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Electronic Control Security Update: A Look At History, Opportunity and Risk

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By Maj Soueidan, Co-founder GeoInvesting

On February 2, 2018, GeoInvesting published a note on Electronic Control Security Inc. (Pink: EKCS). My team and I made this decision to, as quickly as possible, direct attention to a recent shareholder letter I received in the mail.

EKCS has yet to upload this letter to OTCmarkets.com or file it on its website. However, the letter is still available here.  Recall, EKCS went dark in 2015 after some management missteps and the folding of several substantial U.S. government contracts it had been awarded, but never received funding for.

This update will serve to review the first update referenced above and to go a little deeper into some notable semantics and history of EKCS, so there will be some overlap.

To recap, the letter I received touched on the following points:

  • History with government contracts
  • Update on 2016 financials
  • Update on 2017 financials
  • Update on 2018 growing backlog
  • Retained a respected auditor (ranked 11) to bring the company’s financials current

Given this recent development, I thought it would be a good idea to publish a more comprehensive note so that you can understand the opportunities and the risks associated with an investment in EKCS.  And please be aware that there are plenty of risks and unknowns with this potential comeback story that could threaten the company’s survival.  I decided to take a chance, given the multi-bagger returns that I think EKCS could deliver if a few things go its way.

Introduction

I like to create individual miniature portfolios to help me organize my research. One of the portfolios I have created is called the “Run to One” portfolio.  The stocks in this portfolio are penny stocks, trading comfortably under a dollar per share, that I believe have a fighting chance to break a buck to the upside. I also like to look at companies that are “left for dead” with some potential hidden value (as was the case with ESCC, on which you can review the research here). These are both buckets that I believe EKCS falls into.

EKCS manufactures and outsources products and services related to perimeter security.

Perimeter security consists of the technology that creates barriers to entry and monitors safety in various environments.  For example, in its simplest form, think of the gates to your condo or apartment, guarded by number key pads or security personnel, that protect you from outside threats (like, say, your crazy ex).

EKCS provides higher level product offerings.  Historically, the company’s customers have been the Department of Energy, the Navy, as well as prisons and nuclear power plants.

Elevator Pitch

EKCS has been in a 7-year death spiral caused by some bad luck and some missteps that management has fessed up to. The last time the company reported annual revenue, in June of 2016, it reported about $500,000 in revenue.

However, I believe management is working on digging itself out of this hole and, at the very minimum, is trying to get itself into a position to eventually approach its past revenues of $5 to $10 million annually, with a better margin profile. My outlier scenario is one that results in a mega-bagger, with a potential exit strategy to sell the company.

CEO Arthur Barchenko is 84 years old. He owns over 40% of the total outstanding shares. Unfortunately, Arthur’s wife, who had also been part majority shareholder with Arthur, passed away recently, and our prayers go out to him. My worst-case scenario is that EKCS does not dig itself out of the hole it’s created due to a failure to put itself in a position to service its backlog and contract pipeline.

EKCS’ Business

EKCS is a one-stop-shop for its customers. The company:

  • Offers project management and site evaluation to advise customers on the most optimal buildout of perimeter security solutions.
  • Supplies field supervision, training, testing and make sure meets solutions will meet regulatory standards.  Some examples of elements of the environment that need to be considered when devising a perimeter security plan include:
    • Unique Weather Patterns
    • Flocking Birds
    • Sand storms
  • Provides the equipment and related software to build perimeter security solutions (EKCS does not do any of the installations):
    • Cameras
    • Fences
    • Wires/cables
    • Detection equipment/technology
    • Access control
    • Sensors
    • Software to connect hardware and communicate with control stations
  • Provides security personnel (outsourced)

As you can see, some of the company’s activities are outsourced, while others are performed in-house.

Bad Luck

During 2001 and 2010, EKCS’s revenue ranged between $2 million and $5 million (with an outlier year in 2006 of $9 million), with some profitable years. However, some less than optimal circumstances dinged their business.

