Ubiquiti Networks (UBNT) is a fast growing and innovative small cap in the wireless communications industry. The company has seen an astounding CAGR of revenues of 137% from 2006 through fiscal 2012. During this time, the company had an IPO and went public in October 2011.
In May 2012 the company was trading as high as $35/share. However, a revelation that some products were being counterfeited and sold by the company's distributors, a problem that appeared to be quite substantial for the airMax product line caused the stock to plummet. Growth estimates were reduced drastically, and several analyst downgrades followed during 2012. The stock how now been stable around $12/share for about 5 months, and the company released better than expected results in November. Management has taken credible steps to improve the counterfeiting situation, and most importantly the new product lines introduced this year have much stronger protections built in to prevent this from happening more in the future. With growth prospects remaining bright and some unique competitive advantages, Ubiquiti could be a hidden gem with big upside potential in 2013.
Ubiquiti has a market cap of $1.05B and revenues of $336m in the trailing twelve months. EBITDA was $114m, and profit margins are quite high, with the operating margin at nearly 34%.
The company has 6 main product lines which it is actively marketing. This includes the airMax outdoor wireless broadband product line which constitutes more than half of company revenues. Recently, the company has released a number of new products which it reports as the collective "new product" category. These include UniFi, airFiber, EdgeMax, AirVision, and MFi. Below I've given a brief description of each, with some approximate figures on the impact that each product has on company revenues in the latest fiscal quarter. Note that for the newest products, they are not broken out individually yet, so we have to give some approximations based on the most recent quarterly report and conference call commentary.
- Q1 Revenue: $31 million
- Percentage of total Quarterly Revenues: 52%
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AirMax radios are aimed at the wireless ISP industry. The product basically is used to provide broadband access in commercial bandwidths to outdoor locations. Ubiquiti gives several case studies on its website, where airMax is used to power wireless broadband in several open air professional sports stadiums as well as in difficult to reach locations such as beaches.
New Products - UniFi, airFiber, AirVision, MFi, EdgeMax
- Q1 Revenue: $15.6 million
- Percentage of total Quarterly Revenues: 25%
In the past year, Ubiquiti released an array of exciting new growth products to its portfolio. UniFi is a wireless LAN product marketed for enterprises. The product uses a virtual client/server architecture instead of the traditional hardware switches, and requires no additional hardware to be purchased. The product supports up to 300 Mbps and has a 500 ft. range.
AirFiber is a product for the mobile backhaul market which operates in the world-wide license free 24Ghz band. The product is sold to ISPs who want to increase their network backbone capacity. AirFiber has 1.4Gbps+ throughput and has a 13km range, intended for remote outdoor environments.
AirVision is an IP video surveillance camera management system. The product has an easy to use UI interface accessible from any web browser. MFi is a machine to machine communication system. Using a plug and play setup and specific rule management via a management UI, users can create powerful analytics, schedule events and reports.
Finally, the EdgeMax product is the newest line just introduced a few months ago. This enterprise routing product is touted as having breakthrough performance for the price, with retail prices starting at $99 and performance levels as high as 1 million packets per second.
Other Systems Products
- Q1 Revenue: $3.8 million
- Percentage of total Quarterly Revenues: 6%
These legacy products consist primarily of outdoor broadband systems which are being phased out and replaced by airMax. The company doesn't market them anymore, and expects this line to die out in the near future.
- Q1 Revenue: $8.4 million
- Percentage of total Quarterly Revenues: 14%
Several of the engineers at Ubiquiti have years of experience in antenna design from being in the telecom industry. The company has several legacy products in this area, including a variety of antennas and brackets. The sales of this line are also declining quite rapidly and is being largely replaced by airMax.
The growth prospects in the wireless communication industry remain extremely bright. The 7 analysts who cover the stock have estimates of 25% growth per annum in the coming 5 years. The primary drivers for continued levels of elevated growth have to do with the explosion in mobile communication devices (smartphones, tablets, etc.), as well as the rapidly increasingly connectivity of all sorts of other machines and sensors to networks. More and more gadgets are being designed for internet connectivity.
