Clearfield (CLFD) is a real nice company. They've enjoyed profitable growth in a tough industry by delivering products that small cable and Telco operators value. It's a genuine "success by targeting underserved markets" story. But investors have gone insane and slapped a 50 P/E and 6.5x P/Book on a 13% ROE operation that, by its structure and business model, can't plausibly live up to that expectation burden. Clearfield is worth no more than $7-11, which I'll show.
But let's compliment them first:
The numbers speak for themselves (though note that 2011 and 2012 GAAP EPS is inflated by tax benefits; the $0.36 earned in F2013 was an all-time normalized record).
Clearfield's fiscal year ends in September, so their December 1Q14 results are omitted from the table above. It was a fantastic quarter. Here is what their trailing 12-month results look like now:
Clearfield earned $0.47 per share in calendar 2013, while setting records in every meaningful income statement category. Good stuff.
Let's try to value Clearfield before we analyze what the company actually does. In other words, let's value them top-down, and then adjust that estimate afterwards based on some fundamental analysis.
So what's relevant to our top-down valuation?
- Trailing 12 month (TTM) EPS of $0.47
- TTM Sales per share of $4.37
- Book value per share of $3.50
- Trailing three year sales growth of 30% per annum
- TTM ROE of $0.47/$3.50 = 13%
- TTM operating margin of 16%
In sum, fantastic growth, very healthy operating margins, and good but not great returns on equity.
A target price of $9 feels about right (generous actually). That implies a 20 P/E, ~3x P/Book, and ~2x P/Sales. Those focused on growth might argue for a higher valuation, but the value of growth depends upon ROE. A 3x P/Book ratio is already quite aggressive for a company with a 13% ROE.
Now, this business must possess some fantastic intangible characteristics that'll enable enormous sustained profit growth, because investors have tagged CLFD with a 50 P/E, 6.5 P/B, and 5 P/Sales. Let's dig down and find out!
The Clearview™ Cassette, a patented technology, is the main building block of the company's product platform. The value of the building block approach is that Clearfield is the only company to provide the needs of every leg of the telecommunications network with a single building block architecture, reducing the customers' cost of deployment by reducing labor costs associated with training and reducing inventory carrying costs.
Well, I'm no engineer, but that thing doesn't look terribly complicated. Looks like a fiber bundle enters the plastic chassis enclosure in the top left, the fibers are well anchored and organized inside, and then split into a dozen jacks at bottom. I'm sure it is more complicated, but basically this is a molded piece of plastic used to mechanically support and organize the splitting of fiber bundles.
Also, at least visually, it looks remarkably similar to this product from behemoth competitor Corning Cable (GLW):
HICKORY, N.C. Corning Cable Systems LLC, part of Corning Incorporated's Telecommunications segment, will introduce on Feb. 7 newly designed closet connector housing (CCH) hardware that identifies with customers' most impactful needs related to fiber optic housings. The new design is the result of thousands of hours of customer feedback and tens of thousands of product development hours.
Here's CLFD's basic business description from their 10K:
Clearfield, Inc. manufactures, markets and sells an end-to-end fiber management and enclosure platform that consolidates, distributes and protects fiber as it moves from the inside plant to the outside plant and all the way to the home, business and cell site. The Company has extended this product line with a fiber delivery platform of optical cable, connectors and microduct that delivers fiber to environments previously not economically or environmentally viable. The Company has successfully established itself as a value-added supplier to its target market of broadband service providers, including independent local exchange carriers (telephone), multiple service operators (cable), wireless service providers, non-traditional providers and municipal-owned utilities. Clearfield has expanded its product offerings and broadened its customer base during the last five years.
I think we've got the basics at this point. Clearfield doesn't compete with Cisco (CSCO) in the router/switching business. Nor do they compete with JDSU in the optical component business. They don't make the fiber itself. Nor do they make lasers or optical sensors. Rather, they make equipment that mechanically protects, sorts, splits and organizes wires.
This isn't an R&D intensive process; they own 4 patents and admit that, "Research and development are reflected in Selling, General & Administrative expenses and are not material to the overall expense total."
Rather, it seems the key to Clearfield's success is to target small operators that the big boys like Corning Cable aren't interested in. Given Clearfield's success in an industry that appears (superficially at least) highly competitive, I'd infer that they do a tremendous job anticipating customer needs, making a well designed product that genuinely benefits their customers in terms of cost and time of fiber deployment, and marketing directly to smaller customers that are ignored by their larger competitors. So good for them!
