In February of this year, I wrote an article on Occam Networks (OCNW), a stock that I thought could appreciate five-fold with virtually no downside. While the stock has advanced about 75% since my first write-up, I don’t think this performance is particularly notable in light of both the low level from which it started as well as the rise in the broader market. It’s still dirt cheap with a rock solid balance sheet and I believe it can still rise five-fold over the next eighteen months with minimal downside at current prices.
Let me explain why.
Thesis: Then and Now
Occam is one of the leading suppliers of broadband equipment for rural telephone carriers with an estimated 21% market share. With the Obama administration’s avowed focus on deploying high speed broadband to previously unserved and underserved areas, I expect Occam’s business to surge over the next few years resulting in a period of sustained and significant profitability and growth.
In February, I wrote:
13% of this country, or 15 million homes, do not have access to broadband, and rectifying that situation is one of President Obama’s highest priorities.
Congress has just come to an agreement on an economic stimulus bill that will allocate $6 billion to rolling out broadband to rural and other unserved and underserved areas. You are going to see a lot of headlines where the words “broadband” and “stimulus” are used in very close proximity to each other, but make no mistake, the initial round of spending will be highly targeted to the rural America that currently has no access to broadband. This is a niche market, and the biggest beneficiary is going to be a company that I am sure you’ve never heard of.
At the time, Congress had just approved the American Recovery and Reinvestment Act of 2009 (ARRA) which allocated $6 billion or so to rolling out high speed broadband to rural and other unserved and underserved areas of the country. While Obama had made it clear that enabling broadband connectivity was one of his highest priorities, not much was really known about the specifics of his plan or how it would be implemented. With the passage of time and with the first broadband stimulus awards now on the cusp of being announced, we are in a much better position to judge the plan and its potential impact on Occam.
Most importantly, we now know that the amount of stimulus is going to be significantly larger than the $6 billion that Congress had apparently allocated. Specifically,
- The National Telecommunication and Information Administration (NTIA) has been allocated $3.75 billion by Congress for grants aimed at building out middle mile and last mile telecom infrastructure in rural America; however, grantees will be required to contribute at least 20% in matching funds, raising the total level of stimulus to approximately $4.7 billion.
- The Rural Utilities Services (RUS) has been allocated $2.5 billion by Congress for building out rural telecom infrastructure. $2 billion of this amount will be awarded as outright grants, but what most people do not realize is that the remaining $500 million will be leveraged 14:1 to create a lending capability of $7 billion. Therefore, total grant and grant/loan stimulus from the RUS will be closer to $9 billion, exclusive of any equity component provided by the grantees.
In total, I now expect gross stimulus for building out rural broadband will be in the range of $14 billion, very significantly higher than the $6 billion I had previously estimated.
Additionally, there was some initial doubt as to whether the stimulus program would attract significant interest. Despite the promise of free money, there were perceived to be strings attached, particularly in the form of net neutrality requirements, and it was unclear if the carriers would take the bait. As it turns out, none of the largest tier one carriers such as AT&T (T) and Qwest (Q) applied for funds, and neither did many of the large tier two carriers such as CenturyLink (CTL). But the smaller tier three carriers, as well as other alternative carriers, came out in force, submitting almost 2,200 applications for about $28 billion. Nothing could be better for Occam, whose technology is optimized for the smaller carriers and their rural topologies.
What we still don’t know is which applications will prevail, but we’re on the cusp there as well. According to well informed speculation, Vice President Biden will be holding a press conference in Georgia today where the first stimulus winners will be announced. Stay tuned.
Generally Occam: Fasten Your Seat Belts
In February, I wrote:
I believe the biggest beneficiary will be a small company called Occam Networks, one of the leading providers of broadband access equipment to the rural market. I can’t put it more succinctly than this: it is almost as if the broadband portion of the stimulus bill were custom written for them.
I continue to believe this is the case, in fact, more than ever.
With a business that is rooted almost entirely in the rural broadband equipment market and a long list of customers that have historically relied on the RUS for financing, it truly is as if the broadband portion of the stimulus bill were custom written for them. On their first quarter conference call, held shortly after the passage of ARRA, the company downplayed the potential of the stimulus, citing its many inherent uncertainties with respect to both timing and revenue potential. But in a recent conversation with the company’s chief financial officer, she repeatedly referred to the stimulus as a “once in a lifetime opportunity.”
Let’s look at why.
As I said, I believe that total stimulus will be in the range of $14 billion. I expect the first $4 billion to be awarded over the next two months, starting as early as today. The next $10 billion will be awarded in a second stimulus round, which I expect to be concluded no later than the third quarter of 2010. Remember, ARRA specifically mandates that all awards must be made by September 30, 2010 and all projects must be substantially complete by September 30, 2012. That’s an enormous amount of spending in a very compressed time frame.