This 2012 report from Ericsson has some impressive charts showing the growth of broadband and device connectivity in the coming decade. This chart below shows how between 2011 and 2020, the world is going from about 10 billion networked devices to almost 25 billion. Mobile broadband is also increasing from about 2 to 5 billion.
Mobile backhaul, the industry of the airFiber product line, has even more impressive growth figures. According to the DailyWireless, the US mobile backhaul market has expected CAGR of 58% from 2011 to 2016. The new product line of Ubiquiti, including airFiber, has seen quarter over quarter growth of 25% and year over year growth of a whopping 500%. The management made several mentions in the recent conference call that airFiber was off to a great start and was driving sales in this category.
A few other impressive growth figures - TechNavio analysts released a report showing an expected CAGR of 38% from 2011 to 2015 for carrier Wi-Fi equipment. Looking at machine to machine communication, a market targeted by the MFi product, a recent article in the NYTimes talks about the huge growth expected in this market. From 2011 to 2017, it is expected that the number of machine devices connected to the world's wireless networks will triple. That is a CAGR of about 25%.
To conclude on business prospects, it is clear that Ubiquiti is operating in some exciting growth markets. With CAGR expected between about 15-60% per year (depending which sub market you look at), the potential for substantial growth in revenues and earnings is definitely real.
Key Competitive Advantages
Use of the unlicensed RF Spectrum
Ubiquiti uses the unlicensed radio frequency spectrum for its broad communication products. Most countries including the US have regulations around the use of certain radio frequencies. The below table from Redline communications explains the pros and cons of using the licensed vs. unlicensed spectrums:
As the table shows, traditionally licensed spectrum will have higher performance due to less interference issues, especially in congested urban areas. However, it is much more expensive to setup and operate and has a slower time to market.
Ubiquiti however has developed and patented unique advantages to its broadband products which overcome the majority of issues with dynamic spectrum noise, device interference, outdoor obstacles, and unpredictable levels of voice and video which were previously common in the unlicensed spectrum. The new airFiber product has performed very well in poor weather conditions and has an impressive speed capability of 1.4Gbps+, which is higher than most competitor products. Wireless Internet Service Provider Association (WISPA) has named it the industry product of the year in 2012.
Same Capabilities, Much Lower Cost
One key advantage to Ubiquiti is its very low cost on all products, which are targeted for underserved markets. The following table from the 10-K shows average retail costs figures for the main product lines:
The starting prices for most products are less than $100, with the exception of airFiber which runs close to $3000. This is very cheap for commercial class networking and telecommunications equipment. The EdgeMax product is left off here as that was released only last quarter, after the most recent annual report.
Competitor products are often several times more expensive for the same technical performance, and I think several of these new product lines will be quite disruptive to the industry as they come in at extremely low price points.
Ubiquiti Networks Community
Ubiquiti does not employ its own sales force. The company uses a number of collaboration tools and works with its distributors to sell its products. One of the more unique advantages I like is the community forum, which seems to be a well established network of customers, engineers and product designers who can freely collaborate on ideas to extend the platform. Today I checked out the online forum, seen here, and there was over 800 people viewing it at the time. The forum has over 154,000 members. This figure doesn't include guest viewers either (600 of the 800 were guests when I connected). In the annual report, Ubiquiti mentions that the community forum is part of its strategic business model, and helps with product development, sales and marketing, as well as product support. I think its strong push on this model is the right way to go. Those who are familiar with open source software will know how successful this method can be in making successful products. This is how technologies such as the Linux operating system became so popular.
