Quick Pitch: Creative Realities (CREX)

Merger Arbitrage – 20% Spread

I really wanted to like this opportunity. It checks most of the boxes I look for in an attractive merger arbitrage situation: a tiny $15m market cap company, a wide 20% spread, share price close to all-time lows, the business seemingly at the inflection point, and a cash offer by PE group, which owns 20% of the stock already and effectively controls the business. However, after digging deeper, I lack confidence in this setup, mostly due to rather promotional management as well as a bad business track record so far. The current management and Pegasus Capital have been running the company since 2014 and in this period stock price went down from $20 to the current $0.7. The roll-up story and numerous acquisitions have not delivered the expected results so far. With that said, the offer looks credible and maybe this is an opportunity to make an easy 20% on the transaction that the market is simply not paying any attention to. Liquidity is limited with an average daily trading volume of around $50k.

In February, digital signage hardware and software provider Creative Realities received a non-binding acquisition offer from Pegasus Capital at $0.83/share. Currently, the spread stands at 20%. The 3 supposedly independent directors are reviewing the offer. I do not expect much pushback from the Special Committee as the impartiality of the independent directors appears questionable. One of them, David Bell, has previously worked at Pegasus Capital as an operating advisor and also led one of its subsidiaries. The other one, Donald Harris, is on the board since the formation of the current company. Only Stephen Nesbit seems to be truly independent.

Pegasus Capital owns a 20% stake in CREX and has been a major/controlling shareholder of the company for a decade. The firm has funded CREX through several capital raises and is also the company’s largest debt holder. Pegasus Capital is a private equity fund manager with over $2.6bn AUM. While the available information is limited, the PE firm does have a track record of growing and selling its holdings to reputable buyers, e.g. Climatec sale to Bosch in 2015 (acquired in 2012, the top line was up 50% at the time of the sale), the disposal of its stake in Traxys Group to a buyer consortium led by Carlyle (2014) as well as the sale of Six Senses Hotels Resorts Spas to InterContinental Hotels Group in 2019.

Background

CREX sells and installs flat digital displays for restaurant chains, car dealerships, stadiums, and other customers in industries such as retail, healthcare, etc. The company also owns several digital content software platforms, which it then licenses to its hardware customers and which generate sticky and recurring SaaS-type revenue. The company was formed as a merger between Wireless Ronin and Broadcast International back in 2014. Pegasus Capital used to be the sole equity holder of Broadcast International and has retained a 46% of a combined company after the merger. Throughout the years, due to some further acquisitions and equity raises (in some of which Pegasus also participated), the stake was diluted to the current 20%. Keep in mind that 13D filings and the takeover intent letter indicate 39% Pegasus Capital ownership on a fully diluted basis, however, that additional part of the stake is way out of the money warrants.

M&A roll-up growth has been one of the main goals for CREX for many years now. Management claims that US digital signage market is highly fragmented – there are around 300 tiny peers with $3-$5m annual revenues. These mom and pops businesses are under-scaled, hardly profitable, and have low prospects of organic growth. These could potentially be rolled up by CREX. However, a number of previous acquisitions have failed to live up to expectations. Some of these were paid for in cash that was raised through dilutive equity issuances.

The company still wants to continue with the roll-up story. Over the last year management has been repeatedly saying that it is looking at multiple potential acquisitions, but can’t pull the trigger on any of those due to the depressed share price which has made equity issuance impossible.

This privatization would allow Pegasus Capital to continue rolling up smaller digital signage players. In the absence of a publically quoted share price, the issuance of new equity could be done at significantly higher prices and therefore be less dilutive. The buyout would also eliminate public listing costs and pave the way to potentially relisting CREX a few years down the line as a larger organization or selling it to larger competitors.

Several quotes from the recent earning calls are provided below. It might be difficult for the Special Committee to justify the acceptance of the current $0.83/share offer when management was so vocally arguing that the share price is disconnected from the intrinsic value and that the company is undervalued at the current levels “by a factor of multiples”.

