Greenbackd

CoSine Communications Inc (OTC:COSN) is an interesting little pink sheet play: a cash box controlled by activist investor Steel Partners. Steel Partners, whose holdings we recently covered in the Catalyst Investment Research on Steel Partners II Investment Portfolio post, owns 44.9% of the stock and sits on the board. At its $1.75 close yesterday, COSN’s market capitalization is just $17.7M. We estimate the net cash value to be around 26% higher at $22.2M or $2.20 per share. The net cash value has remained stable through 2006, 2007, 2008 and 2009, while the stock has halved from $3.50 to $1.75 for no fundamental reason that we can identify. Usually a discount like that wouldn’t get us excited, but this is not a liquidation play. COSN is an acquisition play with Steel Partners in the driver’s seat (the company also has substantial NOLs). We’re adding it to the Greenbackd Portfolio for those reasons.

About COSN

From the most recent 10Q:

[COSN] was incorporated in California on April 14, 1997 and in August 2000 was reincorporated in the State of Delaware. Our current business strategy is to enhance stockholder value by pursuing opportunities to redeploy our assets through an acquisition of one or more operating businesses with existing or prospective taxable earnings that can be offset by use of our net operating loss carry-forwards (“NOLs”). No assurance can be given that we will find suitable candidates, and if we do, that we will be able to utilize our existing NOLs.

We were a provider of carrier network equipment products and services until the fourth quarter of fiscal year 2004 during which time we discontinued our product lines, took actions to lay off most of our employees, terminated contract manufacturing arrangements, contractor and consulting arrangements and various facility leases, and sold, scrapped or wrote-off our inventory, property and equipment. In July 2005, our board of directors approved our strategy of redeploying our existing resources to identify and acquire new business operations. In 2006, we sold the remaining assets of our carrier network products business with the sale of our patent portfolio and the rights to the related intellectual property. During 2006, we also completed the wrap-up of our carrier services business, providing customer support services for our discontinued products through December 31, 2006, at which time we terminated all customer support offerings. Effective July 1, 2007, we engaged SP Corporate Services LLC to provide all of our executive, financial and administrative support service, rent and personnel requirements and, as a result, we no longer have any employees.

The value proposition

The valuation on COSN is straight-forward: It has around $23m in cash and short-term investments, $0.2M in liabilities and 10.1M shares outstanding. We’ve set out the valuation below in the usual manner (the “Book Value” column shows the assets as they are carried in the financial statements, and the “Liquidating Value” column shows our estimate of the value of the assets in a liquidation):

Balance sheet adjustments

We’ve made the following adjustments to the balance sheet estimates above:

• Cash burn: The company used $0.1M in cash in the second quarter, which we’ve annualized to $0.6M. $0.6M might be too conservative.
• Off-balance sheet arrangements and contractual obligations: According to COSN’s 10Q, it has no off-balance sheet arrangements.

NOLS

A quick primer on net operating loss carry-forwards (“NOLs”) from the most recent 10K:

NOLs may be carried forward to offset federal and state taxable income in future years and eliminate income taxes otherwise payable on such taxable income, subject to certain adjustments. Based on current federal corporate income tax rates, our NOLs and other carry-forwards could provide a benefit to us, if fully utilized, of significant future tax savings. However, our ability to use these tax benefits in future years will depend upon the amount of our otherwise taxable income. If we do not have sufficient taxable income in future years to use the tax benefits before they expire, we will lose the benefit of these NOLs permanently. Consequently, our ability to use the tax benefits associated with our substantial NOLs will depend significantly on our success in identifying suitable acquisition candidates, and once identified, successfully consummating an acquisition of these candidates.

Additionally, if we underwent an ownership change, the NOLs would be subject to an annual limit on the amount of the taxable income that may be offset by our NOLs generated prior to the ownership change. If an ownership change were to occur, we may be unable to use a significant portion of our NOLs to offset taxable income. In general, an ownership change occurs when, as of any testing date, the aggregate of the increase in percentage points is more than 50 percentage points of the total amount of a corporation’s stock owned by “5-percent stockholders,” within the meaning of the NOLs limitations, whose percentage ownership of the stock has increased as of such date over the lowest percentage of the stock owned by each such “5-percent stockholder” at any time during the three-year period preceding such date. In general, persons who own 5% or more of a corporation’s stock are “5-percent stockholders,” and all other persons who own less than 5% of a corporation’s stock are treated, together, as a single, public group “5-percent stockholder,” regardless of whether they own an aggregate of 5% of a corporation’s stock.

The amount of NOLs that we have claimed has not been audited or otherwise validated by the U.S. Internal Revenue Service (“IRS”). The IRS could challenge our calculation of the amount of our NOLs or our determinations as to when a prior change in ownership occurred and other provisions of the Internal Revenue Code may limit our ability to carry forward our NOLs to offset taxable income in future years. If the IRS was successful with respect to any such challenge, the potential tax benefit of the NOLs to us could be substantially reduced.

According to the 10K, as of December 31, 2008, COSN had federal NOLs of approximately $353M, which begin to expire in 2018 if not utilized and state NOLs of approximately $213M, which will begin to expire in 2009 if not utilized. The NOLs have a substantial value as a tax shield should COSN acquire a business with taxable earnings, but assessing that value is beyond us.

Catalyst

Steel Partners’ most recent 13D filing sets out its 44.9% holding. Steel Partners’ strategy is to use COSN’s cash to acquire a business with taxable earnings that can be offset by the NOLs. From the 10Q:

Redeployment Strategy and Liquidity

In July 2005, after a comprehensive review of strategic alternatives, our board of directors approved a strategy to redeploy our existing resources to identify and acquire one or more new business operations with existing or prospective taxable earnings that can be offset by use of our NOLs.

Ordinarly, we would prefer a return of cash to the acquisition of a business. This situation is different from the usual case because Steel Partners’ business is investment, and so we think the risk that they might make a bad investment is low. That said, there’s no assurance that they will find a suitable candidate, or if they do, that COSN will be able to use the NOLs.

Conclusion

COSN presents an opportunity to invest alongside Steel Partners at a 26% discount to net cash in a company with substantial NOLs. We think it’s too good to pass up, so we’re adding it to the Greenbackd Portfolio. The stock is very thinly traded, so take care getting set.

COSN closed yesterday at $1.75.

The S&P500 closed yesterday at 997.08.

[Full Disclosure:  We do not have a holding in COSN. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

Hat tip FF.

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