Those on Seeking Alpha who have followed Aviat Networks' ventures for years will be fully aware of the fact that the company has never made a real profit.
I, for one, believe it never will. Poor management and a highly competitive market has resulted in an accumulated NOL of over $280M, (although an "asset"). This is a testament to how the business has performed and will continue to do, regardless of how many new contracts or cost-cutting moves the management team promises investors.
In this article, I will outline my investment decision process, followed by an explanation as to why I think Aviat Networks is a value trap that should be avoided.
Investment decisions (long or short term) should be made after considering the following categories as the core of the decision-making process:
- Business model
- Management team
- Financial management
- Catalysts
- Valuation
- Sentiment (market, politics, world events and so forth)
I will talk a little about #1 to #5, since #6 is based on an individual's analysis of how the market is behaving at any given point of time, accounting for the fluctuations of the global climate.
Business Model
Aviat Networks' business model is to sell router equipment to telecom carriers that provide access to cell phone networks as well as last-mile customers. The company earns revenues by selling hardware and providing maintenance services, which the company doesn't break down.
One of the emerging market trends over the past decade has been the growth of internet penetration and the business opportunities that presents for wireless communication companies. Unlike the business of selling cell phones or apps, selling networking equipment and routers is a low-yield business, considering costs, bidding low to win contracts, and R&D just to maintain the technology.
Management team
When analyzing a management team, there are two key areas to pay attention to: a) executive experience in the company or industry (based on results from past history) and b) compensation. I will not go into detail about each member of the management team (I may do so in a different article), but I should point out some red flags about the board and management team.
1. Compensation
The compensation awarded to the management team and the board of directors is outrageous, given that the company has lost money over the past three years. Each board member, on average, is compensated more than $140,000 in cash and stock, while the management team gets paid more than $775,000 in cash and stock. Not once has the management team or board offered to reduce their salary in the past three years. The total compensation hovers around $6M, and considering that revenue is $400M, I can understand how that is justified. However, the issue that is pertinent is that the increasing compensation is unjustified in comparison to the poor financial results.
2. Return on Investment in Research and Development
Over the past three years, the company has invested over $115.9M in R&D. Over the same period, the net sales growth has been $19.2M.
Have the R&D investments been spent simply to update the products, like every other company in the industry? Isn't the R&D division the one that supports the future of the company, innovating new technologies that are meant to leapfrog the competition?
While they may argue that it takes years for a product to be developed, in 2011, the company invested more than $40.5M on R&D. On average, it takes a technological company two to three years to bring a new product to the market. 2014's fiscal year revenue shows a sales decline of more than 20%, proving that the new products were not a success in the marketplace.
Most investors would assume furthermore that a management team with extensive experience and high compensation would be able to evaluate and analyze the quality of their products based on the return on investment of their R&D. With Aviat, it seems this isn't the case.
Financial Statement Management
I believe that any financial statement is only as good as the management team that controls it.
Sales over the last 3 years have grown slowly, but have fallen dramatically in the past 6 months. The company will only be able to grow sales by either acquiring a competitor or pricing aggressively and winning contracts. However, even if they do, it doesn't solve the profitability issues: Every new contract they are receiving is at a lower profit margin than the last.
Gross Margins
This is a record of recent gross margins:
- 2011: 28.3%
- 2012: 30.0%
- 2013: 29.7%
- 2014*: 25.0%
* As of December 27, 2013, Quarter
Cash balance
Buying a stock based on price per share as downside protection is imprudent when a company has been losing money for years.
This is a record of recent cash balance:
- 2011: $98.2M
- 2012: $96M
- 2013: $90M
- 2014*: $64.7M
* As of December 27, 2013, Quarter
These records show warnings signs for 2014. This begs the question: Why is there no mention of this in 10Qs?
The 2013 annual report showed the records for 2014, which served as a warning sign that the company's sales were to going to decline by more than 20%. In fact, the management and board members sold some of their shares in September 2013, when the 10K was released. Coincidence?
Catalyst and/or Bull Case
The only way this company "succeeds", so to speak, is that it gets bought out and given the merger and acquisition history of the management team - specifically that of the Chairman, who is 66 years old and close to retirement. A competitor that has more cash, a better management team, and/or a better product can cut $30M to $50M in operating costs within a year. This could be achieved by firing the entire management team and board (a savings of $6M), slashing the R&D division by at least half (another $20M in cash), not taking into account savings of at least $4M from the sales team, administration, reduction in warehousing, and so forth.
Assuming the acquirer pays 5x for $30M, this would value the company at around $2.50 a share (assuming the cash balance stays at $60M USD or so).
Currently, the company is losing $25M in 2014, and 2015 remains a big question mark. Even if a competitor acquires it today, they would need to cut expenses by at least $50M to make it financially worthwhile.
Let's assume the acquirer pays $2.50 a share for Aviat, which is equivalent to $155M in market value or an enterprise value of about $95M. The company would save $30M in costs, which would cover most of the losses for this year, and in the best case scenario, a $5M profit for 2015, a return of around 6%. If the company cuts $50M, the return would jump to 26%.
However, given the nature of the industry and how difficult it would be to cut that much in costs in a short period of time, no acquirer would want to pay more than $2.50 a share. I would estimate that the highest an acquirer would pay is $2 a share, given it would take a couple of years to cut $50M in expenses, and the acquirer would want to be paid a return north of 25% for that risk.
This is where I would estimate the probability of the purchase price of the company per share:
- $3.00: 5%
- $2.50: 15%
- $2.00: 30%
- $1.50: 60%
This equates to a weighted purchase price of about $2 a share.
With the current price of the stock at $1.60, a potential takeover valued at $2 per share would yield a return of 25%, which is enticing, but again, this is assuming the best-case scenario. If the stock were to decline to 50 to 60 cents a share, the risk/reward would be more favorable for the investor and/or the acquirer.
Valuation
Price to sales, book value, P/E and cash per share valuation metrics are meaningless indicators if sales decline every quarter. I don't think the analysts are right about the profit numbers for next year.
Best Case Scenario
For 2014, the company seems to be projecting a cash balance of around $60M or $1 a share. Given that 2015 is a big unknown at the moment, let us assume that the company is able to stabilize revenues, cut costs, and make the company profitable, earning 5 cents a share (keeping in mind it would be the first profit in years). Let's then use a valuation of 8x earnings. I use eight because the company has declining revenues, low operating income and doesn't service a rich multiple. That now gets us $0.40 a share, or a total value of $1.40 a share, a downside of 13%.
Worst Case Scenario
The company's 2015 revenues decline by 20% and the company loses $30M. Since they have no earnings, we can only value the company on its its brand/goodwill, inventories, and the projected $30M in cash it will have in the bank, equaling 50 cents a share. The brand/goodwill value is difficult to determine, but I would give it no more than $15M (about 25 cents a share) given the decline in the business, which brings us to about 75 cents a share for 2015, a 53% downside.
Nevertheless - a slight tangent - I could not help but notice the similarities with another telecom company I used to follow. It was cash rich and had an unreliable management team in an industry with a lot of potential. The company, Alvarion, would announce big pending contracts every quarter, or reveal it planned to continue to cut costs in order to reach profitability. The company never came through on any of those promises. It was a value trap. Investors lost a lot of money, and the stock is now delisted.
In conclusion, given my lack of trust in the management team, declining sales, and a deteriorating balance sheet, I feel the stock may decline by more than 50% over the next year, and if acquired, it will fetch a value less than what people might expect. If it's not, I foresee it becoming delisted, like Alvarion.
Disclosure: I am short AVNW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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