This was not the first time I have come across EKCS. In 2010, I purchased shares due to the Company’s selection as a primary contractor for the United States Air Force (USAF) Integrated Base Defense Security System (IBDSS) Project.  The contract was awarded through an Indefinite Delivery Indefinite Quantity (IDIQ) program.  Second, it was involved with Lockheed Martin (NYSE:LMT) as a subcontractor in an Anti-Terrorism Force Protection initiative (ATFP) for U.S. naval bases worldwide.  Shares had a nice run during this time period, moving from $0.17 to a high of $0.72.

Unfortunately, neither of these two contracts panned out.  IDIQs still require that funding is freed up to release task orders against them. According to management, the individual hired to land and execute the IDIQ award overpromised and underdelivered. Not one single task order was ever issued in conjunction with the IDIQ. 

Regarding the Lockheed contract, EKCS became entangled in a legal battle to collect receivables owed to them from Lockheed. However, lack of funds prevented them from aggressively pursuing legal action, as the company disclosed:

Our cash flow and liquidity continue to be severely impacted with the refusal by Lockheed Martin to pay us for the accounts receivable due from them totaling almost $1 million. These amounts are the subject of litigation, as described in Item 3 of this Annual Report on Form 10-K.

ECSI International, Inc. v. Lockheed Martin Global Training and Logistics. On March 7, 2012, we, through our wholly-owned subsidiary, ECSI International, Inc. filed a lawsuit in the United States District Court for the District of New Jersey against Lockheed Martin Global Training and Logistics (“Lockheed Martin”). The lawsuit, as detailed in the First Amended Complaint and Demand for Trial by Jury (the “Amended Complaint”) dated March 29, 2012, alleges breach of contract and tortious interference by Lockheed Martin and seeks actual damages of approximately $978,000, as well as punitive damages, costs and such further relief as the Court deems equitable and proper. In addition, the Amended Complaint seeks payment under Lockheed Martin’s payment bonds required by the United States Navy Facilities Engineering Command. In Fiscal 2013, Lockheed Martin was granted a motion to have the matter moved from New Jersey to Maryland. We had been aggressively pursuing our claim against Lockheed Martin. However, due to cash flow constraints, we have not pursued our claims against Lockheed Martin in Maryland.

Government sequestration and overall lack of funding allotted to perimeter security programs also posed challenges for EKCS. Here is a quote from Smith & Wesson in 2011 after it announced it was shedding its perimeter security business:

Gun maker Smith & Wesson Holding Corp said it has decided to shed its perimeter security business and is currently exploring alternatives for it in order to focus on its core firearm business. In mid-2009, the company bought Universal Safety Response to diversify into the perimeter security market, but the company has since faced persistent sales declines in the segment. “Since our acquisition of Nashville-based Universal Safety Response, the environment for the perimeter security business has deteriorated substantially as a result of significantly reduced government spending,” Chief Executive James Debney said in a statement.

As if this was not enough, according to management, the CFO left the company (as EKCS was gearing up to become current with it financial reporting duties) due to personal medical issues in the family. This is a contributing factor as to why the financials are not up to date.

Reasons for Optimism

Industry

I never really put much thought into perimeter security as an investible concept until President Trump was elected. Still, I didn’t really consider it to be an industry segment in which I was interested. Owning EKCS forced me to take a closer look.  Here is some information I came across during my research:

  • The report "Perimeter Security Market by Component (Systems (Perimeter Intrusion Detection, Video Surveillance, Access Control, and Alarms and Notification Systems) and Services (Professional and Managed Services)), Vertical, Region - Global Forecast to 2022" states:

The perimeter security market is expected to grow from USD 110.64 Billion in 2017 to USD 196.60 Billion by 2022, at a Compound Annual Growth Rate (CAGR) of 12.2% between 2017 and 2022. The growth of the market is primarily driven by the rise in terror attacks worldwide. The increasing technological developments in video surveillance is said to have fueled the demand for perimeter security systems and services. Furthermore, the increased usage of internet of things (IoT) is also expected to be contributing to the growth of the perimeter security market.

  • Donald Trump isn’t the only one with borders on his mind. World events in recent years have demonstrated that the need for physical security doesn’t start at the front door of the office. With increasing incidents of vehicle attacks and terrorism both inside and outside buildings, more and more companies are realizing that stopping potential bad actors farther from the door is not only desirable — it is necessary.

