First Quarter Summary
Our composite Equity account was up 1.1% in the first quarter. Our composite Balanced account was up 2.6% in the first quarter. Our composite Equity account return was between comparable indices and our composite Balanced account return outperformed its index.
No doubt, our cash levels, currently about 23% of our assets under management, suggest the difficulty we're having finding suitable investments possessing the deep value characteristics we demand (and believe will serve our clients well over time). We will keep working hard. In his 2006 annual report, Warren Buffett said it best, as he so often does: "There's much to be said for just putting one foot in front of the other every day."
|Annualized as of 3/31/07|
|1Q 2007||1 Year||3 Year||5 Year||Since Inception
|Roumell Equity (Net)||1.11%||9.35%||14.96%||11.55%||16.09%|
|Roumell Balanced (Net)||2.63%||9.76%||12.21%||9.85%||11.94%|
|Thomson US Balanced Index||1.25%||8.71%||7.17%||5.70%||4.14%|
Please refer to performance disclosures at end of document.
Globalization and Your Portfolio
We are often asked if we invest in foreign securities. The world's growth is uneven and disproportionately occurring in China, India, Latin America and the old Eastern bloc countries. Essentially, our clients want to know: are we participating in the world's overall growth? The answer is yes, but not necessarily in foreign domiciled securities.
We have owned and will continue to own foreign domiciled securities. Typically, in such instances, we've bought into developed economies: Japan, Canada, and South Korea. However, in emerging economies in particular, there are some real issues to contend with when compared to U.S. capital markets: transparency in financial reporting and legal protections for passive minority shareholders. Several years ago we successfully launched a class-action lawsuit against a major U.S. corporation that managed a closed-end mutual fund we owned. After four years of litigation and the benefit of a plaintiff attorney working on contingency, the suit resulted in our clients receiving back about seventy-five cents on the dollar of their loss. This hardly would have been an option for us had it been a foreign security. To wit, aren't U.S. securities safer due to the superior legal rights afforded to U.S. equity holders, sound financial reporting transparency and overall political stability?
We clearly are willing to hold foreign securities and expect to do so in the future, even if on a limited basis. However, our clients should be aware that our portfolio of American companies participates, in aggregate, in the world's economy in a meaningful way. For instance, about 75% of our current holdings have sales outside of the U.S. In fact, if you take the total sales of all our companies (excluding Capital Southwest because it is a holding company and excluding Berkshire Hathaway's non-Insurance holdings because this information is not available), 18% of those sales come from abroad. Further, on a dollar-weighted basis (accounting for each company's weight as a percentage of our equity holdings) 22% of sales come from abroad. Clearly, we are participating in the world's growth.
The three top purchases in the first quarter discussed below underscore how an American company can be levered to the world: Hypercom Corp. derives nearly 70% of its revenues from abroad; SonicWALL, Inc. receives 30% of its revenue outside the U.S.; and KVH Industries, Inc. brings in 15% of its annual sales from countries outside of the U.S.
On a completely separate note, given our emphasis on analyzing a company's "private market value" (the price an industry peer might pay for a company's operations and/or assets), we are happy to report two of our companies received buy-out offers in the first quarter. SpectraLink was purchased by Polycom on favorable terms, and The Topps Company received a favorable offer that has not yet been consummated because of the potential for competing offers.
Our Three Top Purchases
Hypercom Corp., HYC. Hypercom is a global provider of electronic payment solutions at the point of sale ("POS"). The company designs, manufactures and sells electronic transaction terminals and application software. Customers include large domestic and international financial institutions, electronic payment processors, large retailers and independent sales organizations and distributors.
The outlook for the industry is good: $3.5 billion in estimated annual worldwide sales, growing at an estimated 11% annually over the next several years (domestic growth of high single digits combined with international growth in the mid to high teens). In 2003, the total electronic payment percentage by American consumers was 39% of transactions (compared to cash/check of roughly 61%); in 2006 that percentage rose to 52% and it is estimated to rise to nearly 68% in 2010. International growth is even larger as emerging economies catch up with the efficiencies and increased accountability (strongly desired by governments) offered by electronic payment transfers. The replacement cycle for "swipe" POS devices is also being driven by the need for increased bandwidth for faster and more complex transactions. Finally, there is a growing demand for wireless POS devices by merchants who do not have a physical connection: pizza delivery and taxis, various home workmen, restaurants and "line-busting" at big box retailers to name a few.