Q3’22 (CREX around $0.6/share). :

We could spend the day talking about it. So, let’s just say this, we have a very, very active pipeline of companies that we are in discussions with. [.. .] So, a lot of interest — our challenge today simply is a reflection of our share price. Our market cap today is really disconnected from the true intrinsic value of the company, right. So, we’re looking at buying companies 10%, 15% of our size. And to buy them, the market cap or the dollar amount we have to pay, darn near equals our entire market cap as a company today. So, there’s just a disconnect. And as that disconnect improves, expect us to be more active with accretive transactions only.

Q2’22 (CREX share price around $0.7/share):

Again, we would hope that the share price will recover based on the financial results of the business. And as a result of that, some of the warrants that are outstanding would naturally come in and provide opportunity and runway for us to execute. That doesn’t happen. We’ll see how it plays out. But what we’re not going to do or what we don’t plan to do is go issue a bunch of equity at today’s price to close an acquisition. That doesn’t work, and it’s not part of our plan.

Q4’21 conf. call (CREX share price was around $0.9/share):

Great. Thanks. We got a question here that says, what’s the projected stock price of the company once the meaningful mergers and acquisitions are completed? <…> So, I would say, based on the ARR of the company at the current market multiples, it implies we’re trading well below the intrinsic value of the company, probably by a factor of multiples.

Financial performance

The buyout interest comes at a seemingly opportunistic timing. CREX share price is hovering around its all-time lows, meanwhile, the company’s financial performance has recently started to improve.

The business has been significantly impacted by the pandemic, with revenues going down 45% in 2020. However, last year, the business saw a major rebound as the end markets and display demand recovered and CREX signed some big new contracts. In Feb’22, CREX also completed a large acquisition of its peer Reflect Systems, which nearly doubled the top line.

Revenues in the first 9M of 2022 are already above the pro-forma full-year 2021 figure. It is hard to tell if this improved performance is the result of a continued post-COVID recovery or whether the acquisition of Reflect Systems has really been a success.

Meanwhile, after newly announced contract wins, management is expecting to deliver an even stronger result in 2023 with revenues forecasted to grow +26% YoY and EBITDA to reach $8m. Worth noting that management has failed to deliver a number of times on its forecasts before. Also, hardware sales/installation revenue is contract driven and can be lumpy.

Another important part of the business inflection story is the rapidly growing recurring revenue stream from software licensing. Run-rate ARR is already at one-third of total revenues. This is high-margin revenue. While the company does not split out the profitability of software sales separately, the gross margin for wider ‘Service and Other’ revenues stands at 62% vs 20% for the hardware. Margins on software subscriptions are likely to be even higher. Management says this revenue is very stable due to relatively high switching costs for customers once CREX screens have been installed and customers’ employees have been trained to use the software. ARR growth is not perfectly correlated to total revenues as contracts can vary – sometimes clients just want the screens and then get the software elsewhere, etc.

ARR of $15m is not far from fully covering the operating expenses of the whole company. Once the opex is covered, any incremental gross profit would go straight to the bottom line. In the recent Q3 call management indicated expectations to generate ‘in excess of $5m’ annual ARR from the largest of the new recent contracts (major national quick service restaurant chain), with subscription revenues set to start after the installations are completed in Jan 2024.

Valuation

The current offer at $0.83/share values CREX at 5.4x E2023 adj. EBITDA. It also comes at around 2x E2024 ARR, which then puts zero value on the remaining hardware sale/installation business. Creative Realities has no public peers available for comparison. Given the business recovery, further growth prospects, and forecasted profitability inflection, the offer does not seem expensive and comes off as a bargain for the buyer. The bid also looks low compared to the recent equity offerings by CREX:

• In Q1 2022 the company issued $11m of stock and warrants at around $1.535/unit.
• In Q1 2021 $2m worth of shares were issued at $2.5/share.
• In 2018 during CREX’s uplisting to NASDAQ, the company made a public offering at $3.5 per unit (share and warrant). Pegasus Capital also participated in this offering.

Potential NASDAQ delisting

The company has received two delisting notices from Nasdaq. Unless the share price goes above >$1 by mid-April’22, CREX will be removed from Nasdaq and returned to pink sheets. This could have a negative impact on the share price, especially in the scenario where the takeover fails. From another perspective, this only strengthens the opportunistic angle of the current buyout bid as CREX could easily fix the delisting issue with a reverse stock split, however, it has deliberately chosen not to do it, despite only 1.5 months left until the delisting deadline.