“They want integration of multiple security systems with access control,” DeMao says. “Everybody wants everything tied in and operating from one device.” Or, increasingly, they want to centralize control, he adds. “The biggest trend for us in 2016 was the number of customers asking me to set up access control from a central location where they want to run gates from their headquarters.”

  • Perimeter security comprises products and services that help and manage organization interventions and informs them regarding any potential threats, thereby mitigating risk associated with loss of critical business data. These systems primarily include devices such as sensors, video surveillance cameras, control systems and support equipment which are integrated to provide a complete security and supervision system. Increasing spending by government and organization to curtail the ill effects of intrusions may further spur demand over the next seven years.

Blue Chip Cache

If there is one thing I like about this bet, it’s that this tiny company is no spring chicken. It has:

  • 40 years of history
  • Business with 70% of power plants
  • Business with major prisons, including Sing Sing
  • A relationship with Department of Defense
  • A relationship with Department of Energy
  • U.S. Air Force certified technology

Less Risky Backlog

Given its sour history with some of its past customer relationships, EKCS is now putting more effort in going after projects that are already funded. This way, when they report their backlog, it will come with more visibility (about a 12 to 18 month to completion time frame).  Management will also bid on commercial projects to reduce lumpiness and budget risk.  Management claims that the commercial market is way behind the industry curve.

Moat

I am not sure it’s totally appropriate to claim that a company the size of EKCS has a moat, but I am going to entertain the possibility if things get rolling for the company again.  The company is the sole source provider of services for various customers. This means competition with some of its projects will be limited.  The company’s “soup to nuts” solution gives it a competitive advantage during the bidding process.  Finally, a new software solution allows customers to retain current equipment and infrastructure when upgrading or building perimeter security solutions, saving them money.

These three advantages can potentially provide EKCS with some pricing power; they don’t have to be the low bidder to win certain projects.

Margin Expansion in The Cards

Some catalysts that could dive margins higher include:

  • Going after higher margin business
  • Starting to outsource less product
  • Developing in-house software so that they don’t have to use outsourced software solutions
  • The software component could lead to recurring revenue

Skin in The Game

  • High insider ownership
  • Employees have helped fund operation during recent down years.

An investment in EKCS is clearly not a sure bet. Through my conversations, I have concluded that past company misfortunes (I have not listed all of them) were not entirely due to management incompetence, although they must share some of the blame. 

Important Cautionary Note

With little cash on its balance sheet and total outstanding liabilities of about $4.7M, I need to concede that liquidity constraints remain an issue. Most of the debt is in friendly hands, with $1.9M owed to directors and employees as salary, $850,000 loaned from directors, and $1.35M owed to suppliers as accounts payables. Insiders have apparently committed to keeping EKCS afloat.

While the company does have a credit line with Atlantic Stewardship bank, the terms are unfavorable and its capacity limited. Atlantic Stewardship bank is more of a personal savings-oriented bank and probably an unsuitable credit partner in the long run.  A challenge going forward will be to manage cash so that contracts can be adequately funded.

It seems fair to assume that the company would require some minimal funding to execute on its “shippable backlog.” The good news is the collection terms EKCS has with its customers:

  • 25% up-front payment for domestic orders
  • 50 % up-front for international orders (wire transfers)

These should provide it with it sufficient liquidity to fund growth internally if it can get past its speed bumps and begin to more aggressively draw down on its backlog.

Caveats

  • Lumpy revenue in the past
  • Inconsistent profitability, even at peak revenue levels (although the company’s new business model is addressing this)
  • Government work can still be unpredictable (although the company’s new business model is addressing this)
  • Once projects are complete, the equipment will last for years
  • Still waiting on financials, so there is no guarantee the company can cross the finish line
  • While it’s encouraging that the company is tracking to be profitable, we need to keep in mind that its staff has been greatly reduced over the last couple years and will need to ramp up if growth continues.
  • Management uses the phrase “shippable backlog” in the letter when discussing first half 2018 progress. It is unclear to us what exactly “shippable backlog” means.  For example, we must be cognizant that the company may need to raise funds to fill its backlog, although we do not feel the required funding will be significant.
Equity Disclosure: long EKCS, at time of article
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