In spite of positive industry trends, Hypercom has nonetheless underperformed due to poor management over the years as peers such as Verifone and French-based Ingenico came to dominate the POS device market. The company's annual revenues have been stuck at around $250 million the past few years, having peaked at around $325 million in 2000. We believe the arrival of William Keiper as CEO in March 2005 has ushered in a new era of management competence. Hypercom should now be positioned to participate in the industry's favorable trends. The company's balance sheet is sound given Mr. Keiper's efforts to shore it up: roughly $100 million in cash and no debt, which equates to about one-third of its total market capitalization at our average purchase price. Secondly, as was recently pointed out in an industry magazine serving the POS industry, Hypercom's current product line-up, including its new Blade wireless series, is competitive. Moreover, the complexity of managing the technical relationship between the retailer, merchant processor, card association, card issuing bank and retailer's bank is not small. The industry has had few new entrants in the past ten years and the top three players account for roughly two-thirds of POS device shipments worldwide: Verifone (including its recent purchase of Lipman) with 33%, Ingenico with 24%, and Hypercom with 9%.
Verifone's recent acquisition of Israeli company Lipman (which is slightly smaller than Hypercom) is instructive in estimating Hypercom's intrinsic value. Verifone paid approximately 2.8x Enterprise Value (EV) to sales and 15x EV to EBITDA. At our average price, we paid roughly 0.75x sales (2007 estimate) and about 8x EBITDA (2008 estimate). Our belief is that either Hypercom will participate in a growing and dynamic industry or be acquired by the larger and stronger Ingenico thereby creating an industry dominated by two equals. Even if an acquisition occurred at a deep discount to the Lipman transaction, our investment would do just fine. The turnaround at Hypercom will not be easy or quick. However, favorable worldwide industry trends, a solid balance sheet, new management and an opportunistic valuation make Hypercom a compelling investment in our opinion.
KVH Industries, Inc., KVHI. KVH Industries develops, manufactures and markets mobile communications products - high-end antennae - for the land and marine markets and navigation guidance and stabilization products for defense markets. KVH's land and marine mobile communications offerings, sold under the Trac brand, enable customers to receive live digital television, telephone and Internet services in their automobiles, recreational vehicles and marine vessels. KVH in fact introduced the first digital compass in 1982. The company's defense products, sold directly to U.S. and allied governments along with government contractors, provide navigation and pointing for military vehicles, provide stabilization for heavy guns and radar units and provide guidance for munitions. KVH is led by Martin A. Kits van Heyningen, one of the company's founders, who has served as President and Director since 1982 and as CEO since 1990.
We view KVH as a technologically strong, well managed, well financed operation with at least four distinct business lines providing the company multiple levers to grow its business and leverage its exceptional engineering talent. The company's military contract wins for its fiber optic gyroscopes are impressive given the importance of the application - allowing tank operators the ability to "stay below" while maneuvering their vehicles. The company is also benefiting from the increased demand to stabilize guns and turrets for remote control functionality. Roughly one-third of KVH's business is defense related. On the commercial side, the company is a leader in providing communication and entertainment access: marine accounts for roughly 50% of revenues, while the RV and auto markets are about 10% each. KVH is the only company providing antennae that can provide a full suite of cable channels to an automobile and is partnered with DirectTV and General Motors. The auto segment is still nascent and will continue to be until antenna size and cost are sufficiently reduced. KVH's overall engineering strength was corroborated by an independent analysis, coupled with a site visit to the company's headquarters in Rhode Island with the company's top engineers by a consultant we hired to work on this project.
We purchased KVH at approximately a 10% discount to an adjusted NAV calculation giving credit to its R&D expenditures and a modest value to its brand. This modest discount to "asset coverage" provides us essentially a free option on the company's future growth prospects (wherever that growth may occur). The company's net equity as a percentage of total assets is a stellar 88%, while net cash is over $50 million, which represents slightly more than 30% of its total capitalization at our purchase price. The company's founder, Arent Kits van Heyningen (now over 90 years old), and his two sons Martin and Robert, own roughly 7% of KVH's outstanding shares.
