Commercial Augmented Reality Is Where Vuzix Should Reward Shareholders

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Summary

Commercial use augmented reality technology is set to expand from fringe to mainstream over the next five years.

Vuzix is well positioned to take advantage of this shift.

If the company can capitalize on its M300 technology and, beyond that, its M3000 hardware, it could be a serious industry player in this subsector of the AR/VR space.

Vuzix Corporation (VUZI) has been the subject of some pretty intense scrutinyhere at Seeking Alpha over the last six months. The company seems to split the investment community right down the middle, with bulls pointing to the growth potential of what is essentially a brand new industry as indicative of parallel growth potential for Vuzix, while bears highlight the company’s financials to-date and its track record of relatively lackluster sales as being supportive of a valid short thesis.

At the start of June, the company announced the commercial launch and availability of the latest iteration of its lead product line, a smart glasses product called the M300, and I believe this launch marks the first steps toward Vuzix becoming an industry leader in the commercial and industrial application augmented reality space. Further, I believe that the company’s focus on the industrial and commercial side of the industry is a calculated and potentially rewarding strategy.

For those new to this one, Vuzix is a New York-based technology company that’s focused on the development and retail of wearable technology. Its primary focus is on the above noted smart glasses technology class, with the first iteration of the technology (from a commercial availability perspective) being a pair of glasses called the M100. Most reading will already be familiar with this type of technology, with the familiarity likely driven by the mainstream media coverage of Alphabet’s (GOOG) (NASDAQ:GOOGL) attempts to bring its Google Glass product to market a few years ago.

Google failed pretty miserably and many have taken this failure as indicative of a lack of market readiness for this sort of product. From a consumer perspective, this might be correct. Privacy concerns, comfort (wearability), and technological capability, alongside a whole host of other inputs, seem to have contributed to Google Glass’s lack of attractiveness not just to the individual consumer but also to first adopters at the margin.

In the commercial and industrial side of the market, however, consumer perceptions mean practically nothing and it is this side of the market on which Vuzix is seeking to capitalize. If it succeeds, and I believe it has a good chance of doing just that, it wouldn’t be the first time that a technology has cut its teeth in an industrial setting before making the jump to the consumer.

Before I go any further, I recommend readers take a look at this video.

It is a YouTube video uploaded by user LeeCompany, which is the account of US-based residential and commercial contractor company Lee Company. The video feels a little staged and production isn’t great but it serves to visually illustrate the kind of application that augmented reality smart glasses have in the commercial world. In this instance, an on-location contractor calls into a central location and uses smart glasses he is wearing to get help from a centrally located operator with the job in hand.

The operator makes a couple of recommendations and the contractor highlights the fact that he initially needed somebody to support him in the field, but no longer requires physical assistance because of help the operator was able to give him remotely. Staged or not, the takeaway here is that this sort of technology can save a company money.

As the company in question, Lee Company, points out here, the ROI on its smart glasses outlay (which came in at 500 pairs purchased as of January this year) amounts to $20.11 for every $1 invested in the technology.

This is relevant from an industry perspective and in terms of how Vuzix can expand into this commercial side of the wearables space. But the relevance doesn’t end there – the glasses that the Lee Company is using are Vuzix models.

Specifically, they are the M100 model.

Further, the company isn’t just buying them to kit out its contractors with off-the-shelf technology. Back in April 2016, Lee Company announced a partnership with XOEye Technologies that would see the two team up to create applications that companies could download and use to aid their operations in the HVAC space. The platform on which these applications would run? Vuzix’s M100 glasses.

Sure, this is just one company using the technology. There are others, but in the interest of balance, it’s fair to say that the number isn’t huge. With that said, that’s not the point here. It’s also not the motivation behind me highlighting this specific example. What is, to point out that, while smart glasses aren’t advancing as rapidly as manufacturers might have hoped in the consumer space, there’s an under the radar wave of growth in the industrial sector happening right now.

It stands to reason, then, that with Vuzix targeting a market sector that is under the radar as things stand, the company could be undervalued based on markets missing the core driver behind its current and future growth potential.

