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Joshua Tucker

From: Sent: To: Subject: Joshua Tucker <joshua.r.a.tucker@googlemail.com> 04 May 2013 16:07 Joshua.R.A.Tucker@gmail.com Kerrisdale Capital | Home

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This post expresses a bullish view on SmartPros, Ltd. (SPRO) SmartPros generates material cash flow and trades at a low valuation Its CEO, Allen Greene, has built a strong track record since taking over the company in 2001, in terms of making intelligent acquisitions, steadily increasing the cash flow of the Companys underlying business segments, and acting in a shareholder-friendly manner

In this post, Im going to discuss a microcap called SmartPros Ltd., which trades under the ticker SPRO on NASDAQ. SmartPros is a small continuing education provider for the accounting, engineering, legal and finance industries. Its a well-managed microcap that generates decent cash flow, and trades at a low multiple on all valuation metrics, particularly any valuation metrics that focus on cash flow. That cash flow should grow steadily over time. The relevant materials referenced in this post can be downloaded here. Accounts managed by Kerrisdale currently hold SPRO, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date. Also, note that SPRO is a very small company and the stock is quite illiquid. Bid-ask spreads can be large and an investor must particularly have a long-term investing horizon with these types of illiquid stocks. Company Description and History

SmartPros is a collection of disparate small businesses that are related to one another by one or more of the following: (i) the business provides continuing education, (ii) it serves the financial community, and/or (iii) it has an online component to its business. The core business provides continuing education courses to accountants, but the Company also features businesses that create training programs for IT professionals and design training workshops for pharmaceutical industries, among others. Before discussing the business segments, it would be instructive to outline the companys history, because its an unusual one. SmartPros has been around in some form or another for over 20 years. Its core business, which is 50% of revenues, is a leading provider of continuing education courses for the accounting industry. Accountants are required to take various continuing education courses every few years to maintain their accounting licenses. The largest provider of these continuing education credits is a non-profit called CPA2Biz, which is affiliated with one of the main accounting licensing organizations. Its courses are the cheapest, both in price and quality. There are several higher-end course providers, of which SmartPros, Bisk Education and MicroMash are among the leading ones. SmartPros has been providing courses for 20+ years, and its relationships with various professional organizations and licensing programs provide it a stable customer base. Originally, the Company provided accounting/finance training programs on videotape. In 1998, it recognized that it would have to make its products available over the Internet in order to be competitive. The Company hired IT professionals to build a new media department that, among other things, would convert its programs to digital format for online delivery and would oversee the development of a robust system to deliver courses online, let employers monitor which employees were taking courses, etc. Influenced by the dotcom craze, Smartpros also pursued an acquisition strategy designed to build revenues and diversify into new markets, with little regard to return on invested capital. In 1998, the Company acquired Virtual Education Corporation (VEC), a provider of continuing professional development programs for engineers. The network buildout and acquisition of VEC put a tremendous strain on the Companys internal capital resources. Although the accounting division continued to grow and generate operating profits, SmartPros as a whole began losing money. In the four-year period beginning in 2000 and ending in 2003, the Company generated over $10 million of losses.

