Precision Optics (POCI) Post-Mortem Case Study
Creating Value Even When Main Valuation Thesis Fails
This post summarizes SCC's investment in Precision Optics Corporation (POCI) [SEC filings here]. For the record, the following are the pertinent facts and numerical results for the investment:
Approximate Purchase Date: July 2019
Average SCC Price Paid Per Share (Split-Adjusted): $3.60
Date SCC Original Investment Thesis Published: September 12, 2019
POCI Stock Price as of SCC Publication Date (Split-Adjusted): $4.26
SCC Published Target Price (Split-Adjusted): $8.55
Date SCC Open Letter Published: October 16, 2020
Average SCC Exit Price Per Share (Split-Adjusted): $6.00
Recent Stock Price (as of 2/18/2024): $5.86
Dividends Received: Nil
Overall Gain (%age): ~67%
Time-Weighted Average CAGR (%age): ~16%
SCC's POCI investment thesis [link above] was summarized in our original post as follows:
"Precision Optics Corporation (ticker PEYE) is a microcap medical device company whose products include micro-precision lenses and micro medical camera, 3D endoscope, and robotic surgery systems. Over the past five years, PEYE has basically been treading water, with annual losses ranging from $350,000 to $1.2 million and annual revenues relatively flat in the $3 million to $4 million range [ED: $8 million pro forma for the 2019 Ross Optical acquisition]. However, PEYE recently completed the acquisition of Ross Optical Industries, Inc., which appears to significantly improve PEYE’s investment risk-reward calculus. On a pro forma basis giving effect to the transaction, PEYE was solidly profitable in FY 2018 and basically breakeven in the first three quarters of FY 2019. Moreover, the Ross transaction will cost PEYE shareholders just $2 million at most, pending a $500,000 contingent earnout payment, meaning PEYE acquired Ross at just a mid-single digit P/E multiple, a seeming bargain.
Acquisitions can really move the needle for an acquirer’s investors, occasionally for the better, unfortunately more often for the worse (normally acquisitions are value destructive because they are made primarily for management’s empire building purposes). Happily, however, in PEYE’s case we think the Ross acquisition falls clearly in the former category. With high insider ownership (major shareholders hold around 45% of the outstanding common stock), one can expect the merged company’s assets to be put to their highest and best use, with the benefits thereof accruing to the company’s owners (PEYE longs). Given a recent stock price of $1.42/share [ED: $4.26/share adjusted for the 1-for-3 split in November 2022], there is ample 101% upside for shareholders to our target price of $2.85/share [ED: $8.55/share adjusted for the 1-for-3 split in November 2022] (or ~3.7X our pro forma FY 2019 revenue estimate). This multiple appears more than reasonable given the combined company’s nearly 25% organic revenue growth and near breakeven underlying operations. (For comparison purposes, peers in the medical device space trade at an average revenue multiple of 5.7X.) In sum, with the Ross Acquisition, PEYE’s pie just got quite a bit large for shareholders, but with minimal dilution. Enterprising small and micro-cap investors should carve a slice out for their portfolios."
SCC followed this up with an open letter to shareholders towards the end of 2020 [link above], in which we scrutinized the company's horrible governance practices (no annual meeting held since 2009!) and lack of financial alignment of POCI senior management with shareholders. SCC also communicated with POCI's designated IR representative (Robert Blum of Lytham Partners) on various occasions to try to improve governance practices at the company.
Unfortunately, although it eventually proved profitable, the POCI investment thesis failed to pan out as planned. The company has continued to tread water financially, most recently releasing Q2 FY2024 financial results which were, frankly, woeful (see the company's 2/14/2024 earnings PR here). While FY2024 run-rate revenues of ~$18MM are up 2.25X versus pro forma (including Ross Optical) revenues of ~$8MM for FY2018, profitability is down (and out). As a consequence, POCI's EV/Revenues multiple has declined from 3.7X to the current ~2X (despite our prior prediction of EV/R multiple expansion--oops.) Moreover, in our view there's no clear path to improvement going forward. We were clearly "drinking the Koolaid" when it came to believing management's spin regarding the Ross Optical (and subsequent) acquisitions. In short, one can bet on POCI's management over-promising and under-delivering on a fairly consistent basis.
On the positive end of the spectrum, however, POCI's corporate governance has improved markedly since we initiated our investment, possibly due to our public and private agitation for change. The company now holds irregularly-scheduled annual meetings where shareholders can potentially voice their discontent (see 2022 proxy here and see 2023 proxy here). Moreover, the company declassified its board in May 2022. Interestingly, the top-4 shareholders continue to hold a large chunk of stock (35% of outstanding), but haven't voiced any concerns publicly (a la SCC), although two of the five POCI directors (Miles and Anania) received a large WITHHOLD vote at last year's annual meeting:
Perhaps POCI's improved governance and uplisting to NASDAQ in late 2022 account for the increase in the company's stock price (despite worsening financials). If so, this shows that, at least in tiny companies, activism can cause an otherwise doomed investment to work out fairly successfully. A good rule of thumb (the Three-Year Rule) is to bail if and when management fails to deliver on their prior promises over a three-year time horizon (which provides an honest and competent management team with adequate runway to deliver results). If they deliver, however, one usually has an investment worthy of holding for an extended (tax efficient) timeframe.
DISCLOSURE: SCC sold last remaining POCI shares in February 2024.
