|Submitted By:||Ben Axler (Spruce Point Capital Management)|
|Submitted On:||Dec 27, 2011 at 01:42PM|
|Expected Timeframe:||Less Than 3 Months|
|Situation:||Event / Special Situations|
|Price At Recommendation:||$1.20|
Update: Dialogic is on the brink of insolvency. The company filed an 8-k that they received another 1 month forbearance from Wells Fargo and Tennenbaum Capital, their Term Loan provider. This 1 month forbearance is a month shorter than their last agreement which was for 2 months. The acceleration date is early February. The trends in their markets are deteriorating. Last week Acme Packet (APKT) cut guidance and noted weakness in their session border control business, and area of supposed growth for DLGC, which won't materialize fast enough to save the company. Additionally, the company abruptly canceled their appearance this week at the Needham Technology Conference. It is highly unlikely the company will receive a cash equity infusion at this point. The most likely outcome is a Ch 11 filing in the near future with the lender Tennebaum owning the company and common shareholders left with zero value. Even at 75 cents and a $22m market cap, DLGC is still overvalued and a worthwhile short.
Can Dialogic Avoid Bankruptcy?
Dialogic Inc. (Nasdaq: DLGC or the “company”) is a provider of communications platforms and technology that enable developers and service providers to build and deploy applications without concern for the complexities of the communication medium or network. The Company provides secure communications solutions that enable enterprises and service providers to shift to Internet Protocol (“IP”) based communications while still maintaining existing Time Division Multiplexing (“TDM”) networks. The Company was formed on October 1, 2010 by a merger between Veraz Networks, Inc. and Dialogic Corporation.
One year after closing the deal, the company has not achieved the strategic and financial goals articulated to investors. Meanwhile, the company is struggling with an accelerating decline in sales of its legacy products, a slow ramp in new products, and a high cost structure. Furthermore, the company is facing an unresolved and costly SEC investigation, and has unremedied breaches of its internal controls. However, the highest hurdle facing the company is its burdensome debt load, which is due to mature in early January 2012 and may ultimately cripple the company.
Revisiting the Merger
To say the Dealogic/Veraz merger has not lived up to expectations for shareholders would be an understatement. When the deal was announced in May 2010, the strategic rationale was to combine “Dialogic’s proven expertise in application enablement for voice and video with Veraz’s leadership in voice, data, session control, security, and transport to create a company with innovative products that will enable customers to unleash the profit of video, voice and data for 3G/4G networks.”
The announced financial projections of the merger were listed as following:
• Revenues are expected to be greater than $250 million
• Gross margins of 60-65%
• Adjusted EBITDA of 10-15% of revenues
Now that over a year has passed since the deal has closed, we can analyze how DLGC has performed relative to its objectives. As indicated in the table below, the company has fallen meaningfully short of each financial objective. In the past 12 months, revenues have achieved $203m, while gross margins and adjusted EBITDA margins were 57.1% and -3.4%, respectively. Why has DLGC failed to hit its targets? First, the company is dependent on sales of its TDM media processing brands, which as a legacy product, is in rapid decline from both a pricing and volume perspective. Sales declines are accelerating at a faster rate than initially expected; 35% of company revenues come from Europe, Mideast and Africa where the company reports sales to Portugal, Italy, Greece, Russia and Spain. Meanwhile 43% of sales are reported from the Americas. Last week’s report from the U.S. Department of Commerce also indicate that communication equipment spending is declining at a meaningful rate. The durable goods report showed that communication equipment spending fell by 10.3%, which was the largest drop among all sectors. (source: http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf)
DLGC’s core products have been declining as networks increasingly migrate away and deploy packet-based technology. The company has also been challenged by the adoption of its new products, which have long sales cycles and significant risks, but has indicated signs that mobile backhaul products will pick up next year. We certainly hope this is the case since the company has invested heavily in R&D, sales, marketing, general and administrative expenses, which amounted to over 75% of trailing 12 month revenues. The company’s ability to cut costs further may already be limited since they recently undertook a comprehensive restructuring effort prior to, and following the merger to eliminate headcount and vacate facilities in New Jersey and New Hampshire. Any additional reduction measures could further strain the company’s ability to remain competitive.
DLGC competes with a long list of larger companies with significant financial resources. Its competitors include established telephony equipment providers such as Alcatel-Lucent (NYSE: ALU), Acme Packet (Nasdaq: APKT), Audiocodes Ltd. (Nasdaq: AUDC), Cisco Systems (Nasdaq: CSCO). Genband Inc., Radisys Corp. (Nasdaq: RSYS) and Sonus Networks (Nasdaq: SONS). The company is also reporting to see increasingly intense competition from Huawei Technologies.