But how much of that $14 billion will be allocated toward the type of equipment that Occam makes? After all, that’s the only part we really care about. According to a July 2009 Citigroup research report, 40% of these funds will be spent on equipment, with the balance being spent on labor, real estate and other capitalized costs. I think that number encompasses a wider range of equipment than what Occam makes and I believe that 20% is a more appropriate figure to use with respect to Occam.
So 20% of $14 billion gets you about $2.8 billion of equipment spending for projects that, by law, have to be substantially complete in the next 33 months. That’s more than $1 billion of stimulus per year in what Occam pegs as a $500 million annual industry with otherwise moderate growth. Wow, I say, and no wonder the company feels it is on the cusp of a once in a lifetime opportunity. If these numbers are correct, the rural broadband equipment market can almost triple overnight.
So, can Occam’s revenues effectively triple in short order? I honestly don’t know. It seems far fetched but stranger things have happened. The point of this analysis is to explore a range of scenarios and, given Occam’s current share price, it isn’t a question we need to answer now. It’s possible that my 20% assumption for equipment spending is high and the right number is closer to 15%. It’s possible that Occam’s market share will decline because of a bias toward wireless technologies where the company does not play. It’s possible that the full amount of stimulus awards will never be made as the program becomes mired in accusations of waste, fraud and abuse. But when I take my assumptions straight down the middle, I come to the conclusion that, one way or another, Occam’s business is set to explode over the next three years and absolutely none of this potential is reflected in the valuation of the shares. Given where the company’s share price is now, only a small fraction of things need to go right to have a home run stock.
Specifically Occam: Maybe Even Better
On its third quarter conference call, the company noted that 15-20% of its customers had submitted stimulus applications, which I estimate means about 75 to 90 discrete funding applications. I don’t have a complete list of Occam’s customers, but based on publicly available information, I have been able to identify 27 applications for a total of about $800 million in funding. Extrapolating to the full customer base, this means that total applications by Occam customers were probably in the range $1 to $2 billion. What’s interesting here is that these are existing customers where Occam is the incumbent supplier. These applications, if they prevail, represent an almost captive business opportunity.
So how are these applications likely to fare? Certainly, many of these applications will not succeed owing to the large number of competitive applications; but that being said, it appears that Occam’s customers are seeing significant success thus far. For example, the NTIA has turned to the states for guidance as to prioritizing projects for funding. Out of the 27 applications that I have identified, fully 14 have been expressly given a “high priority” rating by the governor’s office of that state.
- In Maine, the governor recommended just 4 of 28 applications. Two of these, totaling $13 million, were from Fairpoint (FRP), an important Occam customer.
- In New Hampshire, Fairpoint’s $8 million application was one of just three recommended by the state.
- In New Mexico, customer ENMR Telephone’s $11 million middle mile application was one of just 5 of 58 total applications that received an A rating.
Only 7 applications were expressly not given a priority rating by their state, and the status of the remaining 6 could not be determined because the governor’s letter for those states was not made public or, as in the case of Tennessee, was not terribly useful. It’s hard to see how these state recommendations will not have some influence on the NTIA and RUS as they choose whom to fund.
While it’s obviously impossible to know in advance whether any given application will be funded, the RUS at least is beginning to make clear what its priorities are. In a recent appearance in Colorado, Jonathan Adelstein, the head of the RUS revealed some of these priorities:
- They want to fund projects that are truly rural in nature; in other words, satellite providers and others claiming to serve the rural customer need not apply.
- They want to deal with established entities, and prior RUS borrowers will have a strong advantage; in other words, start-up companies with no track record will be disadvantaged.
- They want to lend to companies that have a willingness and capacity to take on debt; in other words, if you are not an established company, with customers and cash flow, that is an issue.
What this all means is that the bias is likely to be right up Occam’s power alley: established rural wireline carriers that have previously borrowed from the RUS. Some commentators have described this as “business as usual” for the RUS and that’s good for Occam, because almost 85% of their customer base has been a RUS borrower at one point or another.
Additionally, Adelstein has made it clear that cost per household will not be an important factor. In other words, there is unlikely to be a wireless bias, as some observers have speculated.
I have specifically identified three monster applications from Occam customers which I believe have a strong chance of being funded. If any one of these is funded, it’s a home run for Occam. If all three of them are funded, that’s $60 million or more in captive business right there. For a company doing just $90 million a year, that’s a big deal.
- West Kentucky Rural Telephone Coop is an Occam customer that has submitted a whopping $114mm application to bring fiber based broadband to eleven counties in the area. I believe this application has a good chance at being funded for a number of reasons. First, this project is focused on an application class called “last mile remote” which involves bringing broadband to the most remote areas of the country, a particular priority of the administration’s. Generally speaking, these areas have the poorest economics and this is the only class where there is the potential for 100% grant funding. Despite the potential for all grant funding, the government’s very strong preference is that outright grants be supplemented by either government loans or, even better, matching equity contributions. West Kentucky is not only proposing a very conservative grant ratio of just 22% of the total project cost, but is also contributing $10mm of its own equity. This will make the project’s economics and seriousness stand far above many competing applications. The proposed project will create more than 300 jobs while bring a cutting edge fiber network to a service area that covers 48,000 people in an economically disadvantaged area of southwest Kentucky. This is exactly the kind of project that the government wants to see.
