Case Study of a Net Net Stock Explosion


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Guest Post

written by

Evan Bleker

What You’ll Learn

  • Case study of a winning net net stock and why
  • What does a company look like if it’s going through challenges
  • When is it okay to favor an unfavored net net company?

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It has been just over 5 years since I first discovered one of my best performing stocks. The Canadian firm—Sangoma Technologies Corp—appeared on my radar in October 2013.

A month later I published an article explaining how the company fit all of my criteria for a successful deep value investment. However, what happened over the next half a decade met my expectations perfectly.

When I first analysed Sangoma Tech, it’s stock was trading right around $0.20 CAD per share. Fast forward to today, you can purchase—or sell—one share for $1.32 CAD. That’s a 469% return. An initial $5,000 investment would be worth over $23,000 just five years later.

It’s what most stock investors would call a 4-bagger.

This sort of massive profit is something I hope every investor gets to experience a few times throughout their career. It can completely change your portfolio’s compound annual return for the better.

This is why I want to look back through the years and dissect exactly why I singled it out from our Net Net Hunter Shortlist and what lead to its tremendous performance.

Hopefully, the next time a firm fits the same mold, we all can get in from the start and reap the same large profit.

The Original Analysis

So what gave Sangoma Tech all the potential?

To really answer this question we need to look further into the company’s fundamentals, history, and management decisions.

In 2010, Sangoma Tech operated within the telecom industry, specializing in those traditional, copper wire telephone systems for enterprises. Just based on that information alone, you can imagine the company was about to face some challenges in the upcoming years.

As their customers began to transition into more modernized solutions, profitability began to suffer. From 2010 to 2013, net profit margin dropped from 20.48% to -33.47%, earnings per share dropped from 0.08 to -0.14, and return on equity dropped from 12.80% to -24.46%.

Sangoma’s stock followed suit, dropping from around $0.80 CAD to $0.27 CAD. With what we know so far, most investors would have run from this opportunity. However, it was at this time that I became most interested and began a deep value analysis.

Cigar butt stocks such as Ultra or net nets have great returns, north of a 25% CAGR in studies and close to that in actual practice, so the odds were already stacked in my favour.

That analysis revealed signs that the company wasn’t going to continue to deteriorate as badly as some may have imagined. To understand what I mean, let’s take a look at the company’s Core7 Scorecard based on the June 2013 year-end report.

STC year end report

As you can see, there was no doubt that the company was cheap. It traded well below net current asset value and net cash value. Both strong indicators that the company had some potential in its future. I knew that at minimum that Sangoma Tech was a fair company selling for a wonderful price.

Running through my checklist, I spotted another promising fact — its small market cap of just $5.77 million. This meant that Sangoma Tech was being overlooked by institutional investors, mutual funds, and even larger retail investors.

Given the thin liquidity, only small investors could invest a meaningful amount of money in the company. The fewer people who could buy the stock, the better the opportunity for small portfolios to capitalize.

You may have noticed a difference between basic share count and diluted share count. This is due to an additional 2.3 million outstanding stock options — in the money between $0.26 – $0.50. In spite of this, I was not concerned. They were not selling shares to raise cash, options can add incentive for management, and the underlying value was not affected as most came due above NCAV.

The cheap price and small market cap made me cautiously optimistic about Sangoma Tech. Digging further, there was still another indicator that suggested that the stock would be a good candidate.

Remember how the firm’s profitability and stock had drastically dropped between 2010 to 2013? Well take a look at its net current asset value throughout those years.

sangoma tech valuation

When a company is going through challenges, net current asset value stability is a great sign.

Buying based on NCAV, you naturally want your source of value to remain intact, since it also means your margin of safety and profit potential remain intact while you’re waiting for the business to turn around. This is exactly what happened in Sangoma Tech’s case.

Net current asset value had dropped just 13% in the last two years. Not too bad!

As we found out earlier, at the end of 2013, the firm’s main operations and sales were fading. However, management provided evidence that it was focused on turning things around. It spent 20-21% of revenue diversifying its product offering.

This resulted in releasing 19 new products to customers. The buckshot approach that Sangoma Tech was implementing is an indicator of future profit potential. They were trying many different ways to make money — eventually a couple of them should stick.

Lastly, I was excited to see that management maintained a zero long-term debt level, increased the current ratio, and even decreased basic share count throughout the recent past. It was clear that management was shareholder focused and saw the challenges as only temporary.

To finish off my original article—published in November 2013—I provided readers with what I believed to be a fair valuation and prediction for the future of Sangoma Tech.

At the current price, the company trades at roughly a 38% discount to intrinsic value. Graham, though, always recommended a range of values when assessing the worth of a stock. I consider $0.32 per share a minimum valuation, given current assumptions about dilution. While your analysis may indicate otherwise, I fully expect this company to regain its traction, increasing both its revenues and net earnings going forward. If the company is even only half as profitable as it was in 2009 or 2010 then, based on a historic stock market PE of 15x earnings, the firm is easily worth $0.60 per share. If it is able to regain it’s 2010 level of profitability then the firm could be worth as much as $1.35 per share.

