Thursday evening, Zhone Technologies (ZHNE) reported revenues of $33.7M, up fractionally year over year. On the surface, Q3 was nothing to get excited about, but the conference call revealed a very different story (see transcript here).
As it turns out, Zhone's lackluster sales masked a significant shift in its balance sheet and operating model profile. It also overshadowed the imminent ramp in Broadband Stimulus revenues, as internet providers around the world begin using generous government subsidies to purchase Zhone equipment to build out their high-speed networks.
Specific to the balance sheet and operating model profile, Zhone sold its Oakland campus and leased back only the square-footage it needs to operate. This took them out of the real estate game, wiped out a big chunk of debt, and set the stage for profitability. In fact, the company turned an adjusted-EBITDA profit and stated that it expects that trend to continue.
Net-net, this transaction changed the complexion and quality of its net asset value, which now represents all but $10M of its market cap. In addition, as Zhone returns to profitability, it will not have to pay taxes, due to a build-up of net operating loss carry-forwards.
From an execution standpoint, revenues were not impacted by weak demand. Rather, difficulty in sourcing components was the culprit. In reality, the company added 20 new customers and enjoy expanding gross margins due to the popularity of its new line of products.
Thus, for a $10M enterprise value, investors get shares of a company with a refreshed product line that attracted 20 new customers in the quarter, $22M in annual R&D, $135M in annual revenue, positive EBIDTA, and pent-up demand for its products, stemming from component shortages that held shipments in check. Most importantly, an investor can sit tight for the next 8-10 quarters, because funding from the U.S. government's Broadband Stimulus Initiative has begun to kick in. This has yet to be reflected in the stock because Zhone only has one analyst covering the company at this time.
It's clear that ZHNE has just reached a critical turnaround point. Reminiscent of Occam Networks' (OCNW) story from Q2, component issues accompanied the start of its Broadband Stimulus demand-ramp. That story came to a head last month when Calix (CALX) announced its intentions to acquire the company for a 40% premium.
It wouldn't be surprising to see a repeat of that ending, with Calix acquiring Zhone to further consolidate the space. In such a scenario, Calix would likely replicate its plans for Occam (lay-off all non-critical, non-repetitive personnel, resulting in substantial operating margin accretion). In ZHNE's case, that accretion would likely lead to 30% operating margins. With $148M in 2011 revenues, $44M would drop to the operating line. With NOLs stemming the tax burden, much of this would flow through to net income.
If Calix were to pay just 3x that $44M Zhone's share price would more than triple from today's levels. At 6x, the share price would reach double-digits. Coincidentally, Zhone CEO Mory Ejabat was at the forefront of the last major Internet build-out as the CEO of Ascend Communications, which Lucent Technologies (LU) acquired for $24B in 1999.
With its new-found profitability and a book value of $1.60 per share, Zhone's stock only represents 30-cents of downside at current levels, while the upside could be as high as $8. On Wall Street, risk to reward ratios like this don't last long.
Just ask Occam Networks.
Disclosure: I hold shares of Occam Networks and Zhone Technologies