One Stop Systems Is Trading At Expensive Multiples (NASDAQ:OSS)

One Stop Systems (NASDAQ:OSS) is a designer and manufacturer of rugged computer systems.

The company made a strategic shift in 2020, and has been trying to position itself in the very nascent AI transportable industry. Its products are the ‘brain’ behind these AI vehicles.

Although OSS saw some improvements in profitability after its strategic change, it has not been able to materialize profitability growth. In the meantime, the company has diluted shareholders substantially. Finally, recent accumulation of receivables and inventories shade doubts over future revenue growth.

For these reasons, I believe OSS stock is expensive on a net income basis but also on a pre-tax minus R&D basis.

Note: Unless otherwise stated, all information has been obtained from OSS’ filings with the SEC.

Business description

High-end rugged computer systems: At the core, OSS sells server boxes with the components already installed. The components are manufactured by the technological leaders of the semiconductor industry, like Nvidia or Intel. OSS packages the products into boxes with specific components and connections.

OSS’ specialty is rugged systems, meaning systems that are designed to perform under heavy environmental conditions. These can be used in a variety of settings, for example when the server has to move constantly or has to be exposed to the outside.

No durable technological advantage: The company’s core competitive activity is to design the frames where the components will be placed. These have to be light-weight, durable, and have good cooling characteristics. OSS also specializes in the connections between the server’s components. In my opinion, these are not incredibly defensible areas, because the technical requirements are not tremendous. The really technologically complex products are inside the boxes, and are not manufactured or designed by OSS.

Order win business: Most of OSS’ business is generated by winning orders with OEMs of other products that utilize OSS’ server boxes. The problem with this kind of business is that the company has to spend significant sales and R&D resources to get design wins. The customer is then in a beneficial bargaining position to lower prices, because most of OSS’ costs are already sunk. If the company has spent X million in a design that will be useful for a single customer, that customer can then bargain on margins because OSS has every incentive to recover at least a portion of the resources already spent.

Low margins: Despite OSS operating in the same market for more than twenty years (public only five), it has rarely sustained even a meager operating margin. This is the clearest signal that its markets are competitive and the company is not in an advantageous position.

A change in strategy: The company announced the termination of its CEO and largest shareholder in February 2020. After that, the company announced a strategic change toward AI Transportable. OSS believes that this market will be ripe for its rugged systems. Indeed I believe this is true, because autonomous vehicles require significant computing power in well protected boxes.

Results are not visible yet: After the managerial and strategic change, the company saw an improvement in profitability that then stopped. True, the company has been increasing revenues, but this has resulted in lower gross margins, not higher profits. On the positive side, the company has kept SG&A and R&D expenses under control. SG&A is usually the weak spot of many low margin companies.

Shareholders have been diluted at good prices: OSS sold shares in 2021, when the company’s shares enjoyed a short lived boom. This allowed the company to capitalize, which has resulted very useful for the enormous working capital requirements that OSS is now facing (more on this later). I believe management was intelligent by issuing these shares.

A strong balance sheet: OSS has about $6 million in debts, mostly concentrated on its European subsidiary. Half of these pay EURIBOR + 3% (estimated, because the company does not disclose this information directly) and the other half pay an average 2.5% fixed.

On the other hand, as of 3Q22, OSS has more than $12 million in cash and investments, and has mostly self-financed an enormous increase in working capital that could have increased the company’s debt otherwise.

Valuation

The growth story is not there: OSS has advertised its top line growth, but that has not translated into bottom line growth because gross margins have been lower than before the managerial change. The short term stagnation can be seen by removing R&D expenses from operating income.

On a longer term vision, the main promise of the AI transportable story is oriented to the very long-term future. For example, the company concentrated its’ investors presentation on the autonomous truck industry, showcasing recent design wins. However, the autonomous truck industry is for the most part in the pilot and testing phases, and years will elapse before these systems require mass production quantities of OSS’ boxes.

Concerns on inventories: Inventories and receivables have been growing steadily. These have more than doubled since December 2021. This could indicate that the company is having trouble generating demand.

On its 10-K report for FY21, OSS mentions that $13 million in revenues of that year (25% of the company’s revenues) were generated under vendor managed inventories agreements. Vendor managed inventories mean that the company bills the products but keeps them in their facilities until the client requests them. These products are eliminated from inventories and included in CoGS and revenue. Usually, until the products are not shipped they are not paid either, so the company accumulates receivables as well.

The practice can indicate two things. One is that the company is building a tighter partnership with one of its customers, making more recurrent shipments to help the customer manage inventories, a common practice under just in time supply chain management. The second one is that the company is lowering its sales standards to bring sales from the future. For example: the company offers higher discounts on volume to its customers, but also offers to hold those inventories until needed and only record a receivable (no cash upfront). This has the effect of accelerating customer demand today, while generating a demand void in the future.

We have no way to judge if the company is engaging in the second practice (known as channel stuffing). However, it is another sign that caution is required.

Multiples: With the company trading at a market cap of $70 million, it has a P/E ratio above 50x, based on annualized earnings from the 9M22 period. That is an unacceptably high multiple, if the investor is considering purchasing the stock on the basis of earnings alone.

However, for technology companies, I also look at price to R&D capacity, which we can calculate as pre-tax income plus R&D expenses. This is a measure of how much R&D expenses the company can finance from self-generated funds. Many technology companies invest all of their operating profitability in new products, yielding EPS that do not represent the company’s business. This self-financed R&D capacity allows the company to continue growing without recurring to risky debt or diluting share issuance.

Of course, because I am usually comfortable with a P/E ratio close to 10x, I demand a much lower R&D capacity ratio, because earnings are distributable, or can be accumulated as cash, while R&D capacity is expended in R&D and will only become profitability if (uncertain) future business is generated.

In this realm the company offers an R&D capacity multiple of 12x (on a $6 million annualized R&D capacity). I believe this multiple is also very high. I would be more comfortable with a multiple at least half that size, of 6x or lower.

Conclusions

I do not believe that OSS commands a premium based on quality. The company does not have a competitive advantage, it is not growing in its current markets, and offers only a promise on yet to develop industries.

Further, the recent growth in inventories, added to the vendor managed inventories program, is concerning for short term revenue volatility.

With that in mind, I believe that both multiples (on earnings and on R&D capacity) are too high. I prefer to issue a hold rating on OSS stock and wait for other opportunities.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.