In 2001, it hired a new chief executive officer, Allen Greene, who had previously been the chief operating officer of a publicly traded specialty finance company. Greene implemented a successful turnaround, refocusing the business on its core competencies, cutting overhead, substantially reducing debt and raising additional equity capital. In 2004, Greene took SmartPros public and raised $6m, mainly for acquisitions. In 2006 and 2007, it made 7 acquisitions, which well discuss. At the same time, it continued growing its core businesses of accounting and engineering continuing education programs, and its customizable training courses in ethics, legal and compliance issues (through a business it bought in 2003). And it grew cash flow. The financials are on page 1 of the attached materials. They paint a respectable historical cash flow growth story. From 2003 to 2008, EBITDA grew from $0.6m to $1.6m to $1.0m to $1.5m to $1.9m to $2.2m. EBITDA less capex grew similarly well, from $0.2m in 2003 to $1.4m in 2007. Its difficult to separate organic vs acquisition growth, but its essential to note that SmartPros has paid very little for its acquisitions. Working capital is generally a source of cash, because for much of their accounting business, they receive large cash payments up front, then recognize revenue during the terms of the courses. NOLs shield them from taxes they have about $3m of NOLs remaining. The company has no debt. It generates plenty of cash. Management More than with most investments, SmartPros underlying value is tied to the actions of its CEO. Thats because SPRO doesnt feature a solid underlying business with a healthy growth trajectory that offers strong returns on reinvested capital. Rather, SPROs core business is a slowgrowing cash generator, and the cash appears to be better spent in ways other than reinvesting it in the core accounting continuing education business. Greene has elected to use the cash to make accretive acquisitions. SPRO is run more like a private equity portfolio than a typical public company. Usually, the private equity portfolio approach makes me cringe. But after an eight-year track record, Greene has demonstrated an adept ability to make intelligent capital allocation decisions, and a commitment to maximizing cash flow.

