to push more of our technologies as we possibly we can and that definitely increases our margins. So that’s what we are working towards especially in the UK we’re looking at lot of biogas opportunities where we would be just using our GasPT devices and no chromatographs. So we see that as a huge opportunity to help with margins.

Mike Wallace

So, moving between the lines here 27.3% is probably the bottom from here we go up.

Daniel Ford

Fair statement.

SG&A Expense

Daniel Ford

I'd say it's going to be between $8.5 million and $9 million a quarter; some of that is going to be impacted by what the exchange rates are for our UK operations, but it's going to between $8.5 million and $9 million a quarter.

Armed with this data we can develop a loose scenario analysis using various segment gross margin and revenue assumption:

  • Q1 2018 Revenue Split of 77.5% PE&M and 22.5% Energy
  • 35% PE&M gross margins
  • 30% Low gross margin Energy scenario
  • 40% High gross margin Energy scenario
  • Stable SG&A

SG&A will likely trend higher at much higher revenue levels, but you can start to see how profitable the business can potentially become.

6. Valuation

Analyst estimates do exist for CUI.  Analyst currently are calling for loss of $0.25 for fiscal 2018 then a turn to profitability in 2019 and 2020 with EPS estimates of $0.22 and $0.35 respectively.

Valuing CUI based on estimates is a tough task since some unknows are present that could shift the story magnificently to the positive or decidedly to the negative.

We need to go out to 2018 and 2019 to find value. For example, applying a modest P/E of 15 on 2019 and 2020 EPS estimates equates to eventual targets of $3.30 and $5.25.   Based on an EV/S of 0.9, shares could appear to offer value if meaningful profitability materializes sooner than expected, or it becomes clearer that Europe is going to come through. To be honest, the valuation proposition using analyst estimates two years out is almost irrelevant in a story where so much uncertainty appears to exist in terms of the timing of events. If I had a preference, I’d wait for positive news flow on contracts in the hopper. 

But as investors, we need to assess the risk/reward profile of investing in a company that is dependent on a major catalyst. Sometimes, these moves work out like it did for Bluelinx Holdings Inc. (NYSE:BXC), up ~450% since we placed our inflection point bet on it, while other times we totally miss the mark, as was the case in $VISI (lost 45%). But that is the beauty of “investing math.” You cannot lose more than you put into a stock, but your upside is unlimited. 

Europe could be a game changer for CUI and the stock could trade ahead of positive news (likely rendering analyst estimates conservative).  More importantly, I may not be able to buy the stock at a reasonable price on a bullish news announcement. It is for these reasons that I established a starter position in CUI, through the purchase of the common stock and call options. Unless the political environment sours and/or P&EM faces cyclical headwinds, I plan to let this investment marinate for the time being.

Caveats

  • We would like to see CUI spin off or sell its P&EM business. Stocks that have a business plan of acquiring and running unrelated businesses can tend to carry lower valuations.
  • Many of the products that CUI sells are based on technology that CUI does not own (licensing relationships). Furthermore, some of these relationships call for the Company to make minimum payments. These license agreements, in some cases, also provide for advance royalties and minimum guarantees to maintain technical rights and exclusivity - According to management, the most important of these arrangements are in perpetuity as long as the company keeps making payments.
  • Potential cyclicality of P&EM business
  • Timing of the resumption of the Italian contract is unknown and not guaranteed.
  • CUI has yet to report consistent profitability.
  • Even if the company possesses superior technology, there is no guarantee it can convince potential customers to make the switch, especially in a politically motivated environment.

Business History

2000 - 2004

2004 – 2008

  • Name Change to OnScreen Technology
  • During the first quarter of 2004, NMMI paid the inventor of the OnScreen(TM) technology $575,000 for the remaining royalty payments and to receive all of the inventor's contract rights, including all royalty rights in the OnScreen(TM) License Agreement.
  • Redirects business focus from the EyeCatcherPlus and the traditional Light Emitting Diode (LED) to the OnScreen(TM) LED display architecture, which is a new generation of bright LED video display architecture that is expected to provide key design improvements in cost, weight and brightness of LED displays for such applications as compact portable signage, billboards, large outdoor venue video screens and outdoor video advertising. Since the Company redirected its focus to the Onscreen(TM) technology, the Company does not expect to record significant revenues until it implements its OnScreen(TM) business plan strategy.
  • On October 4, 2005, the Company paid $50,000 to extend a letter of intent for the sale and purchase of certain intellectual property. One of the Company's Board of Directors and another officer of the Company both have a controlling interest in the company that is selling the intellectual property. The letter of intent gives the Company the right to acquire the WayCool technology for $800,000 and the issuance of warrants to acquire five percent of the Company's fully diluted equity securities after giving effect to the Company's fund raising efforts.
  • Effective December 12, 2007, the OnScreen Technologies, Inc. corporate name was changed to Waytronx, Inc. Effective January 7, 2008, the new OTC:BB trading symbol for Waytronx, Inc. is WYNX. The new company name was adopted to more accurately reflect the company’s current strategy to focus on thermal management technologies in advanced electronics. Management adopted a new statement of position to emphasize this new strategy. Waytronx, Inc. is now primarily focused on commercialization of its proprietary innovative thermal cooling technology, WayCool™, our proprietary scientific approach to addressing intense heat generated in electronic systems, including computers, home entertainment systems, test fixtures and medical monitoring devices. 
  • Generated Minimal Revenue

2008 - 2013

  • May 19, 2008 - acquired CUI, Inc., a provider of electronic components including power supplies, transformers, converters, connectors and industrial controls for Original Equipment Manufacturers (OEMs). The acquisition offers significant synergies for revenue growth. CUI’s expertise in power technology combined with the thermal dissipation architecture from Waytronx offer design engineers a comprehensive solution set for the next generation of high power application that must operate at higher temperatures. Also, CUI’s manufacturing relationships and R&D infrastructure will accelerate the commercialization of the Waytronx architecture, incorporating a variety of patent pending designs to address intense heat in electronic systems. Cost synergies include leveraging existing sales and distribution infrastructure for cross-selling opportunities.
  • January 4, 2011 – CUI Global, Inc. becomes new name and broadens name (after some acquisitions) to a platform company dedicated to the acquisition, development, and commercialization of new, innovative technologies. CUI Global continues to seek a strategic partner to develop its WayCool™ thermal management architecture and WayFast™ power and communications architecture.
  • In an effort to concentrate our business focus on our core product development and marketing, in December 2011, we conveyed our WayCool and WayFast patent portfolio to Olantra Fund X, LLC for a cash payment of $500,000.

2013 to Present

  • March 2013 acquires Orbital Gas Systems Limited a United Kingdom-based provider of natural gas infra-structure and advanced technology, including metering, odorization, remote telemetry units (“RTU”) and a diverse range of personalized gas engineering solutions to the gas utilities, power generation, emissions, manufacturing and automotive industries.
Equity Disclosure: long CUI, at time of article
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