How Will the NBBI Stimulus Affect Small and Medium Cap Communication Stocks?

This article is a follow up to an earlier article. I repeat: several of these stocks are quite risky and should be, at most, a small part of a balanced portfolio. Visibility is low on the micro cap stocks, but experienced investors know that the majority of the growth in the stock market comes from outside the S&P 500 and Dow industrials. Data movement is increasing rapidly because CDNs and cloud networking specialists need to move larger amounts of data faster in order to be competitive with traditional networks; Cisco estimates total data transfer will increase 5X over the next five years; hard to imagine, but believable since AT&T increased wireless traffic 300% the last six months.

The National Broadband Initiative stimulus affected most of these stocks. The first tranche is 4.2B from the government and another 0.8B matching funds for a total of $5B. That is split among everything from rural computing centers to sophisticated packet software. Far over $20B of RFPs are competing for this $5B, so there is really no way to guess who will win in September; however, the government will try to be 'fair' and different sectors will get represented proportionately. Fiber is roundly expected to be half the spending (2.5B), including everything from actual fiber cables to software that runs the modulators that manipulate the laser signals (not to mention "administrative costs").

My response is to divide the fiber installation specialists who will be involved by market share, then give each a conservative cut; and, to assign ten percent to the optical and back haul companies and divide them by market share. I will discuss some companies that were not part of the original article.

Procera Networks (PKT) (0.68 to 0.59) got a nasty write up in TheStreet.com. They pointed out that PKT had a dilutive stock sale and is burning as much cash per quarter as they have in the bank. That was true, but PKT's sales are on pace to rise at least 20% for the year and become cash-flow neutral by the end of the year. PKT sells session border controllers (SBC), an annual market expected to grow 77% over the next four years, and intelligent packet inspection; PKT is in several partnership discussions and has a Tier 1 customer. SBCs are an important part of network capacity growth, so it is possible PKT will be acquired, and doubtful they will go BK. At 0.59, I would still be a buyer.

Fibertower (FTWR) (0.47 to 0.66) and Zhone (ZHNE) (0.42 to 0.58) already got exactly the bump I estimated for the stimulus. FTWR builds out fiber-connected and hybrid towers and are a good bet to thrive over the next four years while 4G is built out; and, ZHNE specializes in transitioning from copper to fiber. Both have plenty of cash, low enough debt, but have never made money. Sycamore (SCMR) (3.11) has so much cash they could liquidate tomorrow and you would make money -- and so diluted they may never reach a normal PEx. They seem to have missed the consolidation wave from 1H, and they must raise rev over a multiple of four to get a 16PEx at this price. This stock has little downside, but little visible upside either; they could absorb several million in stimulus and not move a penny; then again, we have all seen super cash-rich tech companies focus on R&D and get ahead of the curve, so who knows long-term.

Occam Networks OCNW (3.90) already got its stimulus bounce, as it should since it is a rural specialist; at 0.8 P/Sx and 1.5 P/Bx, it is still a good price. Powerwave (PWAV) (1.24) is operational cash flow positive, priced for bankruptcy at 0.2 P/Sx, and still waiting for a stimulus bounce; quarterly sales were down 45% YoY but cash flow does not lie, this company has strong international sales and is not going BK soon (as I warned before, Chinese customers over-ordered in 2Q, thus 3Q could be ugly, then 4Q good).

Finisar (FNSR) (0.63 to 0.94), JDSUniphase (JDSU) (5.80 to 7.02) and Opnext (OPXT) (2.25 to 2.71) are the #1-3 OCN subsystem and component suppliers. They all got their stimulus bumps already, so there is no upside there. FNSR's active optical cables are already being used in HPC networking even though standards have not even been developed. I have a hard time imagining any of these three will not double in the next two quarters because more fiber is absolutely necessary; JDSU has double exposure to stimulus because they are the optical testing leader-- every system installed will be tested. EXFO and XXIA are the other testing specialists, both should get a little bump. Long term, I do not like the fact that FNSR is heavily diluted at over 400M shares (which is why it receives so much hate), so I may sell after its steep rise once revs increase.