SonicWALL, Inc., SNWL. Founded in 1991, SonicWALL designs, develops, manufactures, and sells integrated network security, content security, and business continuity solutions for small to medium size networks. The products are designed to provide secure Internet access, enable secure Internet-based connectivity for distributed organizations, inspect content entering and leaving customer networks, protect organizations against email threats, and provide business continuity in the case of data or connectivity loss.
In 2006, SonicWALL was the overall winner of the VARBusiness Annual Report Card for security appliance vendors for the third year in a row. It was rated best in class in technical leadership, product innovation, partnership, and loyalty of resellers, while customer support improved over prior years. Led by Matthew Medeiros, CEO and President since March 2003, the company continues to show fiscal discipline as it grows its business.
From a valuation standpoint, our investment in SonicWALL is buttressed by private transaction data. At the price we paid, SNWL was trading at about 1.8x EV to 2007 sales. Comparable industry transactions suggest that SNWL is worth a minimum of 3x sales plus net cash. RSA Technology was bought out last year by EMC Corporation for over 5x EV/sales and Internet Security Systems was purchased by IBM last year for 3x EV/sales. In addition to a solid balance sheet possessing $235 million in net cash, which approximated 40% of market capitalization, it is a strong free cash flow generator with a free cash flow yield of about 8.5% in 2006, with similar expectations for 2007. During the fourth quarter of 2006, SNWL spent $12 million to repurchase over 1.1 million shares in the open market at an average price of $10.47. Our shares were purchased at almost a 20% discount to the price the company paid to repurchase its shares. Moreover, SNWL is ramping up its subscription-based services, which should reach 50% of total revenue by year end. Such revenues are more predictable and, therefore, more valuable.
In SonicWALL, we believe we own a strongly financed and well managed company in a consolidating industry purchased at a deep value price.
We are pleased to announce that we have added another member to our team. Debbie Saady has joined Roumell Asset Management as an Administrative Associate. Prior to Roumell Asset Management, Debbie was the Controller of Broadcast Capital, a venture capital fund, as well as the founder of her own consulting business. She is currently working toward a dual Bachelor's degree in accounting/MBA. Debbie also has a love for the arts as proven in her role as choreographer for various theater productions. Please feel free to give Debbie a call at extension 308 if you have any questions about your account that are of an administrative nature.
Once again, we want to thank you for the trust and confidence you have placed in us.
Investment Strategy: Roumell Asset Management, LLC ("Roumell") is an independent registered investment adviser and employs a value investment strategy in managing client portfolios. Roumell Equity accounts can have up to 100% of assets invested in stocks; Roumell Balanced accounts typically have 65% of their assets allocated to stocks (though the figure can range from 50% to 80% depending upon the needs of the client).
Calculation of Rates of Return: First and foremost, readers of this letter should recognize past performance is no guarantee of future results. Returns are reported net of all management fees and applicable trading costs; annualized returns are the result of linking quarterly returns (only accounts present for the entire quarter are included in a given quarter's performance composite); returns are time-weighted; returns reflect reinvestment of dividends and other earnings. Returns include an insignificant number of accounts that utilize margin. These returns are based on a composite of Roumell's accounts and therefore were not necessarily duplicated in any specific account. These consolidated performance numbers include all of Roumell's fully discretionary accounts within each category. Discretion is defined as the ability of the firm to implement its intended investment strategy without restriction.
Inclusion of Accounts: As of 3/31/07, in the performance calculations for Roumell Equity, there are 490 equity portfolios totaling $182.0 million. This represents 65.8% of total portfolios and 59.8% of total dollars under management. The standard deviation for Roumell Equity in this quarter is 1.0%. Currently, in the performance calculations for Roumell Balanced, there are 161 balanced portfolios totaling $90.3 million. This represents 21.6% of total portfolios and 29.7% of total dollars under management. The standard deviation for Roumell Balanced in this quarter is 2.1%. A complete list and description of the firm's composites is available upon request. Additional information regarding policies for calculating and reporting returns is available upon request.
Comparative Indices: Because Roumell utilizes an all-cap (large, medium and small companies) investment strategy, there is no perfect index for comparison purposes. We have included two equity indices and one balanced index to allow readers to judge our performance against benchmarks that collectively offer good comparative illustrations.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.