Lighting Science Group (OTC BB: LSCG) is a step above the everyday vermin that inhabit the OTC BB. It has two real businesses, one of which manufactures and distributes LEDs, and the other of which installs LED and other lighting systems. The one problem with Lighting Science is that its value as a real company is dwarfed by its market cap. In this way it resembles some other companies I have criticized in the past, including Continental Fuels (OTC BB: CFUL) and Noble Roman’s (OTC BB: NROM).
First, the market cap: with a total of 26.524 million shares (fully diluted) outstanding after its recent 1-for-20 reverse split, and a recent price of $9.90, Lighting Science has a fully diluted market cap of $263 million. The company has some sales and is a real business, but the thing it is best at selling is its shares: its share count has doubled in the past year alone (see the 10Q on page F-3 for details; this calculation excludes the 1-for-20 reverse split).
Book value is something that cannot easily be faked. While different industries have different capital requirements, book value is a very good way to compare the size and intrinsic value of different companies in the same industry. As of September 30, 2007 (still according to the company’s 10Q), the company had a book value of $3.5 million. However, after a recent reverse merger with a private company, LED Holdings, the combined company has much greater book value of $24 million, including $16 million in cash (see the pro-forma financial statements).
The combined company (which will keep the name Lighting Science) had $5.7 million in sales for the first eight months of 2007. This is equal to an $8.5 million annual revenue run rate. This leaves the company with a stratospheric price to sales ratio (P/S) of 31, as compared to a P/S of just about 2 for GE [[ge]], one of the best and most consistent manufacturers, and a P/S of 6.5 for CREE [[cree]], a much larger manufacturer of LEDs.
I should note that LED Holdings has had a poor 2007 in terms of sales. Sales for all of 2006 were $8.9 million, but they fell to $3.7 million (a run rate of $7.4 million) in the first half of 2007.
While quickly increasing revenues is normally a good thing, it is not good to increase revenues and at the same time increase losses. Lighting Science’s (not including LED Holdings) loss over the first nine months of 2007 ($8.1 million) was 4.8 times greater than the loss over the same nine months in 2006. The third quarter 2007 loss of $4.8 million was 3.7 times larger than the 3rd quarter 2006 loss. LED Holdings, while being profitable over the last few years (with a profit of just over $1 million in 2006), has seen much slower growth in sales, and its profits in 2007 will be a lot lower than in 2006. The combined company would have had a pro-forma loss of $5 million over the first eight months of 2007.
Longtime readers know of my disdain for PIPEs, or private investments in public equity. With penny stocks, these usually mean that a well-heeled investor gets shares at a deep discount to the market price and as soon as a six-month or year-long lockup period is over that investor will flip the shares onto the public for a tidy profit, even if the stock price of the company decreases.
Note 11 in the 10Q details a PIPE from a year ago in which the shares were placed for $0.30 ($6 per share, post-split). In addition to 0.667 million post-split shares, the investors also received (for free) 0.5 million post-split Class A Warrants and 0.667 million post-split Class B Warrants. The Class A Warrants give the holders the right to by the post-split stock at $7 per share. The Class B Warrants give the holder one full share and the right to buy 3/4 of a share at $6 (post-split) per share. Given a stock price of $9 (below the current $9.90), the the “PIPE-fitters” would have garnered themselves $8.5 million on an investment of $3.6 million ($9 per share times 0.667 million shares plus $2 per share times 0.5 million Class A Warrants plus $3 per share times 0.500 million Class B Warrants).
When PIPE investors do so well (more than doubling their investment in under a year), the company and its public shareholders do poorly. In return for a measly $3.6 million in cash (plus an extra $6.5 million when the warrants are exercised), shareholders were diluted by 1.667 million post-split shares with a market value of $15 million. If Lighting Science’s business were truly doing well, it surely could have found more advantageous funding sources.
La Revanche de David Gelbaum
Perhaps a good investment strategy would be to short sell any stock in which David Gelbaum invests. His Quercus Trust showed up as a large holder in Octillion (OTC BB: OCTL) and he is a large holder of Lighting Science.
[Edit 3/31/08: upon further review, I think it is more accurate to state that Gelbaum invests fairly indiscriminately in ‘green’ companies. So his investment does not mean much of anything, good or bad.]
Perhaps the most comparable company to Lighting Science is CREE [[cree]]. It manufacturers LEDs and has some good technologies and patents. It trades at a P/S of 6.5 and a price to book ratio (P/B) of 2.7. If CREE is fairly valued and both it and Lighting Science deserve similar multiples, Lighting Science is overvalued by 500% according to the P/S ratio and by 430% according to P/B ratio. Being generous to Lighting Science, I would call it 400% overvalued and give my fair value estimate as $2.35 per share, one quarter the current price of $9.40. Of course, because Lighting Science is not profitable (unlike CREE) and is much less established, it deserves to trade at a significant discount to CREE. A 50% discount would be reasonable and would result in a fair value of around $1.20 per share (88% below the current market price).
A Bit of Positive Press
Perhaps you caught Jeff Bishop’s positive review of the company on SeekingAlpha. His article is entirely fluff. Furthermore, his company, Beacon Equity Research, has a nasty habit of covering a ton of OTC and Pink Sheets stocks and rating them “speculative buy” or “outperform”. I looked at over half of their reports, and all of the companies that were rated (one was not rated) were rated either “speculative buy” or “outperform”. Highly rated companies included such utter dreck as Rocket City Automotive and Universal Property Development and Acquisition Corp. Beacon is paid to cover most of the companies it covers, either directly by the companies or indirectly by large shareholders. That explains why Beacon is so overwhelmingly positive about the companies it covers.
Reverse Stock Split
Lighting Science recently completed a 20 for 1 reverse stock split, increasing the market price from around $0.48 to around $9.60. Academic research (pdf) has consistently found that companies that undergo reverse stock splits underperform the stock market drastically.
Lighting Science Group Co. is at best a halfway decent company that could eventually become profitable. At worst, it will continue to lose money for the foreseeable future. Either way, it is way overvalued. While LEDs will be a great market, there is little reason to believe that Lighting Science will be a leader in that market. It has too many competitors with more resources. If anything, my target price of $1.20 for Lighting Science is too high. I would argue that the comparable I used for the valuation, CREE, is overvalued as well. In fact, CREE is one of the most highly shorted companies on the NASDAQ.
Lighting Science Group Corp. is overvalued by any means. Smart investors should head for the exits and watch this company’s stock collapse from the sidelines.
For More Information
Disclosure: I am short LSCG. I have a full-disclosure policy.