Hazelton Capital Partners letter for the fourth quarter ended December 31, 2015; discussing the fund’s long position in CUI Global Inc (CUI).
Hazelton Capital Partners - Long CUI Global (CUI)
CUI Global is a manufacturing and service company with two very distinct revenue segments. The majority of its revenues and earnings are currently derived from designing and selling power supplies, transformers, converters and connector for original equipment manufactures (OEMs), a slow growing but steady business with predictable margins. To augment the power supply business, CUI made two acquisitions focused on the natural gas industry: Exclusive license and eventual ownership of GasPT2 technology in 2009, and in 2013, Orbital Gas Systems, an engineering, infrastructure and high-tech service solutions provider primarily to natural gas operators in the United Kingdom. GasPT2 is a technology that is able to quickly measure the physical properties of gas sample and then infer its composition. The acquisition of Orbital Gas was also key to CUI's future growth, not just because of the relationship it had with British natural gas utilities, but because of Orbital’s VE Probe which can be used to safely and quickly draw natural gas out of pipelines. Combining the VE Probe with GasPT2 creates a gas chromatograph (GC), an instrument used to measure the contents of a gas and can be used by natural gas pipeline operators to measure the content of their gas.
A traditional gas chromatograph (GC) measures the makeup of a gas by drawing a sample into a chamber, mixing it with a carrier gas (mostly helium), and then separating and measuring the components. This process can take up to 30 minutes to return a result. To convert this technology to operate properly with a natural gas pipeline, a traditional gas chromatograph also requires a sample probe, a low and high pressure sample line, a pressure reduction unit, a skid, and in total costs upwards of $250,000. By contrast, CUI’s GC, which requires no carrier gas or additional components, mounts directly onto the natural gas pipeline, provides nearly real time measurements and costs approximately $55,000. And because CUI’s gas chromatograph does not require any carrier gas to operate, there are no additional monthly maintenance or calibration costs. Historically, gas transmission operators would purchase natural gas based on its energy content (BTU) and then bill their customers based on volume consumed, assuming no significant change in the level of BTU. With the recent increase in natural gas with differing levels of methane, the main determinant of the energy content within natural gas, pipeline operators now have a reason to accurately measure the methane content of the natural gas in its pipeline.
Snam Rete operates Italy’s largest natural gas transmission and distribution pipeline, and with over 20,000 miles of pipe, it is one of Europe’s largest natural gas pipeline operators. The company receives natural gas mostly from Russia, Iran, Qatar and Iraq, distributing it to residences and businesses within Italy, as well as acting as a transportation hub into other countries like France, Germany and the Netherlands. The methane content of natural gas from Russia is significantly lower than the gas coming in from Iran or Iraq. Because all the gas received by Snam Rete is mixed together, they currently have no way of determining the BTU levels they are delivering, and as such, are required to only charge at the lowest BTU rate. To solve this problem, Snam Rete has decided to install GCs throughout its pipeline to accurately measure and bill its customers for their BTU consumption. After three years of consistent delays, CUI and a competitor received a RFQ (request for quote) from Snam Rete in September, 2015 for the all-in cost (the unit, installation and yearly maintenance costs) for delivery of over 3,300 units, 10 times the size of the original plan. Snam Rete has indicated that the order could grow as large as 7,000 units over an extended period of time. The RFQ was returned on October 29th with a decision scheduled to be made by December with delivery starting by the 1st quarter of 2016.
On paper, CUI is the clear winner over its competitor; CUI meets all the requirements set forth by Snam Rete, which includes real time measurement and a gas chromatograph that does not require a carrier gas to operate. But one must keep in mind that Snam Rete is a regulated pipeline company and must show their regulator that the RFQ is completely above board. In the past, when Snam Rete was in a similar situation, the contract was split between the two competitors, allocating 90% of the deal to the clear winner in order to avoid claims of collusion. Winning even a portion of this project would be a huge boost to CUI’s revenue and profit margins. Historically, utilities are slow to adopt new technology. But once they do, the entire industry tends to move as a collective over time. Snam Rete is seen as the “first adopter” within the European gas pipeline industry, and a deal with CUI could prove to be the “good housekeeping” seal of approval encouraging other pipeline operators to follow suit. Around the same time that CUI was submitting its RFQ, it began fielding calls from pipeline operators in Germany, France and The Netherlands.
Hazelton Capital Partners has owned CUI global for nearly two years. Our initial investment was a much smaller holding, and the position was reduced even further after the share price nearly doubled in less than 6 months, as the market anticipated a pending deal with Snam Rete. After hitting its highs in March of 2014, CUI’s stock price lost its momentum as the Snam Rete deal continue to be delayed. After years of waiting and finally receiving and submitting a RFQ, CUI is in a much stronger position to win a larger portion of the order. Additionally, CUI has made some significant inroads into other product segments including its IRIS system, which allows pipeline companies to remotely monitor and operate sections of their pipeline from any computer, and its mercury detection unit that is based around its VE Probe. To date, the only sales CUI has received from its gas chromatograph system has been from pilot and testing programs. If one were to value CUI Global solely on its power supply business and pipeline service revenue, adjusting for expenses associated with its natural gas products, its earnings power would be conservatively worth around $6.25/share. Even with a modest revenue outcome from the Snam Rete RFQ deal, CUI’s value could increase meaningfully. Additionally, the Snam Rete deal could lead to increase orders throughout Europe and as growth, testing and piloting programs take hold in the US, this could provide a continued boost to future revenues and profits.
CUI is the type of company that Hazelton Capital Partners feels comfortable making an investment. It operates in a niche segment of large industry, flying below most investors' radar. We feel the downside is identifiable and limited, while the upside could be very significant with a number of positive events beyond the Snam Rete deal.