Sunday, December 23, 2007

RC Group: Growth on Sale

At 6x last twelve months earnings, and with top-line growth in the latest reported period of 71%, you'd expect RC Group to have some serious hair on it. The only major issue--which isn't even a company related issue but a stock one, has to be one of the odder (and more unfounded reasons) I've seen a stock drop. Fortunately, at least from what I've been able to uncover, there aren't any operating issues here--except perhaps for the long-term risk that the company experiences increased competitors and margin compression, signs of which have not yet occured. I believe the stock's decline has been unwarranted, and that if this stock gets ascribed anything approaching emerging market valuations, or merely a reasonable valuation, the stock could go up several fold.

RC Group is an exciting high-tech/emerging market growth story in the biometrics and RFID space. It trades on the AIM exchange (UK), though it also likely has a pink sheets equivalent somewhere in the US. RCG has focused primarily on Southeast Asia, but recently has begun seeing substantial revenue growth from the Middle East and China. They also recently signed a distribution agreement in the US, which hopefully will begin to bear fruit sometime next year. It's worth noting that the company's two prior entries into new markets (the Middle East and China) have both been very successful.

In addition to the organic growth (181% in FY06!), the company has also been rolling up complementary businesses. It's been targeting acquisitions in the 8x-12x range, mostly in emerging markets, and has recently been priced out of many attractive opportunities. Rather than continue to acquire at all costs, the company has put the brakes on its acquisition strategy, an uncommonly prudent move for a high growth story. Because of its most recent equity raise at prices about twice current levels, the company has nearly a 1/3rd of its value in cash, making the ex-cash P/E an absurd 4x trailing earnings.

Frankly, anytime I've seen a company with this combination of value, growth, and story, it has almost always turned out to be a scam. But many of the hallmark issues that signal red flags just aren't there:

1) Stock option issuance has been generous, but by no means grossly excessive (about 3% of outstanding shares issued as options per year).
2) Accounts receivables and inventory growth is very reasonable given the revenue growth. The company is actually turning its earnings into cash, maybe not at as fast a rate as analyst would like, but it is happening.
3) There are no reported related party transactions or egregious insider sales. The CEO owns 7.8% of the company, though no other management owns a sizable amount.
4) They're a little bit more dilution happy than I would like, but I've seen much worse. With the cash on hand and the still unfavorable acquisition environment, I doubt we'll see much more in the way of dilution soon.
5) One matter I find somewhat suspect is the background of management. The CEO and Chairman of the Board appears to have almost no tech experience; he worked in property and corporate finance most of his life. In this interview he briefly alludes to his rationalization for his experience, which basically is that he spotted the potential in the market and figured as a non-tech guy he could make dispassionate decisions. The COO, who seems even less qualified (her experience has been working as a research manager at a surveying company, and a marketing manager at a real estate agency). That said, management is very communicative with investors and generally non-promotional, both of which usually are positive signs.
6) The company will likely face margin pressure over time. That said, at these prices and given its growth potential, those risks are more than priced in.

Furthermore, the company actually did, at one point, have a more reasonable valuation. In March, when they did their latest equity raise, the company was valued at a trailing P/E of about 13 (which is still cheap for such a fast grower). The company would be nearly three times its current price if it was awarded that valuation again today.

So, what has changed?

On April 3rd, RCG had just completed an equity offering, and was coming off an incredible year. That same day, a seemingly unrelated event would have a big impact on the share price. Chinachem announced that its owner and "chairlady" Nina Wang had passed away. This wouldn't have mattered to RCG's stock, if not for the fact that Nina owned controlling interest in Veron International, which holds 27.6% of RCG. Over the next three weeks, as investors connected the dots, the stock sold off from 137 to 104 pence, on fears that whoever inherits the fortune will go ahead and sell their shares, providing a huge overhang. On April 24th, the company addressed this issue in a press release. Since then, the stock price has continued to trend down, and my educated guess here is that many of the ra-ra emerging market managers have shunned the name due to fears of short-term selling pressure. In an emerging market environment where everything (until recently) has been going up, and return expectations are absurd, why wait out a name with short term issues?

Also, if Nina Wang's own legal battle to inherit her husband's fortune is any indication, its likely that an award of the assets could drag on for years (it's been nine months thus far, and still no resolution). Wikipedia actually has a fascinating entry on Nina Wang and the issue here. The man who claims to be the beneficiary of the fortune is Tony Chan, who was Nina Wang's fortune teller and fung shui master. Multiple articles have cited him as being most likely to inherit Ms. Wang's fortune, though her family is understandably gearing up for a legal battle to challenge it. Oddly enough, Tony Chan is the brother of Bobby Chan, a passive co-founder of RCG who himself owns a 20%+ stake in the company. Not only do I think that the overhang concerns are overblown, but its very possible that given the family and personal connections, Tony Chan won't even sell the shares (if he is even the one who ends up with them).

The Bottom Line
Though there are some legitimate margin compression concerns and a revenue model that currently lacks a recurring revenue stream, at these prices the risk/reward appears to be incredibly attractive. If RCG's operating performance continues at its torrid pace, or even just continues to grow at a 15% clip, I can't see how the stock can remained at these depressed levels for long. The market also was recently spooked by flat sequential growth, which should reverse itself in Q2, as the company benefits from year-end weighted seasonality of this business.

In terms of catalysts in the near term, outside of continued operating performance, I think the stock could trade up meaningfully at the release of year end earnings (slated for end of February). RCG's latest trading update pointed to another stellar performance. It's also worth noting that RCG has historically traded up noticeably on both trading updates and announcements of interim and year end results. Below you'll find a glimpse of the price appreciation that occurred in all announcements this year, based on the price one week prior to the announcement, and the price 1 day afterwards.

Date Event 1 week prior 1 day after 8 day return (%)
15-Jan Trading Update 93.25 105.50 13.1%
12-Mar FYE Results 109.75 145.00 32.1%
31-May Trading Update 106.00 116.00 9.4%
16-Jul Trading Update 97.00 99.95 3.0%
11-Dec Trading Update 74.75 90.00 20.4%

I normally don't do much short term trading, but with trends like that and the valuation being what it is, I may very well take my chances. I have some more work to do here, but assuming their are no land mines , this has got to be one of the best risk/rewards I have seen in a long time.

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