I simply forgot to include Oclaro (OCLR) (0.72 to 0.89) in the earlier article. No debt and lots of cash, OCLR is a combination of the best parts of two different optical companies, operation cash flow positive, and selling for 0.38x rev, ridiculous; many people lost money on OCLR's predecessors so it is widely hated as well. Oplink (OPLK) (13.81) did not make my P/Sx bargain list at 1.91. Its CR is 11.1 and has no debt; P/Sx in comm equip averages 4.4; they made money last quarter; and, they may be the best investment with only 20.5M shares outstanding and all the right customers. No stimulus bump yet, then should go up steadily as revs increase.

Harris Stratex Networks (HSTX) (6.32) is 'The worldwide WiMax specialist', just like five other companies, but their title did not keep them from losing Clearwire (CLWR) (and a lot of China) to Huawei (the new champ?). HSTX is strong in Africa and India and has several Tier 1 customers. WiMax is great for rural areas and the 2nd and 3rd World because it is relatively inexpensive, fast, simple and reliable and adaptable to current packet technology. HSTX has plenty of cash flow so I am surprised they did not get a stimulus bump; if you can get them around six and hold out until the stimulus funding is announced in September, you should be rewarded. I have the exact same advice for Adtran (ADTN) (22.63), an excellent company that is no bargain; ADTN already has experience with rural telecom, and no downside if I am wrong, solid.

ADC Telecom (ADCT) (8.04) was not part of my high-risk bargain portfolio, but it is priced at 0.7 P/Sx. Its price has been fluctuating wildly but appears to have a stimulus bump priced in. SInce ADCT is already cash flow positive, it should be profitable again before most of its competitors, thus I recommend this stock regardless.

The big guns are Tellabs (TLAB) (6.31), Motorola (MOT) (7.72) and Commscope (CTV) (26.04), 0.8x P/S. I am not impressed with TLAB long-term, but it gets the HSTX advice. MOT's price may not move even if they do score on stimulus, too many cell phone issues; of course, if they get good news on the stimulus and a good reaction on their new Android phones at the same time. CTV is exciting here: most of the companies listed here have segments that will not be effected by the stimulus -- every CTV segment is effected by the stimulus; furthermore, their sales are in the toilet because of the 1H Tier 1 telecom spending freeze, and as the cap ex spending ramps up again CTV's rev should go up substantially (T is expected to raise spending 30% 2H).

Ceragon (CRNT) (7.21) has a 1.2 P/Sx, a 1.4 P/Bx, and positive operational cash flow. DRGN, CRNT and ALVR are backhaul specialists that should get some stimulus dollars, esp CRNT. DRGN is no bargain and ALVR has a 1.0 P/Sx. AIRN (0.08) is on the verge of insolvency despite having some cash, but if they get a few million from stimulus they could have the most immediate upside -- VERY RISKY. Beware pump-n-dump on this stock.

Nextwave (WAVE) (0.33 to 0.83) merits a mention since they are up 151% since my article. No news, huge volume and very little accumulation make me guess a little institutional activity and and a lot of day-trader pump-n-dump. I have been making money trading this stock, but at $0.83 it is no longer a bargain; if Android phones sell great, I will get back in.

Since this article focuses so heavily on optical, INFN merits a mention. The stimulus is for last mile fiber, and INFN specializes in long-haul. First Huawei began taking large chunks of their value-priced long-haul, now Ciena (CIEN) appears to be competing on high-tech long-haul. INFN says they will be cash-flow neutral by the end of the year and make money next year and I believe it, but it has little upside at this price and is in a bad position long-term since it is getting forced into a very small niche. The CEO quitting is strongest factor.

This is not an exhaustive list, simply a mix of companies of which I keep track likely to effected by NBBI stimulus. The stocks under $2 are subject to manipulation, and the stocks under a $1 are often manipulated so be careful when investing. Networking, telecom and the cloud (the internet?) are becoming the same thing, so prepare for disruption as flexible companies lose revs but become more profitable and old work horses get plowed into the field.

Generated using InfonGen, Seeking Alpha transcripts

Disclosure: Long PKT FTWR ZHNE OPXT AIRN FNSR PWAV CTV OCNW JDSU OPLK ADCT OCLR

Comments

[Toad680:]

Insead of looking at price to sales, have you considered EV/sales? Some companies are cash rich, while others are heavily leveraged. It makes for a big difference in who you would consider cheap and who you might not.