One aspect I like about this growth company is the seemingly good alignment between management and shareholders. Robert Pera, the CEO and founder, owns 57m shares which is 68% of the float. The company does not pay a regular dividend, however, it did announce a special dividend of $0.18/share at the end of 2012. This is a yield of about 1.5%. To me actions like this show the company has shareholders in mind despite the recent troubles it has seen. It also shows some confidence in the company's prospects going forward.
Catalysts for 2013 - What Could Bring Ubiquiti Higher
Showing the Counterfeit Situation is in the Past
In May 2012 it was revealed that Ubiquiti was involved with a counterfeiting situation that impacted its airMax line. In the months that followed, more news came out which brought to light the full impact as being quite severe. In early August, the company released a press release stating that it was facing very sophisticated counterfeiters in China who had been able to get a hold of the intellectual property of the company. These parties had even setup manufacturing facilities and were placing the fake products in the same legitimate distributor sales channels as the real ones, thereby confusing customers. Following the release of this information in August, shares took a further hit (down another 40%), and several analyst downgrades followed in the few days after.
Now 5 months later, the share price seems to have leveled out, and the company is taking credible steps to fix the issue. In the November conference call, the following statement was made by CEO Robert Pera:
I'm pleased with the progress we are making in attacking the issue, and I expect the revenue line will rebound in the future quarters. As you know, we have taken a series of aggressive legal actions and will be unrelenting in protecting our brand name and intellectual property. Our fundamentals have remained strong with a 27% operating margin, $0.15 earnings per share and approximately $14 million of net income for the quarter. These excellent results underline our robust business model.
In the call, they also go on to indicate how the company has a new general counsel, Jessica Zhou, and they have setup an expanded legal infrastructure making solid progress in containing counterfeit activities.
I think also more importantly, is that the new products released in the past year all have much better technical protections built into them making this kind of stealing much more difficult. All of them have anti-counterfeit integrated circuits, and there is a cloud server authorization program with hardware keys at all factories. So it would be incredibly difficult for this type of counterfeiting to happen again.
The company seems to be recovering quicker than expected and gave a very upbeat forecast for the current quarter, with revenue guidance between $70 million and $78 million, and adjusted earnings per share of $0.17 to $0.20. The shares soared more than 20% after this announcement in November. This seems to show the problem is under control, and I expect a couple more very good quarters in early 2013.
Award Winning Products
As mentioned above, airFiber has recently received an award for product of the year in 2012. These kinds of awards show the strength of Ubiquiti R&D, and that clearly it has some exciting new products which are gaining share, driven by airFiber and UniFi. Although revenues are only $15 million in total for this category, it has grown 500% in 1 year, from only $3 million in 2011. There is also at least one new product coming in 2013 which will further drive this growth of both the top and bottom line.
When you examine some of the competitors of Ubiquiti, it will become clear that many of them are very small micro caps with limited profitability. Ubiquiti for sure has some strong proprietary technology and, despite counterfeiting, has maintained very impressive margins. The operating margin is over 30%, compared to only 5% for the industry. Although I don't want to speculate on specific takeovers, the fact that the industry is growing significantly but some of the smaller players are not very profitable would seem to indicate that there could be some consolidation in the coming years. This could be an opportunity for Ubiquiti to expand to new markets and further solidify its position as it has one of the stronger financial positions in the industry.
Besides the counterfeit situation mentioned above, there are a few other risks that are worth highlighting with Ubiquiti. Here is a summary of the most important ones, and reasons I think they are not a cause for major concern.
Investment Risk: Reliability of Contract Manufacturers
Ubiquiti relies on 3rd parties to manufacture and distribute their products. This loose structure can cause issues with being able to control the supply chain and being able to have a good view of the sales pipeline, and this is a risk the company highlights itself in the 10-K. One good news about this I think is that the counterfeiting situation has really made the company zero in on this risk. One key problem is the difficulties in enforcing intellectual property laws in China where most of the products are manufactured. The most effective measures the company can put in here I believe it has already done with sophisticated technological anti-counterfeiting measures. Many other successful and much larger companies have contract manufacturers in China, such as Apple (AAPL), and have managed to control the supply chain very well. I fully expect this to be much less of an issue going forward, as the lessons have been learned the hard way.
