Opnext: 'Net Net' Value with Good Risk / Reward

Feb. 4.10 | About: Opnext, Inc. (OPXT)

Opnext (NASDAQ:OPXT) was founded in 2000 as a subsidiary of Hitachi (HIT) and spun out of its fiber optics component business unit in early 2007 via an IPO. It has gone almost straight down since that time to where it now trades barely above the cash on its books. It is a relatively large for a “net net” value situation.

Business overview

The company manufactures very complicated optical components used in telecommunications, as well as certain industrial and commercial applications. You would probably need an (advanced) engineering degree to understand their 10-K’s business description. Cisco (NASDAQ:CSCO) and Nokia (NYSE:NOK) account for about 60% of sales, which have grown to about $320 million per year, up from $150 million per year in 2006.

That said, sales have been flat year-over-year, and the company has never shown a consistent ability to produce a profit to go along with all that growth.

On the other hand, it hasn’t burned much cash via operations recently, so it doesn’t look like the $150 million cash pile on its balance sheet (and hence a big portion of any margin of safety) is in immediate danger over the next several quarters.

Net asset value

Based on the balance sheet analysis shown below, I peg the reproduction value of the assets at approximately $4.42 per share as of its 9/30/09 financial statement. The major estimated adjustments were the 25% haircut I placed on the inventory and net PP&E, and the addition of both R&D (2 years) and SG&A spending (1 year) to intangibles.

Given the highly scientific nature of their product, 2 years of R&D may even be conservative. On the other hand, it’s hard to get really aggressive on the R&D when the products aren’t turning a profit and the rate of change in the technology is so fast.

Earnings power value

I’m not creative enough to deliver an earnings power analysis or private market value here, but would love the input if someone had access to some type of specialized market comp set.

Growth value

Again, intentionally omitted since it’s impossible to properly capitalize the growth if you can’t estimate the earnings.

Valuation continuum and margin of safety assessment

Obviously, any play here for a value investor is purely based on the discount to current net asset value. If the company does turn the corner of profitability, there may be an argument for potentially big upside, but it would be a stretch to rely on any type of earning power at present for a margin of safety.

The company’s growing sales point to some apparent importance as a supplier to its blue-chip customer base, hence an NAV analysis (based on a going concern) should be a reasonable estimate of Opnext’s value.

However, a quick liquidation analysis is provided below for comparison:

The liquidation value of around $2 per share doesn’t allow for any cash burn from operating losses, but assumes literally zero value for the R&D/patent portfolio, which seems draconian for a company that sells several hundred million per year into growing, highly technical markets.

A summary of these levels is as follows:

Summary and conclusions

Based on today’s (2/3/10) closing price of $1.94, OPXT is trading below where I calculate the margin-of-safety buy point at $2.21 (50% discount to the NAV of $4.42). At the current market valuation, you are pretty well covered by tangible liquidation value and getting any value of the R&D portfolio and the potential for future profits for close to free.

Another way of looking at it is that, net of cash, you are basically paying a $15 million enterprise value for a growing supplier of key components to Cisco, et. al. with sales of over $300 million and a tangible book value (again, excluding the cash and intangibles) of over $100 million.

Given the lack of current earnings and the higher risk in technology markets, I placed a 50% margin of safety requirement here vs. my standard of 33%. The liquidation value should provide a reasonable support for the share price, but the big risks out there would be a major customer loss or technological innovation that leaves these guys behind.

Closing the gap to my calculated NAV could deliver a gain in the range of 50% to 100%.

Disclosure: Author currently has no position, but intends to go long OPXT