For instance, you mention Occam networks as being cheap. But with $2.10 per share in net cash, it's even cheaper on an EV/sales basis.

Others with a lot of debt are going to look more expensive.

It would be interesting, and perhaps more user friendly, to see these metrics in a table as opposed to sporadic mentions in the text. That way they could be compared and contrasted relatively easily.

Thanks for the comments. I agree with you that this space is in for a nice run.

Sep 06 12:34 PM

[Wisdom vs. ...:]

toad, thank you. my experience on micro and small caps is that if things go wrong, all that cash will get blown, and if things go right, that debt will not make any difference (except that, hopefully, it prevented dilution; but stock buy-backs can dissolve that, so which is cheaper long-run? depends upon how much the share price has gone up; thus, if you think your stock is undervalued, debt is best). this is why most investors who have been around a while ignore tangible book value on small caps; further, companies like PKT and AIRN have healthy CRs and no debt, yet could go BK by the end of the year while FNSR has plenty of debt yet is far more likely to thrive. you will find TBV quotes in my articles, but they are for readers, not my evaluation. i agree that EV is great for mid and large caps

referencing the matrices i use, my stock purchases are a product of my perception of the input of my life. since both your perception and input will vary, i prefer to discuss our observations and conclusions only.

Sep 06 02:11 PM

[Tesla_x:]

Might I suggest a table showing Company, Tier 2/3 Marketshare, resulting potential stim participation value as a % of that share, Debt, Shares outstanding, etc.

The qualities of each company should become apparent then.

Sep 06 02:33 PM

[Toad680:]

Fair enough. My use of EV is based upon my own experiences and desire to put everything on an apples to apples basis before I start to consider other factors like margin structure, cash flow, break-even point.

Given that we are also looking at companies in a steady state that are all about to be exposed to a similar catalyst, it helps to get a sense for the cost of the enterprise, because that can then be compared to the relative impact from the catalyst, which in my mind is the best measure of the delta here and of which stocks are likely to do better than others. For instance, if two companies with similar margin structures will get an incremental $50 million in business from the stimulus, but one has an EV of $25 million and the other of $250 million, There is clearly a lot more leverage to the stimulus for company 1 than company 2.

But you are right, there are a lot of ways to skin a cat and it's not worth the time to debate the appropriate technique.

What I like about Tesla's post is that he is starting to go down the road of measuring market share in the markets in which the stimulus will be spent. We know $7.2 billion will find its way into generally underserved areas for broadband. Some have suggested that the methodology for distributing the funds will actually leverage what is being handed out and result in up to $14 billion being spent. So somewhere between 7-14. Fine.

Can we then break down the total dollar amount to the likely markets in which it will be spent ie access equipment vs laying fiber etc? We could then get a sense for the dollar amount going to specific market segments. Compare that to current market share in those segments and we will have a pretty goo idea of the company by company impact of the stimulus.

Sep 06 04:29 PM

[Toad680:]

I will throw out a few guestimates. Let’s try to isolate access equipment vendors. Zhone has an estimate out that across all technology types, 58% of total expenditures if for equipment. Zhone further estimates that active elements are 35% of the total.

Maybe that’s high, maybe that’s not. But just to be conservative, let’s assume that only 20% of total broadband expenditures will be spend on active elements.

We know that a minimum of $7.2 billion will be spent on broadband in underserved areas, but possibly as much as double that. Again to be conservative, let’s just assume that it will be $7.2 billion.

That implies that active equipment vendors will be seeing 20% of $7.2 of funding provided by the government over the next three years. That equates to a stimulus to a small group of companies of $1.44 billion.

The estimates for market share of rural access that I have seen is the following for 2008:

Calix 37.8%
Occam 20.9%
Tellabs 19.7%
Zhone 14.2%

I don’t have any reason to believe that these market shares will change that much, with the exception of Tellabs, whose market share has been cut in half from 2 years prior and who has chosen not to focus on the access business in all its forms. So the other three probably stand to benefit from that in future share percentages.

But just using what we know from 2008, we can make a pretty reasonable guess at the revenue impact of the stimulus.

Calix $544 million
Occam $301 million
Tellabs $284 million
Zhone $204 million

These numbers could be higher if the stimulus is greater than $7.2 billion, if the active equipment components are actually closer to 35% instead of 20% and higher for Calix, Occam and Zhone if Tellabs continues to exit the access business.