Investment Risk: Potential Fines for Export Control Violations
One point worth mentioning is that when the company started taking a close look at its distributors a few years ago, it realized there were some export control issues. Basically one distributor in the Middle East was selling products into Iran, which was a violation of US laws. The company made a voluntary disclosure to Office of Export Enforcement (OEE) and Office of Foreign Assets Control (OFAC), the 2 US government regulatory departments who deal with export control violations. OEE issued a warning letter in August 2011 but did not fine the company and cleared it of future litigation. OFAC has not yet responded, so there is still a cloud overhanging there. However, this risk has existed since the company went public (it was already in the initial prospectus for the IPO). At the time the company mentioned that it was estimated this could cost it as much as $1.6 million, but not more. For a company that is growing so substantially, and the fact that nothing has come out of this inquiry in well over a year now, I don't think this is a very big risk moving forward. Similar to counterfeiting, the company has learned this lesson the hard way and I expect much better oversight of all distributors moving forward.
Depending on the sub-market looked at, Ubiquiti has many competitors. This includes some larger companies, such as Cisco Systems (CSCO) or Motorola (MSI), and also many micro-cap companies with sub $100m market caps. Some smaller examples include Alvarion (ALVR), which competes in the integrated radio market, and DragonWave (DRWI), which is a main competitor in the backhaul market. These companies however have market caps of only $27m and $82m respectively, and they only compete with Ubiquiti on certain products making it hard to compare them to Ubiquiti directly.
Perhaps the most useful comparison is just looking at general valuation metrics of the entire wireless communications industry, which has 200 public companies. Compared to its industry peers, Ubiquiti seems fairly attractive, with a P/E of 12.79 compared to 15.33 for the industry. Also looking at the PEG ratio, Ubiquiti is only 0.64 vs. 1.18 for the industry. These figures would suggest the company could be 30-50% undervalued based on the growth rate of its earnings.
Looking at a DCF analysis, the following table shows 3 scenarios I have modeled. For EPS I have used the average analyst estimates for FY13 of $0.74. I think it is important not to take the TTM EPS of $0.93, and to be more conservative and factor in recent declines in earnings due to the counterfeiting issue which has not fully shaken out yet. Analysts also estimate 5 year EPS growth of 25% per year, which I think is probably a bit optimistic. The likely scenario I have put lower at 20%. If sales of airFiber and airMax continue to be very strong though in the coming few years, (these markets have estimated CAGR >30%), I think there is a chance the company could grow even faster. So I have modeled an optimistic scenario with 30% growth. Similarly, there is always a chance several products don't do well or technological changes cause certain markets to collapse. Therefore, I have a 0% pessimistic growth scenario as well.
|Optimistic Scenario||Likely Scenario||Pessimistic Scenario|
|Earnings Growth Rate Next 10 years||30%||20%||0%|
|Terminal Growth Rate||3%||3%||0%|
|Years of Terminal Growth||10||10||10|
|Probability of Occurrence||20%||60%||20%|
The DCF analysis shows that the current market price of $11.83 at time of writing is quite attractive. This is a margin of safety of nearly 50%. Note I've also used a discount rate of 12%, which is higher than I normally use, but it allows for heightened risks especially around continued revenue and earnings pressure in the near term due to the counterfeiting. Even with this, the potential upside here I believe is nearly 100%. There is also some attractive comparison points to the overall wireless communications industry as I mentioned above in the comparative valuation which only further supports the undervaluation case.
In conclusion, I think the company is undervalued based on the fundamentals, and this coupled with potential catalysts in 2013 make this a very attractive investment opportunity. The next earnings release will be on February 7th, and I think now is a good time to consider taking a position in order to take advantage of this significant alpha opportunity.