So lets talk about Allen Greene. Allen Greene was formerly the CEO of Ryan Beck & Co., VSB Bancorp and Valley Savings Bank, and COO of a small specialty finance company. He tried to retire, but got bored and went back into consulting. Then he came across SmartPros, a small, money-losing continuing education provider, and took its CEO job. He proceeded to cut costs, turn the business around and raise equity capital to expand the business. His long-term performance since 2001 has been commendable. The business has steadily improved cash flow and the intrinsic value of the business has grown. Greene talks about buying back shares when theyre cheap, being very disciplined about acquisitions, cutting costs when feasible, keeping executive and board compensation reasonable, etc. The whole story is quite unusual. Here, you have a man whose understanding of capital allocation is superior to many Fortune 500 CEOs. And yet hes running a $10m enterprise value business. Go figure. For our purposes, his actions overall during the past 8 years have been above-average. Not all of his acquisitions have worked out, but when Greene makes decisions, he keeps his downside limited, which is terrific. For Smartpros as a whole, profitability and cash flow have both grown admirably under his watch. Acquisitions and Business Segments Now that we know the Smartpros story and Allen Greenes background, lets take a look at the component businesses that make up Smartpros, as well as discuss the way in which they were acquired. The business segments and their historical revenue figures are on page 2 of the attached materials. Then on page 3 is a chart discussing all of the acquisitions since Greene took over SmartPros. In many of his acquisitions, Greene has paid little cash up-front and has structured a large part of the purchase price in the form of earnouts, where the seller will receive much of the money only if the acquisition performs well. Some acquisitions have done well, some have not. But in all cases, he hasnt overpaid. Lets go through each one (note that the EBITDA numbers are my estimates). For Working Values, he paid $300k in 2003 for a business that has made approximately $4m in sales since then, and perhaps $500k in cumulative EBITDA, by my estimates. It seems to be faltering now, but it has proven
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to be an intelligent purchase. For Skye, arguably his best acquisition, he paid $700k (and another $1m in earnouts) for a business thats making $2m-$3m sales and $400k+ EBITDA annually. For Sage Group, he bought a decent amount of content for $225k of cash and some liabilities. For MGI, he spent $100k for a business that probably makes $100k EBITDA annually. For Cognistar, he paid $320k for a business thats only negligibly profitable at this point. For Selbst, he paid $180k for a business thats also negligibly profitable so far. For BrightIdeas / WatchIT, he paid $175k for a business thats breakeven. With FinancialCampus, he basically paid $0. The seller, SkillSoft, receives $175k if the acquisition meets certain sales targets. FinancialCampus provides training courses for the insurance and financial services industries. It was formerly part of NetG, a corporate learning solutions company that was owned by Thomson and sold to SkillSoft for $270m in 2006. FinancialCampus was a very small piece of NetG, and its profitability had declined because Thomson hadnt paid much attention to it. SkillSoft didnt want to shut it down, for fear of upsetting some of its customers, and was fine with handing it off to SmartPros for minimal proceeds, as long as SmartPros would upgrade certain IT systems that needed to be revamped in order to keep those customers happy. Today, FinancialCampus generates $1m to $2m in sales and is materially cash flow positive. SPROs acquisiton of Loscalzo has also provided a respectable return on capital thus far. Collectively, Greenes acquisitions have done fine and the purchase prices have been low and disciplined. In terms of the component businesses, as theyre organized on page 2, here are brief discussions: Accounting: Comprised of the core accounting continuing education business and the recent Loscalzo (live training for the accounting profession) acquisition, this segment is growing steadily and generating material cash flow. Engineering: Performance has slipped due to timing issues and recessionary impacts over the past two quarters, but the core engineering continuing education business has proven stable over the years and the acquired MGI courses have provided a very attractive return on the original purchase price.
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Video Production: This is a legacy business that is a negligible part of the company now. Legal and Ethics: Both the Cognistar (legal continuing education) and the Working Values (ethics and compliance training) businesses have been slipping over the past few quarters. I dont have insights into their longterm future performance, but Working Values has generated a respectable return on the originally invested capital, and while Cognistar has been a less stellar performer, SPRO didnt pay too high of a purchase price to originally acquire it. Skye: A custom training / consulting business, Skye has grown nicely since being acquired, and should continue to grow cash flow well. WatchIT: This segment is about breakeven. Financial Services: This segment combined the FinancialCampus, Selbst and Sage acquisitions, with FinancialCampus (various finance licensing and continuing education courses provided to insurance companies, banks, etc.) being the main driver now. Sales and profitability have grown decently well. Recent Results So why is the stock lower than its IPO price in 2004? My best explanation is that the Company reported poor earnings in the most recent quarter. There seemed to be several culprits. First, the Company made an acquisition in July of Executive Enterprise Institute (EEI), which provides live conferences and seminars for corporate finance, tax and legal professionals. Similar to some previous acquisitions, EEI incurred costs in its initial quarter and will take some time to begin generating cash. Two other factors helped drive the weak results. First, Smartpros began to feel the impact of the recession in a variety of its segments. Second, timing issues in some of the business segments resulted in lower revenues in the third quarter. For instance, the engineering division saw revenues drop from $236k to $148k, partly due to timing differences in placement of orders and partly due to engineering firms / government agencies reducing their staff education budgets. Financial services consulting saw a decrease of $45k. As well, the companys Skye division had $440k of