I welcome your thoughts on the above.



On Sep 06 04:29 PM Toad680 wrote:

> Fair enough. My use of EV is based upon my own experiences and desire
> to put everything on an apples to apples basis before I start to
> consider other factors like margin structure, cash flow, break-even
> point.
>
> Given that we are also looking at companies in a steady state that
> are all about to be exposed to a similar catalyst, it helps to get
> a sense for the cost of the enterprise, because that can then be
> compared to the relative impact from the catalyst, which in my mind
> is the best measure of the delta here and of which stocks are likely
> to do better than others. For instance, if two companies with similar
> margin structures will get an incremental $50 million in business
> from the stimulus, but one has an EV of $25 million and the other
> of $250 million, There is clearly a lot more leverage to the stimulus
> for company 1 than company 2.
>
> But you are right, there are a lot of ways to skin a cat and it's
> not worth the time to debate the appropriate technique.
>
> What I like about Tesla's post is that he is starting to go down
> the road of measuring market share in the markets in which the stimulus
> will be spent. We know $7.2 billion will find its way into generally
> underserved areas for broadband. Some have suggested that the methodology
> for distributing the funds will actually leverage what is being handed
> out and result in up to $14 billion being spent. So somewhere between
> 7-14. Fine.
>
> Can we then break down the total dollar amount to the likely markets
> in which it will be spent ie access equipment vs laying fiber etc?
> We could then get a sense for the dollar amount going to specific
> market segments. Compare that to current market share in those segments
> and we will have a pretty goo idea of the company by company impact
> of the stimulus.

Sep 06 06:31 PM

[Toad680:]

In the interest of fair disclosure, which you have posted on your intial article, I am long Occam (OCNW).

My thesis is that the company will run at 10% net margins on incremental business and possibly more than that on a big surge like the stimulus.

It has an Enterprise Value of $25 million. But it will earn over the next 3 years $30 million in net income from the stimulus alone and possibly more than that.

I think Occam will be multiples of its current share price over the next 12 months.

Others, like Zhone, will benefit greatly, but I think the large exposure to the stimulus that Occam has, coupled with the very low enterprise value will make it the best investment.

Sep 06 06:42 PM

[Tesla_x:]

Gentlemen,

If one were to use the above rev by marketshare numbers Toad lists, and then weight the impact to company EPS based on share count, things start to clarify markedly on who gets their stock pushed the highest.

For example, assuming p/e of 15 and 10% net margin for all, OCNW goes 7X SP (North of $20) while ZHNE gets only maybe a 3-4X bump at best, since they derive much of their business from overseas (non-stim markets) and not just the US, and have 7x the OCNW share count.

Numbers of shares outstanding, US Rural share, percentage of total revenues derived from the stim as a percentage of total company revs, and relative stim exposure matter....a lot.

Many companies have stim exposure....but very few have the PURE rural US and stim leverage that OCNW does.

This is significant, I think, and has been grossly under-reported to date.

Sep 07 04:40 PM

[Tesla_x:]

And, for the record, I hold shares of OCNW as well.

Big surprise huh?

Bottom line is that I too would like to see a better side by side stim, sharecount and % of total company sales chart to better illustrate the best investment vehicles going into the first stim round.

This would foster further discourse and contributions of data and perspective on verifying inputs as the stim season kicks off soon...

Sep 07 05:12 PM

[Abe Haj:]

The above analysis is horrible and an agenda for a designed opininion.
The author's previous recommendation (UTSI, PKT, OPTX) is the worst and those stocks have high chance of BK.

Sep 07 09:03 PM

[Abe Haj:]

The author needs to understand the technology and some financial before putting his comments. It seems that he lacks in many areas.
PWAV with a clean balance sheet and high gross margin will do magic in coming months.

