From Value Discipline

Beaten down stocks can often be value traps and turnaround candidates often take much longer to turnaround than one expects. The danger of being too early can result in significant underperformance, confidence can take awhile to be restored, and dead money is frequently the result. However, a bit of patience, a bit of care, and an understanding of competitive advantage can provide the courage to buy the turnaround security. A decent balance sheet provides the comfort of knowing that delays in a turnaround can be absorbed without having to resort to new debt covenants and higher interest costs or worse.

I believe that Cogent Systems (COGT) fits this bill. Cogent sells Automated Fingerprint Systems (AFIS) used for immigration and border crossings, national ID programs and voter registrations. Cogent’s AFIS system is regarded as the fastest and most accurate biometric database search system. This system generates rapid and accurate real-time searches with its state of the art image processing, neural networking, and parallel processing capabilities.

The year 2006 has been difficult for the company as revenues have dropped off some 35-40%. As a result, the shares have fallen off a cliff, down some 50% YTD.

Governments around the world have captured millions of images of various biometric markers such as fingerprint or facial recognition images in order to secure border crossings, monitor elections, and provide national ID systems. Consequently, the demand for biometric data mining has grown substantially. A trade organization, the International Biometric Group estimates that the AFIS market will grow at a 25% compound rate to 2008.

Historically, two principal customers for Cogent have been the U.S. Department of Homeland Security and the government of Venezuela which together represent about three quarters of sales in 2004 and 2005. Unfortunately, both customers pulled back from the market in 2006. Homeland Security had but one contract award in 2006 which was taken by a competitor, Sagem. COGT management questions Sagem’s ability to meet the technological needs stipulated by some contracts.

The US-VISIT program of Homeland security initial stage was completed in 2004 with capture and processing at fifty ports of entry. Cogent management believes that spending on US-VISIT will pick up again in 2007 as a result of conversion from two-fingerprint scanning to ten-print scanning. The more involved the database requirements are, the greater the need for a Cogent system.

Cogent, as I mentioned previously also is involved in election systems. Venezuela, representing about 35% of sales in 2005, established a Cogent system for national elections in 2004 and has expanded that system for regional elections. Mexico, Brazil, Bolivia, and Uruguay are all apparently considering voter AFIS systems. National ID systems are being considered in Argentina, Thailand, Italy, Russia, and the UK.

Beyond international interest, there also appears to be growing interest by law enforcement agencies in the States to upgrade their systems. The California Department of Justice and the FBI are considered to be interested in upgrading their AFIS capabilities.

Cogent is hardly alone in the AFIS market. The major players are Motorola (MOT) with its Printrak division, the Japanese major NEC, a private company Sagem, and Cogent. However, Cogent appears to be the largest pure-play in the area.

Cogent has pursued various contracts through a relationship with Northrop Grumman (NOC) in the past. In 2005, NOC began to work with Sagem and successfully bid on the EU-VISIT program. Cogent is now suing NOC under the belief that NOC utilized Cogent’s intellectual property in its bid for the EU-VISIT program. The trial date is set for May 22, 2007. Cogent is seeking over $200 million in damages and states that NOC owes royalties for not only past use of the intellectual property, but also damages for the negative competitive impact of using this IP. Potentially, this could represent a significant financial settlement. In the meantime, the company bears the increased legal costs associated with this lawsuit.

Financials

The company demonstrated tremendous sales growth from a base of only $14 million in 2002 to $160 million in 2005. Sales this year, given the lack of contract awards, will likely be somewhere around $95-$100 million.

Gross profit margins which had ranged between about 63% and 69% between 2002 and 2005 dropped to about 51% in the most recent quarter. Operating margins in the most recent quarter came in at 19%, a very respectable level for most businesses, but well below the norm for COGT which has been north of 30% for the 2003-2005 period.

The market cap for COGT is $1.04 billion. There is no long term debt and there is a cash balance of about $300 million hence, the enterprise value is about $700 million. Enterprise value is about 19.6 times EBITDA and about 20.5 times EBIT which at first glance does not seem terribly cheap; however, this is measured against depressed earnings.

System maintenance revenues ordinarily constitute some 20% of revenues, but given the lumpy nature of contracts, this can swing widely. The company has forecast fourth quarter gross revenues of between $46 to $56 million, a significant improvement from the first three quarters of this year, but has indicated that revenues may get pushed into the 2007 year depending on the timing of purchase orders. The company has also indicated that gross margins for the fourth quarter should show improvement relative to the third quarter.

The balance sheet has no long term debt. On a TTM basis, the company has generated some $35 million in free cash flow.

Return on invested capital is at a depressed 8% on a TTM basis compared to last year’s 14.2% and the prior year’s 19.2%.

For a relatively small stock, there is a considerable amount of analytical coverage, 14 estimates for 2006 and 2007. The 06 estimates range from 30 to 38 cents. For 07, eps estimates range from 37 to 62 cents. Long term growth rates are estimated by nine analysts with a range of 20 to 40% and a mean of 27.23%.

At current prices, I believe the market is imputing a long term growth rate of 9 or 10%, well below the estimated growth rates and well below the 37.9% growth rate of earnings on a trailing five year basis.

Conclusions:

Cogent, after some incredibly rapid growth has been hit by postponement of contracts and some pricing competition. Gross profit margins dropped but operating margins cratered earlier this year. Operating margins have improved recently as revenues have started to pick up; clearly the company demonstrates significant operating leverage.

The stock which had peaked last year at about $37 has reflected the disappointing revenue stream and the choppiness of the contract awards. In my view, expectations are quite low for this unique business.

Despite the choppiness, my sense is that we should see some improvement in contract awards through next year. The company has started to diversify its client base with various state and municipal awards. Recent experience demonstrates that because of technological superiority, COGT can displace Sagem systems. Successful resolution of the lawsuit could not only relieve the company of its legal expense burden but also provide a large financial boost.

Insider ownership is very high at 54%, held primarily by the CEO Ming Hsieh. Holdings of management outside of the founder’s stake are insignificant. There are 3.7 million stock options outstanding representing dilution of about 4%. Interestingly, no stock options were issued in 2005.

Though the board has not instituted a dividend program, a share repurchase plan is in place to buy back up to $30 million in shares over a period of six months following its Aug 2006 announcement. So far, merely $3.9 million has been bought back.

The long term prospects for the business seem strong and margin recovery could well take place over the next several quarters. In my view, the company could easily return to a high teens to low twenties kind of a valuation.

The risks as with any technology company relate to obsolescence. Biometric solutions exist beyond fingerprinting and facial recognition. Voice, iris pattern and retinal blood vessel solutions could reduce COGT’s market opportunity. Contract awards and revenues are lumpy and revenue recognition of maintenance revenues can provide deferred revenues. Pricing pressure appears to have developed to some degree in this marketplace.

Disclaimer: Neither I, my family, or clients have a current position in Cogent.

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