So just how big is the potential here?

A recent IDC analysis concludes that dedicated AR and virtual reality headsets collectively will grow from just under 10 million units sold in 2016 to nearly 100 million units sold in 2021, with a five-year CAGR of 57.7%.

The same analysis points out that AR continues to sit slightly in the background of VR and that the reason for this is not that AR is less important, but rather it is harder to achieve. Further, IDC believes VR headsets will continue to lead in terms of volume throughout the forecast period but maintains that AR, in general, will have a much bigger impact overall on the industry.

Importantly, and supportive of the thesis that underpins my own analysis:

“IDC believes the large opportunity for dedicated AR headsets exists in the commercial segment. A huge level of interest and investment is happening as we speak around vertical markets such as healthcare, manufacturing, field service workers, and design. Supporting this is a wide range of products, some of which are commercially available, but most are from non-household names.”

The VR side of this is of course dominated (as things stand) by the consumer targeted hardware of Facebook, Inc. (FB) and Sony Corporation (SNE). As pointed out in the above quote, the AR side of the space is dominated by non-household names, one of which is Vuzix.

Here’s a table from the same IDC analysis:

(source)

As illustrated, total AR headset sales are expected to grow at a CAGR of 172.9% between 2016 and 2021. Right now, commercial AR units account for 68% of the total units sold. By 2021, this will rise to 83.3% while consumer AR units will fall to 16.7% market share from their current 32% share.

Vuzix is perfectly positioned to ride this wave of growth.

As others who have covered this company have pointed out, from a financial perspective this company doesn’t look great. Revenues during 2016 totaled $2.1 million, down slightly from the $2.7 million recorded during 2015 and, again, down on the $3.0 million recorded during 2014. Net loss also is moving in the wrong direction, coming in at $20.8 million, $14.9 million and $7.8 million during 2016, 2015 and 2014 respectively.

Management has highlighted that the dip in revenues from full-year 2015 to full-year 2016 (from $2.7 million to $2.1 million, a decline of a little more than 22%) is rooted in the delaying of many customers purchasing hardware in anticipation of the release of an updated model. In other words, customers didn’t want to shell out for the M100 model when they knew the M300 model was just around the corner. The M300 took a lot longer than initially expected to hit shelves (as noted above, it only just became commercially available, with Vuzix having initially targeted a late 2016 release) and I believe that this has hurt the company more than management would like to admit. If the M300 was on time, the delay in commitment from customers would have been limited to 2016. Now, it’s looking like we are going to see the same situation apply not just to the first quarter of this year but also the second quarter.

Cash on hand at the end of March 31, 2017, came in at a little over $10.39 million. Quarterly burn (based on the first quarter of this year) totals circa $4.5 million. As per this 10Q, management states that it expects this cash balance to last for the (and I’m quoting here) “foreseeable future even with continued operating losses for the next-quarters.” The assumption is that revenues from M300 sales should serve to foot the bill for the operational expense and that, combined with the cash on hand, this should be enough to get the company through the next 12 months at a minimum. This is circumstantial, of course, and requires Vuzix to meet its own sales targets on the M300 device. If it doesn’t (and given the nascent nature of the industry, there’s a decent chance it won’t) then it’s going to have to raise to fund the shortfall.

The assumption is that revenues from M300 sales should serve to foot the bill for operational expenses and that, combined with the cash on hand, this should be enough to get the company through the next 12 months at a minimum. This is circumstantial, of course, and requires Vuzix to meet its own sales targets on the M300 device. If it doesn’t (and given the nascent nature of the industry, there’s a decent chance it won’t) then the company is going to have to raise to fund the shortfall.

With all this said, and while these numbers are worth keeping in mind, they are not accurately representative of valuation for a company in Vuzix’s position. The company is a technology stock working to try and establish a market for a fresh piece of hardware. Cash flow positivity is rarely achievable at this stage of a nascent market and it can be five to 10 years before the companies leading the charge are able to establish any degree of sizable (and profitable) market.