(See Table in Attached File)
Will Revenues Pick-up Fast Enough to Forestall Bankruptcy?
The accelerating decline in legacy products and slow adoption of NextGen products has put DLGC in a precarious position. The company currently has $109m of debt outstanding at an average interest rate of 14%, a shrinking cash balance, and is not in compliance with any of its key bank covenants. In the table below, we summarize the key terms of the company’s revolving credit facility (“RCF”), term and shareholder loans. What’s most troubling is that DLGC’s senior lenders for its RCF and term loan can accelerate the maturity of the debt early next year starting on January 6, 2012.
(See Table in Attached File)
It does not appear that DLGC has enough cash or assets to continue servicing its debt in the long-run, or pay back its lenders. In the table below, we have listed the company’s key assets and liabilities, and included our estimation of the liquidation value of the assets. Much of the company’s cash is domiciled in foreign jurisdictions, so we have applied a 30% repatriation tax rate to the balance. The remaining assets we apply between a 50-70% haircut to be conservative. We have ascribed zero value to goodwill or intangible assets. As of March 2011, the company reported as a material risk that two of their key patents expired. As a result, we believe there is limited to no patent value for the company.
(See Table in Attached File)
Other Issues Plaguing the Company
On March 28, 2011, the Company received a letter from the SEC stating that they were conducting an informal inquiry and requesting that the company preserve certain categories of records. In a follow up discussion with the SEC on March 30, 2011, the SEC informed the company that the inquiry related to allegations of improper revenue recognition and potential Foreign Corrupt Practices Act violations of the former Veraz Networks Inc. business during periods prior to completion of its business combination with Dialogic Corporation. The Board appointed a committee to review these issues, with the aid of counsel, and to make recommendations to the Board as to what, if any, remedial actions would be appropriate.
The company is cooperating fully with the SEC Inquiry and intends to continue to do so. As of its last quarterly filing, the company could not determine the probability of or quantify the amount of any fines or penalties associated with the SEC matters discussed above. However, the company has taken charges totaling $2.5m related to the SEC inquiry through its income statement in the general and administrative line. This represents yet another strain on the company’s rapidly depleting cash.
The company also appears to have an unresolved deficiency with its internal controls. The management and KPMG identified a material weakness and significant deficiencies for the year ended December 31, 2010. In connection with the financial audit of the following material weakness was identified, which results from the aggregation of certain significant deficiencies identified during the audit: insufficient staff with technical accounting expertise to apply accounting requirements, as they relate to non-routine and highly complex transactions, in accordance with U.S. GAAP. Specifically, it was noted that there was a lack of sufficient accounting and finance personnel to perform in-depth analysis and review of accounting matters. This weakness resulted in certain audit adjustments to the amounts or disclosures of the following items: inventory reserves, debt issuance costs, stock-based compensation expenses and restructuring expenses. As of its lastquarterly filing, the matters described above have still not been resolved.
The survival of DLGC will depend significantly on an unexpected stabilization in the decline of their legacy products, and material pick up in NextGen product sales. Otherwise, DGLC will struggle under the weight of its high cost structure and significant debt load. Given the pending debt acceleration timetable for early January 2012, rapid decline in its cash and meager cash flow ability, the company appears to have limited breathing room. It also appears unlikely that a white knight will emerge to save the company. According to the company’s merger proxy from 2010 (http://www.sec.gov/Archives/edgar/data/1366649/000119312510158348/dprem14a.htm), there appeared to be few interested parties willing to enter into a strategic transaction. Absent a significant and highly dilutive equity raise in the near-term, or debt restructure, the common stock of DLGC will be rendered worthless.
Disclaimer: Use of the research produced by Spruce Point Capital Management, LLC is at your own risk. You should assume the author of this report holds positions in the securities of Dialogic that will benefit from a drop in the price of the common stock. Following publication of the report, the author (including members, partners, affiliates, employees, and/or consultants) may transact in the securities of the company covered herein. The author of this report has obtained all information contained herein from sources believed to be accurate and reliable and has included references where available and practical. However, such information is presented “as is,” without warranty of any kind– whether express or implied. The author of this report makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any of the information contained herein. Spruce Point Capital Management, LLC is not a broker/dealer or your financial advisor and nothing contained herein should be construed as an offer to or solicitation to buy or sell, or recommendation, for any investment or security mentioned in this report. You should do your own research and due diligence before making any investment decision with respect to securities covered herein, including, but not limited to, the suitability of any transaction to your risk tolerance and investment objectives and consult your own tax, financial and legal experts as warranted.
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