Back in January I wrote about Ubiquiti Networks (UBNT) as I saw a great opportunity in the beaten down wireless communications company. For those who didn't read my first article, the story of Ubiquiti in 2012 can be summarized in a few lines.
The small cap company is a growing niche player in the wireless communication market which operates in industries that have impressive double digit growth expectations in the coming 5 to 10 years. Despite the seemingly bright prospects, starting in early 2012 the company began dealing with a serious counterfeiting issue in China which hurt sales considerably for its biggest product line, the AirMax. The uncertainty around this issue caused the stock price to fall from the mid $30s down to single digits. However starting in November it seemed that the company was starting to turn the corner and had the situation under control, but the market was still punishing the stock unfairly. Since I wrote my article in early January predicting significant upside in 2013, the company has reported 2 more good quarters of improving results that have beaten analyst expectations. The stock is now up over 70% in a little over 3 months.
In January I put a fair value on the stock of about $21/share. With the shares now trading close to the $20.50 level it seems prudent to re-evaluate the position and see if the growth story is now fully realized or if improving fundamentals warrant a rise in the intrinsic value.
In my opinion the improvements in cash flow and earnings do warrant a substantial increase in fair value to as much as $35/share, however this makes a big assumption of high growth rates far into the future which may not be sustainable. For this reason I recommend to hold the stock today if you already own it, but don't buy in now unless there is a pullback into the mid teens.
Breaking Down Q3 Results and Recent Events
Ubiquiti achieved net income and operating margins of 25% and 29%, respectively, in Q3 on the back of strong sales of the AirMax product which were up 14% on a sequential basis. Operating margins were up 100 basis points sequentially. With three straight quarters of growth in AirMax sales, revenues are now back more or less to levels seen before the counterfeiting issues. Revenues for AirMax as a percentage of the total have increased from the low 50% range up to 67% in the most recent quarter. The company expects continued strong growth, and I would still model long-term growth in the Wi-Fi carrier industry to be in the 15-20% range.
What I found particularly interesting about recent quarterly results was that the new products category (UniFi, AirFiber, AirVision, MFi, EdgeMax) had relatively flat sales at $11.8m. This is actually down from November 2012, when the sales were closer to $15m. Much of the recent talk has been around UniFi 3.0 and the 802.11ac Wi-Fi capabilities which is a first of its kind in the marketplace and clearly has some competitive advantages in terms of pricing, performance and the free management software available. This has obviously driven recent quarterly sales in this category, which indicates that some of the other platforms including the more expensive AirFiber had a significant slowdown.
All of these new products operate in long-term high growth industries, with most market analysts projecting a CAGR of growth of between 15-60% depending on which submarket you look at. Several analysts asked about the slow sales in this category on the conference call, and management was quite confident in their responses that several of these products will drive stronger growth rates in the second half of 2013. The explanation being that as first generation new products were released in 2012, it has taken a few quarters of stocking the distribution channel. There was an initial burst of demand after release which has slowed as the products gain a critical mass in the marketplace, and should now pick up again. Although I was a bit surprised by the slowdown here, the explanation given by management is a plausible one, and overall results were still stronger than analysts expected. There was also strong growth of more than 25% in the antenna/other category, which management stated is mostly from spare parts and accessories and will be unpredictable going forward. So this added bonus in the quarter probably helped the company beating expectations.
Near Term Outlook and Catalysts
The company has published Q4 guidance of $0.26 to $0.29 EPS, which is a healthy 17% higher than the previous estimates given by the 6 analysts who follow the company. The strong outlook for the second half of 2013 has probably contributed to the renewed market enthusiasm and huge one day price increase of the stock. Going forward I see a few catalysts which could drive the stock higher still:
- Rebound in Sales Growth of New Products - The success of AirMax is now in, plain for the market to see, and the continued near term success of the product is expected. What will really drive the stock significantly higher is tangible signs that one or more other new products, such as airFiber, is having a similar growth trajectory.
- Increased Traction of Ubiquiti Reputation in the Marketplace - Ubiquiti utilizes its community forum as its primary method of interacting with customers for support and questions. The company does not staff a full sales and marketing team and maintains a lean structure which results in higher margins than many major competitors. Most engineers and buyers of the products give very strong reviews. One negative often cited is that the limited support infrastructure makes the products not suitable for large enterprise deployments. I'm skeptical of this argument however, as in practice support from informal channels or the community forum is just as fast and effective as what competitors offer. With the growing use of open source software, which often uses similar type of support structures, I think today's IT engineers are already quite used to this model. Even if this makes it difficult to break into the Fortune 500 type corporations, there is still plenty of room to expand elsewhere. Ubiquiti's reputation and position in the marketplace has for sure not been hurt either by the fact that two of the company's major competitors, Aruba Networks (ARUN) and Ruckus Wireless (RKUS), reported disappointing results in the quarter. Although it is hard to predict from this alone whether Ubiquiti has gained market share, definitely it plays to the credibility of the company and its ability to perform strongly when others are struggling.
Clearly the company is healthy now and has a strong growth trajectory ahead of it. The question in mind then is whether the growth is now fully priced in or not. FCF/share has been growing at a healthy clip the past year, and now stands at about $1.21/share for the trailing period. Using this as a starting point and revisiting my DCF model from a few months ago shows an impressive growth in fair value:
Growth Rate Next 10 years
Terminal Growth Rate
Years of Terminal Growth
Probability of Occurrence
Weighted Average Intrinsic Value
With big improvements in FCF and general prospects of the business I think the stock could now be worth more than $30/share.
The Bottom Line
Despite a recent run up in price, Ubiquiti has increased its intrinsic value substantially in the past several months and I like what I see out of the company. For this reason I will continue to hold the stock. Note that despite a seemingly large margin of safety I'm a bit hesitant to recommend it as a strong buy today, as I think the company is a lot less out of favor than it was a few months ago and the higher valuation is mostly based on high growth expectations. As I'm always a bit skeptical of basing buy decisions on this point alone, I'll rate the company as a hold today, and would only recommend to consider purchasing shares on a pullback to the mid teens.