Let’s look into what happened to Sangoma Tech over the next five years.

The Anticipation

Based on my conservative intrinsic worth of $0.32 per share, the stock reached fair value only 3 months after publishing my article. This means in February of 2014, Sangoma Tech was trading at par with its per share NCAV.

Depending on a predetermined sell rule, some investors would have exited the stock for a nice profit of 60%. Looking over the short term, this would have appeared to be a good decision. Over the next 36 months, the stock price bounced between a low of $0.28 CAD and a high of $0.42 CAD. It wasn’t until February 2017 when the net net began to show it’s explosive potential.

Want to know what happened in that month? We’ll get there. First we need look into some of the actions management took while their stock was channeling for 3 years. In my original article, I made the prediction that a diversified product offering would eventually gain major traction.

I proved to be correct as sales from Q1 2014 to Q1 2017 increased by a significant 112%.

sangom quarterly sales

Sangoma Technologies Quarterly Sales (Source: Sangoma quarterly financial statements)

Also during the stagnant period, Sangoma Tech made two acquisitions—Schmooze Com Inc and RockBochs Inc. The former is a globally recognized developer of the voice over IP and telephony server, FreePBX.

The latter offers a Fax-over-IP monthly service and semi-custom telecom appliances. Both became valuable pieces of Sangoma’s operations over the coming year.

On top of those transactions, the firm introduced multiple new services for their customers. This includes an express for the Lync platform, IP phones for FreePBX and PBXact, a PBXact unified communications solution, and a cloud-based business communications service. These were all successful steps towards improving the firm’s overall operations.

The Explosion

The stock market continued to overlook Sangoma Tech for 3 long years. That was until Monday, February 6, 2017 when record 2Q results were announced.

The quarterly statement reported revenue to be $6.57 million, the highest in the company’s history. Sales increased 29% and EBITDA increased 85% from the same quarter the previous year.

If you ever wanted confirmation that the markets act irrationally, take a look at what happen to Sangoma’s stock price over those 5 years.

469% gains in 5 years

Sangoma Technologies Stock Graph. Sometimes a company can test investor patience before eventually producing outstanding returns.

It would be an understatement to simply say that investors were pleasantly surprised with the announcement. After the stock’s initial 2014 bump up in price, investors ignored the firm as management steadily improved the business. But, in early February 2017, that all changed.

Over the next 7 days, shares would trade at prices not seen in 230 weeks! It would eventually close out the month trading at its highest level since November 15, 2010—$0.59 CAD. The great comeback didn’t just stop there.

From the time of the record breaking announcement to the writing on this updated article, share prices have appreciated over 216%. The unbelievable explosion ignited by a single announcement is just one of those crazy phenomenons that can happen in the stock market. However, it wouldn’t have come unexpectedly for one of my favourite deep value investors, David Dreman.

The well known contrarian once conducted a study to determine the effects surprises have on favored and unfavored companies. Prior to Sangoma’s announcement it would have been considered unfavoured based on it’s low price an anemic stock behaviour.

What Dreman discovered was that positive announcements result in major price gains for these unfavored companies, while having little impact on the favoured companies. To the contrary, announcements that simply reinforce low expectations for unfavoured companies were found to have minimal impact on their stock price.

This would explain why Sangoma’s stock was treading water for 3 years until the positive record-breaking revenue surprise resulted in a massive price spike. Lastly, Dreman discovered the increased momentum caused by surprises will continue to positively impact the stock for another 4-6 years.

This provides explanation for why the company has continued to appreciate even today. The findings are a testament to the advantage of buying unfavored, deep value stocks—such as Sangoma Tech.

It is just one of the many reasons why I feel so confident in building a portfolio with them.

The Aftermath

If we look back at my three intrinsic value calculations, we can see that I was not too far off. The most conservative was $0.32 which was achieved only a few months after publishing the article.

The second valuation of $0.60 was based off of the historic stock market price/earnings ratio. Sangoma’s stock blew right past this benchmark shortly after their record-breaking announcement. Since then, the stock price has never dropped even close to these first two intrinsic value levels.

At the current price of $1.32, it is now trading on par with my most optimistic valuation.

sangoma june 2018

Unfortunately, Sangoma Tech is no longer a tiny deep value play with explosive potential. It is now much larger and possibly overpriced. Small investors lost their competitive advantage with the increase in market cap, high price to net current asset value, and excessive price to net cash value.

These were all factors that once made this stock so attractive. Although I would not recommend currently purchasing this stock, I would like to point out an interesting fact. In 2008, these shares sold for prices very similar to today’s levels.

It took only 5 years for the firm to become the prospective net net that we once admired. It then took another 5 years for it to revert back to being overpriced. Will history repeat itself in similar fashion?

I wish I knew!

While we shouldn’t expect Sangoma to appreciate much higher, are there similar situations on offer today? With all the discussion on how hard value investing has become in these expensive markets, few investors think so.

This hasn’t been our experience, however. Investors can still find this kind of bargains if they’re willing to search. For example, we recently recommended both Mongolian Growth Group and Support.com on The Broken Leg Investment Letter.

But, whether they fit your portfolio now is up to you to decide

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