Opnext Valuation Update: Trading as a Call Option

| About: Opnext, Inc. (OPXT)

OPXT has been a challenging recommendation since I penned my original analysis, which has become a bit dated. I’m still long and the company’s stock has basically been dead money, other than a brief run into the 2.40 - 2.50 range during the spring. The purpose of this update is to refresh my financial analysis and evaluate if any change in position is warranted.

Net asset value

Based on the balance sheet analysis shown below, I peg the reproduction value of the company at approximately $4.38 per share as of its 3/31/10 10-K filing. Note that this level is basically unchanged from the $4.42 value I calculated in February. However, I would note that the sands are slowly shifting underneath this calculation, and not for the better. Comparing this calculation to my previous analysis, you’d see that a smaller portion is supported by the difference in tangible assets (cash, A/R, etc.) over liabilities, and a higher portion is represented by capitalizing the value of the R&D and SG&A spend. The slide is even more apparent in the liquidation analysis further down.

Alternative valuation

I still think it’s impossible to peg any DCF-based metric to this company without making ambitious assumptions, and I don’t have the technical expertise to value the R&D portfolio on an industry basis. The best remaining fundamental value driver is a liquidation value of the company’s assets:

This liquidation value of $1.71 per share is about a 15% slide from the $2.02 per share calculated in February and, in my opinion, highlights one of the biggest risks in holding this long position. There was some noise in the latest year due to an acquisition, so in the analysis below I took the most recent full year results and tried to isolate a cash burn rate based on current operations:

Based on the full-year 2010 financials in the 10-K, it looks like OPXT currently has funding needs of about $25 million per year between cash operating losses and capital expenditures, compared to a net cash position (less debt and capitalized leases) of approximately $87.5 million. This would imply that the company could fund the current state of operations for about 3.5 years before hitting the wall. Note that the remainder of the balance sheet would have a current ratio high in excess of 1.0, given the high level of A/R and receivables over payables and expenses, so I think the 3.5 year analysis is supportable. They would be very stretched at that point on a cash basis, but would have adequate formulaic support for a bank line of credit. On the other hand, with the high fixed cost base of R&D and SG&A against a product sold into a highly competitive market with relatively low gross margins, the operating conditions are obviously subject to rapid changes (and I didn’t ding them for stock-based compensation either).

Valuation continuum

I’ll repeat the valuation continuum chart here, noting again that the liquidation value of $1.71 per share doesn’t allow for any cash burn from operating losses, but assumes no value for the R&D portfolio either.

Summary and conclusions

Based on the last closing price (7/23/10) of $1.76, OPXT is basically valued as a call option on either the value of the product/R&D portfolio/customer relationships and/or the future profitability of the company. But if you are going to look at this situation based on the embedded option value, be aware that I calculate the current “theta” of this option at about 28 cents per annum. For those of you not familiar with option terminology, theta here could be simply translated as the time decay you will experience in the value of your option. If OPXT was breakeven, I would say that a price of $1.71 gave you a “free option” on any upside in the company’s valuation (though you would be taking liquidation risk and assuming that the company didn’t start losing money in the future). However, there is no hint of free option in this scenario: at the current burn rate estimate and liquidation value, you are losing about 16% per year (28 cent cash burn divided by 1.71 liquidation value) to fund the potential valuation upside of the company turning profitable or being sold to a strategic buyer who values its asset portfolio above liquidation value.

In any case, I remain long based on the fact that I think the option value here is a reasonable reward vs. risk trade over a multi-year time frame (i.e. – a $1 to $2 rise in the stock price represents a return potential multiples higher than several years of the current cash burn rate). It does seem like their technology is solid, selling several hundred million dollars of product per year into some of the best internet backbone companies in the world. That being said, management’s talent here seems questionable and I’ll watch this closely for any developments relating to either the potential for their products or a degradation in their current operations (increased cash burn) – either of which could skew the reward vs. risk profile significantly.

Disclosure: Author and/or family members are long OPXT common stock