Friday, May 25, 2007

Ditech Networks (DITC) Holder Riley Investment Management Requests Dutch Tender Auction

In a 13D filing on Ditech Networks, Inc. (Nasdaq: DITC), 5.8% holder Riley Investment Management discloseed a letter to the company expressing its concerns about the company's performance. The firm said due to the excessive cash on the balance sheet and improved financial condition, they suggested that the company should return at least $100 million to its shareholders through a dutch tender auction at a price between $9 and $11.

The firm said if the company was unable to purchase the requisite number of shares, they suggested that the remaining cash should be returned to shareholders via a dividend. The firm also stated that it may seek representation to the Board of Directors.

A Copy of the Letter:

Dear Sirs:

Riley Investment Management has been a shareholder intermittently for the last six years and currently owns or has beneficial ownership of approximately 5.8% of Ditech’s common stock. We are writing you to express our view regarding the most efficient way to return value to your shareholders. We believe our view is prevalent in the financial community.

Since your public offering in June 1999, Ditech has accumulated losses of over $80 million. During this time the Company has spent over $110 million in stock and cash on acquisitions and invested $188 million in R & D. The current enterprise value of approximately $140 million ($114 million if you present value the Company’s N.O.L. carry forward) suggests a high degree of investor skepticism towards Ditech as a profitable investment. This skepticism has been well earned. Historically, the Company has chosen to hoard its cash, has diluted its shareholders and has consistently disappointed its investors. The fact that 3.7 million of the approximately 4.0 million shares of stock owned by Company insiders consists of options is particularly disconcerting. As investors have paid real dollars and lost real money, management and the Board have collected fees and salaries, issued options and sold stock. In particular, we believe that the $135 million in cash on the balance sheet the Company has maintained is inappropriate and detrimental to the creation of shareholder value.

However, over the last six months we have become more encouraged about Ditech’s business fundamentals and believe the Company is well positioned for consistent, strong cash flow and operating profit as its customer base increasingly diversifies. In fact, our analysis suggests that Ditech could be at an EBITDA run rate of $25 million in the next couple of quarters and possibly up to $35 million in the near future with continued customer wins (specifically a third domestic carrier that the Company has indicated it may close).

Given the Company’s excessive cash and improved financial condition, we believe that the Company would go a long way to reestablishing credibility with investors by immediately conducting a dutch tender auction and/or dividend that will result in a return of at least $100 million to shareholders. Specifically, the tender price per share should be between $9 and $11. If the Company is unable to purchase this amount of shares, then the remaining cash should be returned to shareholders via a dividend. After the tender or dividend, the Company would still be in an enviable position of having over $40 million in cash while potentially generating $20 to $35 million per year in free cash flow. We believe this is a reasonable course of action. The Company’s argument that it “needs” to have $100 million in cash on the balance sheet to market to its customer base in our opinion does not hold water. Ditech has been around now for enough years and generates enough cash that in our opinion carriers will be more than comfortable with our proposed balance sheet. In fact, one could clearly argue for a larger return of cash given our belief in the Company’s ability to generate cash going forward.

At the high end of the dutch tender auction range, the Company’s enterprise value would be $165 million. Before the April quarter, which is considered an aberration because of the Company’s international results, Ditech had been generating between $3.7 and $2.9 million in EBITDA per quarter for the last three quarters. Just annualizing those numbers results in approximately $12 million in free cash flow. Accordingly, at a tender price of $11 per share, the Company would be purchasing the shares at a free cash flow yield of 7.3%, higher than the interest rate the Company is earning on its cash. However, if our analysis proves to be correct and the Company’s free cash flow rises to $20 to 35 million, the Company would be buying the stock at a free cash flow yield of 12.1% to 21.2%, respectively—clearly a much better investment than cash. From an earnings perspective, with a self-tender, if EBITDA is $25 million, earnings per share would increase to approximately $0.63 from $0.56, and at $35 million EBITDA, earnings per share would increase to $1.02 from $0.95. From a non-GAAP perspective, which we believe is the preferable focus, this transaction would be accretive even at $16 million in EBITDA.