Sep 07 09:08 PM

[Wisdom vs. ...:]

gentleman, i am a strictly a trend trader, and i truly appreciate you adding some hard numbers. your numbers look good to me, so let me explain my style a little better.

most importantly, i do not trust the gov't to continue the stimulus past the first tranche, thus i refuse to consider anything other than the first 7.2B. second, every one of these companies has different specialties, and third, each carrier has preferences, some of which are based upon nothing but familiarity. i started with market share per share to get a basic idea of who would get the best bumps. then, i am looking at this strictly in terms of fiber (the 58% estimate which i have seen as well), then who has what percentage of US fiber; finally, who deals with Tier 2 & 3 carriers? right there, i lose the ability to call hard numbers, so i begin to research who has been winning Tier 2 & 3 deals lately. now, i make arbitrary decisions based upon price value, competition and Tier 2/3 business.

however, there is a larger problem with hard numbers that will blow away the effect of the stimulus, a reward for everyone who has read this far: Tier 2/3 have almost completely shut off cap ex this year waiting to find out how much stimulus each would get; thus, everyone's numbers have been hurt and shares depressed. so, consider what will happen to Tier 2/3 cap ex spending once the stimulus is announced? that is why hard numbers will have a hard time to breaking down bumps.

Sep 07 09:49 PM

[Wisdom vs. ...:]

Abe, you need an English lesson, i recommend PWAV heartily b/c they are priced for BK, not b/c they are going BK.

furthermore, i explicitly state in the previous article that some of these companies will go BK, thus balance is necessary, so what is your point?

Sep 07 10:02 PM

[Toad680:]

Understood, we have different approaches and we are trying to accomplish different objectives. I'm looking to pick the very best horse in the race. You are taking more of a basket approach and spreading your risk, while making sure to capture the benefit of the stimulus. Both can be very effective.

I agree wholeheartedly with you comment about the prestimulus depression in capex. Occam for instance hit 30 million in quarterly revenue prior to the stimulus and was profitable, but revenue has slowed to 20-22 million the last two quarters as everyone put plans on hold to evaluate the government program. As you know, a huge portion of their business is rural broadband.

So I think you are correct in your statement. There are really two near-term catalysts here for all companies in the space. 1) the stimulus dollars themselves (which I attempted to quantify in an earlier post), and 2) the resumption of normal spending patterns (and possibly catch up of several quarters of below trend spending) by the bulk of the market once winners are announced.

There was $28 billion of stimulus funds requested in the first round and only $4 billion (well, call it 5) is going out. Those not receiving awards will have to continue to build their networks and probably at an accelerated pace.

The sector is likely to get a very material bounce in the 4th quarter on the accelerated resumption of plans and what will probably be an unusually large budget flush year. Then in the first half of 2010 the actual stimulus dollars will be hitting the P&Ls of vendors geared to the space.

You are going to see some of these stock double and triple or more from here. You mention in your article that some of these stocks have already gotten their stimulus bounce. I don't think we've seen anything yet.


On Sep 07 09:49 PM Wisdom vs. Information wrote:

> gentleman, i am a strictly a trend trader, and i truly appreciate
> you adding some hard numbers. your numbers look good to me, so let
> me explain my style a little better.
>
> most importantly, i do not trust the gov't to continue the stimulus
> past the first tranche, thus i refuse to consider anything other
> than the first 7.2B. second, every one of these companies has different
> specialties, and third, each carrier has preferences, some of which
> are based upon nothing but familiarity. i started with market share
> per share to get a basic idea of who would get the best bumps. then,
> i am looking at this strictly in terms of fiber (the 58% estimate
> which i have seen as well), then who has what percentage of US fiber;
> finally, who deals with Tier 2 & 3 carriers? right there, i lose
> the ability to call hard numbers, so i begin to research who has
> been winning Tier 2 & 3 deals lately. now, i make arbitrary decisions
> based upon price value, competition and Tier 2/3 business.
>
> however, there is a larger problem with hard numbers that will blow
> away the effect of the stimulus, a reward for everyone who has read
> this far: Tier 2/3 have almost completely shut off cap ex this year
> waiting to find out how much stimulus each would get; thus, everyone's
> numbers have been hurt and shares depressed. so, consider what will
> happen to Tier 2/3 cap ex spending once the stimulus is announced?
> that is why hard numbers will have a hard time to breaking down bumps.

Sep 07 11:13 PM

[Wisdom vs. ...:]

PWAV has 300M in long term debt to be exact, definitely at least a 'smudge' on the balance sheet I would say, but I will save judgements on Abe's financial analyses for when he gives a definition of 'clean balance sheet.'

Sep 16 08:24 PM