- Rural Telephone Service Co. of Lenora, Kansas is an Occam customer that has submitted a $100mm application that they expect to create an estimated 402 jobs in western Kansas, an area which is 99.5% unserved or underserved. This company has been specifically cited in congressional testimony as a cutting edge provider of rural broadband services and has regularly been publicized as one of the RUS’ success stories. They are one of the top businesses in the state and have thus far cooperated on at least 32 successful projects with the RUS. Credibility with the RUS is an important factor, and this company will stand above its peers.
- Local Internet Service Co. (LISCO) of Iowa is an Occam customer that has submitted a $70mm application to bring fiber to the rural communities of southeast Iowa which have a population of 77,000. Currently, 98% of the area is underserved. They are seeking only 33% of the total cost in loans and, once again, this ratio is well above average. LISCO is a well regarded firm and has worked successfully with the RUS twice before and this will also be a significant advantage. Interestingly, their application specifically notes that 50% of the funding will be spent on equipment and specifically cites Occam as the primary supplier.
Occam has a strong balance sheet with $45 million in cash and no debt. With just 20 million shares outstanding, that works out to about $2.25 per share. The current market capitalization is about $88 million dollars, but more than half of that is cash in the bank. With an enterprise value of $43 million, the shares trade at a ratio of enterprise value to sales just 50%.
Where should the shares trade? In a recent report upgrading the shares to a buy rating, George Notter at Jefferies noted that the peer group average valuation was 100% of revenues. He also noted that many of the companies comprising this peer group had “massive” balance sheet and cash burn problems reflective of poor business fundamentals. On that basis, I would suggest that the absolute minimum valuation for Occam would be 125% of revenue, or about $8 per share.
One of the problems in valuing Occam in conjunction with the stimulus opportunity is that there aren’t many comparables. But soon we will have both a benchmark and, I believe, a potent catalyst for higher valuation. Occam’s most significant competitor in the rural broadband equipment market, a company called Calix Networks, has filed to go public and we will soon have a suitable comparison.
Despite its status as a private company, Calix has always had an outsized reputation and was often rumored to be a going public candidate. This is going to be a relatively prominent IPO, with lead underwriters Goldman Sachs and Morgan Stanley and I believe it will catalyze a revaluation in Occam’s shares. While Calix has not set a valuation yet, they are seeking $100 million in new capital and my understanding is that the company is seeking a valuation in the range of 200% of revenues. If successful, this would set a benchmark for industry valuation and extending this valuation to Occam would result in a share price close to $12, almost triple today’s value.
I don’t want to get into an extended comparison of Occam versus Calix because that’s not the point. If the stimulus comes through, both will be enormous beneficiaries and together I expect they will get close to 60% of the incremental stimulus business based on current market share. In my opinion, Occam is the better company owing to its superior technology resulting in a better margin structure. Calix, on the other hand, is larger with a more potent sales and marketing team. I hope and expect they will both do well.
The Calix IPO isn’t a done deal yet, but some time around February teams of bankers and salespeople will be criss-crossing the country touting the potential for the broadband stimulus plan to catalyze a period of sustained growth and profitability for the industry. Comparisons will inevitably be drawn to Occam, and it is difficult to see how the shares will not close the valuation gap. If Calix can come public at the valuation it wants, then Occam shares should be worth $12 or more in the relatively near future.
In the introduction to this article, I promised you a five-bagger and that implies a $22 stock. Nothing in life is guaranteed, but if the potential benefit of the stimulus is anywhere near what I think is possible, this will be an easy target over the next 12 to 18 months. Occam is at break even now, and incremental revenues will fall 35% or more to the bottom line. With just 20 million shares, there is the potential for highly significant earnings per share leverage.
One way or another, the next several years are going to be very kind to Occam. While the broadband stimulus plan will be mostly over by 2013, I believe there will be a potent political tail wind that could potentially extend to 2016 or beyond. Investing requires a leap of faith into the future and I believe that, one way or another, Occam will find many incremental opportunities. In fact, Obama is already discussing the potential for increased broadband funding. For example, last week, in a speech to the Brookings Institutio, he stated:
“[W]e’re proposing a boost in investment in the nation’s infrastructure beyond what was included in the Recovery Act, to continue modernizing our transportation and communications networks. These are needed public works that engage private sector companies, spurring hiring across the country.”
I believe that Obama is going to do for broadband what Eisenhower did for the federal highway system and Kennedy did for space exploration. He will not only fund it and enable it, but he will make it a core value of the national psyche. One way or another, this is going to be extremely positive for Occam. Buy now or forever hold your peace.
Disclosure: Long OCNW