As stated above, we believe an EBITDA of $25 to $35 million is a reasonable projection. The Company has publicly stated that its operating model calls for operating profit of 20% to 30%. This is higher than the Company’s more recent non-GAAP profit margins of 12%. However, we believe that Ditech’s operating model is highly leveragable and that the majority of incremental gross profit will fall directly to the bottom line. Given 70% gross margins and roughly $45 million in annual cash operating expenses, it is easy to see that quarterly revenues need only approach $23 million for Ditech to garner 21% EBIT margins—not to mention $5 million in quarterly free cash flow. Accordingly, we concur that the Company’s target operating model is achievable as revenues increase, and believe further that the Company should be able to generate substantial free cash flow as Ditech’s revenue approaches $30 million per quarter.

In this regard, we believe that generating $30 million in quarterly revenues is achievable in the near future. The following sets forth our assumptions in our model for the Company’s revenue:

- $14 million quarterly revenue contribution from Verizon, the Company’s largest customer. This is reasonable considering that Verizon has been averaging $13.5 million per quarter in revenues over the last twelve months ($15 million in the most recent quarter), which is up almost 20% from the preceding 12-month average.

- $6 million quarterly revenue from the Company’s international business. Our assumption is even more conservative than the Company’s projections. Ditech’s international business has averaged $7.3 million per quarter year-to-date before its announcement that 4th quarter revenues would be approximately $2.5 million due to a delay in negotiation agreements in closing transactions. The Company has suggested that international business should bounce back in the June quarter, but our sense is that it should be closer to a $6 million revenue run rate per quarter.

- $2 million quarterly revenue from the Company’s PVP business. The Company’s PVP business has been slower than anticipated, but the Company has characterized this opportunity as having “tremendous upside” and that activity levels around this product set has been “tremendous.”

- $8 million quarterly revenue from new customers. Using existing numbers, the Company already has a $22 million run rate before any new carriers. The Company has indicated “some real optimism about being able to close the third” large, domestic wireless carrier in a recent conference call. When asked on the conference call if the new domestic customer could be as big as Verizon you said the following “…we could certainly see the opportunity ending up at that level. I’m not prognosticating that today, but we’re really excited.” Given our assumptions above, for Ditech to achieve quarterly revenues of $30 million, the new carrier would need only to generate $8 million per quarter--approximately 60% of Verizon. This seems achievable if not conservative.

Our analysis does not address operating expenses, to which we do not have detailed access. However, history has shown that when an existing long-term CEO leaves, expenses are typically reduced. We would suggest to the new CEO a full analysis of services and expenses. One example would be to replace PWC with a regional auditor. We have found this typically to reduce costs by at least 40%, which in the case of the Company would result in a savings of approximately $250,000.

It is possible that our analysis of the Company’s business is overly optimistic. Even if this were in fact the case, the Company’s decision would be simple – dividend out at least $100 million in cash in a special dividend to shareholders, representing $3 per share.

Ditech is at a critical juncture in its history. In 1999, shareholders entrusted the Company with over $75 million in cash through an IPO at $11 per share and a secondary at $51.50 per share. While insiders and VC investors took this opportunity to sell over $75 million of stock in the secondary and subsequently more through open market sales, investors have seen their shares decline 84% in eight years. Now, the Company’s fundamentals appear to be improving and the Company has the opportunity to bring on a new CEO that understands and is committed to shareholder value and is cognizant of the shareholder base. He or she must realize that the dollars on the balance sheet are those of shareholders and must not think that accepting a position at Ditech is akin to receiving carte blanche with these dollars. We believe it is time to enhance shareholder value by returning cash to your shareholders.

We look forward to discussing this possibility and our other thoughts to increase shareholder value with the Board in the near future. Moreover, we may seek representation on the Company’s Board. We have appointed directors to over 12 boards in the last three years and have had a high success rate in recognizing shareholder value through our contributions on various boards.


Bryant Riley, Managing Member

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