Wednesday, May 9, 2007

Eyelogic -- my most exciting long term holding

When I first began my blog, I wrote a detailed overview of eyelogic, which trades on the toronto venture exchange (symbol EYE.A). With their annual and q1 just reported, I thought now would be a good time to finish the write up I had started on them some time ago. Please refer to the prior write up for background info.

Business Overview
The majority of Eyelogic's business is in Canada but, over the last couple years, the company has expanded its sales operation internationally. In Septemember 2006, the company was dealt a brief setback when it was barred from selling its product until it received a class 2 license from the health board of Canada. The company did so in February, but was unable to sell its product in Canada for the intervening five months. This forced the company to focus sales efforts elsewhere, resulting in an increased focus on marketing in the US, and the largest sale in the companies history to a chain in France.

Eyelogics systems sell for 10k-30k, depending on the type of system ordered. A significant portion of revenue comes is recurring (coming from leased systems), and the remainder are sold on a one off basis, which can make earnings a bit lumpy. Gross margins are very high (about 66%), though I would expect this to decline over time as the market matures. We are far away from this point, though, in my opinion.

Eyelogic reported year end results last week, with EPS down 19% to about $.13 per share, due largely to the health canada issue. Without this issue, the company would have earned about $.20 per share, which would give them a P/E of about 11 on todays stock price. Instead, sales for Q4 were delayed until Q1, when the company made up the majority of the sales. The company recently reported earnings of $.13 for Q1, due to the large sale to the french company, as well as the backlog of orders they had that they could not fulfill in q4. The Health canada issue in q4 06 will inflate FY07 earnings due to the backlog filled in q1, though I expect healthy growth, even adjusting for the Health Canada issue.

Insider ownership is high (about 35%), with another 10% in option grants. Management is highly incented to grow the business, and is themselves excited about the appreciation potential of the stock.

Valuation, Growth Potential, and Catalysts
It is difficult to value Eyelogic, as I view most of the value to be in the form large, lumpy sales that I expect to occur over the next year or two. The majority of Eyelogic's sales, to date, have been small one to three system orders. As the company expands its sales efforts internationally (the sales force has grown considerably over the last year or two, and sales cycles are very long, delaying the impact of the added resources), I expect earnings growth to grow at a steady pace, about 25% per year. The real value, however, is in the possibility of Eyelogic winning large orders from chains (e.g. like the French order). For various reasons, I believe this is more a possibility now then ever.

The French order for 80 systems was the largest order in the history of this industry. Eyelogic was up against several competitors, but ended up winning the order due to the quality of their system. The french chain has about 600 stores, and purchased 80 as a pilot. So far, they are very happy. If they were to go ahead and order more for just half their store base, I would anticipate the revenue from this order to be roughly equivilent to all of Eyelogic's revenue in 2006. According to the COO, the french chain is currently very happy with the systems (he is currently meeting them in France). It is not a jump to assume that, if things go well, more orders from the company is inevitable.

The COO has been meeting with the large retail chains pitching the system for years. They are all intrigued by the technology, but no one as of yet has willing to make a dive. As with most new technologies, many companies are followers more than they are innovators. Once they see it work for someone else, they'll want it to. I believe the large French sale will help to be a strong catalyst to generate interest in the technology, as well as be a huge selling point for eyelogic in sales negotiations. Remember, eyelogic beat out all the other companies to win this big order, and they'll be able to leverage that win in deals, both small and large, against competitors. If another chain wants to purchase systems, Eyelogic will be the logical frontrunner to win the business.

The 2nd potential catalyst comes in the form of what should be a new product launch by the end of the year. Though still a bit murky on details, the COO has confirmed that they are in the works on a new model of their system that they expect to help the technology gain much more market acceptance. Other companies have released new models, too, but the upgrades have been largely cosmetic. The COO is very excited about this potential product release, though I assume we will have to wait for details on this in the upcoming months.

Important: For those of you looking to purchase Eyelogic shares, please note that it is very illiquid and difficult to accumulate in blocks. I highly reccommend using limit orders, and being patient. Occasionally sellers come into the market and sell big blocks. There was one such seller for the last couple months, off whom I purchased most my shares, but I believe he was taken out after the last earnings announcment. Anyhow, given the run the stock has had over the last couple years, and the frustrating liquidity, patience should be rewarded. Also, its not particularly easy to exit your position, so you have to be content parking the money here for an indefinite ammount of time.

Though Eyelogic is very small, and extremely illiquid, I consider it a core long term holding due to a combination of low valuation, exciting growth prospects, multiple near term catalysts, and a nice 6% dividend while we wait for it all to come together. If eyelogic wins just one or two deals with chains, we can expect revenue and profit numbers from those deals alone to be potentially multiples of current revenue and profits, which I would expect to give the stock simmilar upside (multiples from its current price).

Note: This write up is based on my research and opinion, and should not be taken as investment advice. It is not a recommendation to buy or sell shares.

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