What investors should really be looking at, therefore, is the company’s potential as extrapolated in line with the above-illustrated industry growth rate. As noted, commercial AR unit sales are expected to grow at a CAGR of 184.1% between 2016 and 2021. Vuzix is at the cutting edge of this commercial side of the industry and, if the company can maintain its positioning going forward (and I’m only talking about a three- to five-year period here) then its revenues should expand in line with those of the wider commercial AR industry.

I’m not saying this one is a risk-free exposure, far from it.

Numerous risk factors feed into the investment thesis for Vuzix. On top of the above-mentioned necessity to maintain its positioning as one of the industry leaders in commercial AR (which is a big ask in itself for a company of this size, going up against much larger and resource-rich names), Vuzix is going to have to continue to improve on its hardware offerings while incentivizing third-party developers to continue building (and maintaining) applications for the company’s products.

This is going to be costly and this capital necessity is going to require Vuzix to raise at open market, above and beyond any raise necessary to meet near-term operational expenses (as noted above). Early shareholders, therefore, are likely going to have to shoulder some degree of dilution as the company raises capital to meet the demands of this rapidly growing industry. Again, that’s not unusual for a technology company in this sort of position, but it has to be considered when weighing up the potential return on an allocation.

With that noted, I see the potential for OEM arrangements mitigating this capital necessity somewhat. Certain technology behemoths are discovering that it’s cheaper and easier to use what amounts to white label hardware as the basis of their own AR offerings and Vuzix is working on numerous fronts to capitalize on this trend. The deal with Toshiba Corporation (OTCPK:TOSBF), announced earlier this year, is one example of the company’s efforts to this aim.

These sorts of deals should boost top line near term (as well as bring with them an albeit modest infusion of upfront capital), meaning the load that shareholders have to bear when it comes to the company raising cash is reduced.

Further risks exist outside of the potential for dilution.

This is a small-cap stock (current market capitalization comes in at a little over $143 million) and its ability to compete with much larger and more established players in the technology sector is both crucial to its success and far from guaranteed.

Even if Vuzix can establish a market for its technology (something that it’s well on its way to doing but that it’s not quite achieved yet), when it does, the market is going to draw the attention of companies with much deeper pockets and far larger established customer bases. If Vuzix is unable to differentiate from these newer, larger entrants, there’s a good chance it will lose market share longer term. The hope is, by that point, Vuzix will have established itself in the AR space to enough of a degree that it can compete, and potentially outplay, new entrants. The slowness of certain business customers to adopt this technology in the first place may actually play into Vuzix’s favor longer term, with the same reluctance to speedy adoption also likely surfacing in the customers’ reluctance to change to a newer version of the technology post-adoption. In other words, if Vuzix can get its technology in the hands of commercial clients first, newer entrants are going to have to work that little bit harder to unseat the company.

There’s also a macro adoption risk here. Sure, analysts expect the AR space to take off over the coming half decade but there’s no guarantee that it will, or that another version of the concept won’t overtake current AR technology across the period in question. If commercial customers fail to adopt AR technology as expected, or if the technology that underpins the M300 and future Vuzix hardware becomes dated, it’s going to severely limit the company’s ability to grow in line with market projections.

Sure, analysts expect the AR space to take off over the coming half decade but there’s no guarantee that it will or that another version of the concept won’t overtake current AR technology across the period in question. If commercial customers fail to adopt AR technology as expected or if the technology that underpins the M300 and future Vuzix hardware becomes dated, it’s going to severely limit the company’s ability to grow in line with market projections.

The bottom line here is that this company is far from faultless and – when looked at from an historic perspective – looks like a punt at best. However, when taken against a backdrop of industry trends, things start to look far more attractive.

It’s not going to achieve cash flow positivity overnight and there are some capital concerns and competitive pressures that come with the territory of being a pioneering technology hardware player. However, as a long-term exposure to an industry that (irrespective of what many see as a sluggish start) is going to really take off over the next decade, investors could do far worse than Vuzix.