But, the key point is that their business model does not have "lottery-ticket" potential. This isn't a software company with zero variable costs, and therefore massive operating leverage. It doesn't participate in the pieces of the Optical Communications industry sector where R&D can deliver patentable technological breakthroughs. I think the bear case is sufficiently proved, but I'll provide a bit more detail on the company.
They also have no presence in the major fiber optic distributors such as Anixter, Avnet and Grainger where a major part of the business is transacted. While this is a strategic decision on their part, all of their competitors sell through this distribution channel, including Corning, Comscope, TE, Hubbell, and Panduit. Direct sales do provide additional margin that would otherwise be taken by the distributors. But they must do internally the services otherwise provided by distributors such as warehousing and inventory control, kitting (combining parts in a shipment for different phases of the project), shipping, customer support, which increases their SG&A and other overhead costs. There is a reason the major companies sell, and customers buy through distributors. They are more efficient than manufacturers in supporting the end customer's needs which includes maintaining inventory in geographically distributed warehouses for rapid shipment to the job site, and cross-referencing to alternative components if a part is not available. In turn, if sole source parts are needed for an installation or a part fails, the system is down or the installation stalls until the parts are received. Those parts must ship from Clearfield's own facilities resulting in additional downtime.
What's my point? That scaling Clearfield won't be simple, nor cheap, that costs will rise at a rate similar to sales, and that these factors eliminate explosive home-run potential. But the valuation requires that Clearfield explode. If their sales tripled overnight, and their operating margins went to 20%, then they'd be earning $1.70; at the current stock price, they still wouldn't be cheap!
Again, the point is not that Clearfield is a bad company. Rather, it's that Clearfield's business model and cost structure eliminate the possibility of living up to the expectations implied by the current valuation. Investors projecting trailing 5-year earnings growth out into the future don't understand that explosive historical earnings growth required the condition of starting from low operating margins. With 15% current operating margins, and little available operating leverage, future earnings will grow at a rate similar to sales.
The absurd valuation is not the only thing Clearfield investors should fear. Here's an excerpt from the most recent 10-Q:
"Customers A and B comprised approximately 48% and 11% of net sales, respectively, for the three months ended December 31, 2013. Customer B comprised approximately 23% of net sales for the three months ended December 31, 2012."
So customer A, whoever that is, was a less than 10% customer in 1Q13, and a 48% customer in 1Q14. More than all of CLFD's y/y growth is due to that single customer.
As a general rule of thumb, trailing growth is a better predictor of future growth if the trailing growth is broad-based. What happens to CLFD's stock valuation if "customer A's" purchases drop by 2/3's, and CLFD's growth stalls? It's a long way down from 50x earnings.
Before wrapping up, I'm going to mention a general phenomenon I think relevant to valuing Clearfield. Here's a blog called "Lesswrong" on statistical vs. expert prediction:
"A parole board considers the release of a prisoner: Will he be violent again? A hiring officer considers a job candidate: Will she be a valuable asset to the company? A young couple considers marriage: Will they have a happy marriage?"
"The cached wisdom for making such high-stakes predictions is to have experts gather as much evidence as possible, weigh this evidence, and make a judgment. But 60 years of research has shown that in hundreds of cases, a simple formula called a statistical prediction rule (SPR) makes better predictions than leading experts do."
I recommend you read the whole blog, but the general point is that in a wide variety of contexts, basic statistical rules out-predict human experts. Quantitative Value, a book by Gray and Carlisle, shows that the same is true in investing. Simple statistical rules beat bottom-up fundamental analysis, on average. In a prediction context, people are good at identifying relevant variables, but poor at integrating them, and assigning relative weights. In Clearfield's case, that means not grasping the extreme unlikelihood of any company - much less one in an industry as difficult as Clearfield's - of living up to such an enormous valuation.
The relevance here is that from a top-down quantitative perspective, Clearfield looks like an awful investment. I see nothing in the details that changes my mind, but obviously many investors disagree. But, at least statistically speaking, the burden of proof is on the bulls. On average, paying 45-50x EPS, and 6.5x book for a company with a 13% ROE, ends badly. Maybe this time will be different, but I'd bet on $7-11 once the dust settles.