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revenue, compared to $1m two quarters ago. The legal and ethics group saw revenue decline 50%, due to the weak economy. I dont think that the breakeven EBITDA of Q3 is an appropriate run-rate. As the EEI costs go away, thatll immediately improve profitability and cash flow to a more healthy level. As well, I dont think that the timing / recession-related drivers behind the Q3 numbers will be significant or long-lasting enough to reduce normalized EBITDA below the $2m+ annualized range that the company has achieved in recent quarters. Over the past four quarters, SPRO has posted rolling LTM EBITDA of $2.2m, $2.6m, $2.7m and $1.9m. Valuation If we assume that SPRO is a $2m EBITDA business, then it currently trades at just under 5x EBITDA. Capex is low with this business, so at $2m EBITDA, SPRO trades at 6.0x 6.5x EBITDA less CapEx. I think that those multiples are too low. As a reminder, SPRO does not pay taxes due to its NOLs. And its working capital is typically a source, not use, of cash. A more appropriate multiple is probably 7.5x EBITDA for this business, if were using $2m, which I think is on the low side. Its understandable that SPRO would achieve a valuation discount to a typical company with a similar cash flow growth profile, because of its very small size and the illiquidity of the stock. But I think 7.5x EBITDA is discounted enough. A 7.5x EBITDA multiple gets us to a more appropriate $4.25 valuation for SPRO, or about 40% upside from the February 19th close of $3.07. If we use more aggressive numbers, like $3m EBITDA and 8.5x multiple, we get to a $6.25 stock price. Risks In terms of risks, Id first point out that Im generally concerned about how each segment is overly reliant on its division head. When the head of Video Production left, that segments decline accelerated. Working Values has steadily declined since its previous head left several years ago. Imagine a scenario where a couple other division heads leave. Or
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accidentally pass away. In the near-term, I spoke with Greene about each division head, and dont think its a near-term problem. Second, for many of these businesses, barriers to entry are low and the company is neither a low-cost nor leading provider in the business. In theory, Kaplan could enter the accounting continuing education business, begin a substantial marketing program and steal material market share away from SmartPros. And accounting appears to be the most defensible business. With the other divisions, theres not much of a moat or material competitive advantages to the business lines. On the plus side, the businesses are currently profitable, not capital intensive and are in sufficiently growth-oriented fields. Third, results in Skye Multimedia, its interactive multimedia segment (and Working Values) are lumpy, because theyre based on the timing of large projects, as opposed to recurring revenue. Hopefully, we will not experience adverse timing in terms of when the projects recognize revenues / profit. A couple quarters of muted operating results from Skye could stretch out the time horizon wed have to wait to get our desired return. Fourth, its unclear what the exit strategy is for Greene. Because SmartPros is run like a private equity portfolio, a departure of Greene is a significant concern. The businesses are too small and integrated within the central IT infrastructure to sell off individually. Im not sure a strategic acquirer would be too interested in the SmartPros portfolio of businesses. Greene has said that financial buyers have expressed interest, given the Companys healthy cash flow. A financial buyer would have an equally difficult exit strategy were it to take SmartPros private, but ultimately, cash is cash there may be a financial buyer who would be interested in the healthy annual cash dividends that the Companys cash flow would represent, even if their exit strategy would not be as clear for SPRO as it may be for other typical sponsor portfolio companies. Conclusions I think SmartPros represents an attractive equity investment at the current stock price. Per usual, this email does not constitute investment advice or a recommendation of any sorts. Kerrisdale Capital may buy, sell or short
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any of the stocks mentioned at any time. I may be wrong; it wont be the first or last time. LEGAL: THIS COMMUNICATION IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND SHALL NOT BE CONSTRUED TO CONSTITUTE INVESTMENT ADVICE. NOTHING CONTAINED HEREIN SHALL CONSTITUTE A SOLICITATION, RECOMMENDATION OR ENDORSEMENT TO BUY OR SELL ANY SECURITY OR OTHER FINANCIAL INSTRUMENT OR TO BUY ANY INTERESTS IN ANY INVESTMENT FUNDS OR OTHER ACCOUNTS. THE AUTHOR HAS NO OBLIGATION TO UPDATE THE INFORMATION CONTAINED HEREIN AND MAY MAKE INVESTMENT DECISIONS THAT ARE INCONSISTENT WITH THE VIEWS EXPRESSED IN THIS COMMUNICATION. THE AUTHOR MAKES NO REPRESENTATIONS OR WARRANTIES AS TO THE ACCURACY, COMPLETENESS OR TIMELINESS OF THE INFORMATION, TEXT, GRAPHICS OR OTHER ITEMS CONTAINED IN THIS COMMUNICATION. KERRISDALE CAPITAL MANAGEMENT, LLC OR AFFILIATED ENTITIES MAY OWN SECURITIES OF OR OTHERWISE HAVE AN INVESTMENT RELATED TO ANY COMPANIES MENTIONED IN THIS COMMUNICATION. THE SENDER EXPRESSLY DISCLAIMS ALL LIABILITY FOR ERRORS OR OMISSIONS IN, OR THE MISUSE OR MISINTERPRETATION OF, ANY INFORMATION CONTAINED IN THIS COMMUNICATION. Printer friendly version Share This Tags: SmartPros

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