Ruckus Wireless: Signals Are Good, Time To Connect

| About: Ruckus Wireless (RKUS)

Summary

Consistent performance, after going public, has proven that doubts over business model have no merit.

New products, strong service provider market and improving operating margins point to decent performance in the coming months.

Stock offers 30-40% upside with improving earnings and low expectations, while the consolidated market place makes it a good takeover candidate.

Ruckus Wireless (NYSE:RKUS) stock is almost at the same level as it was when it went public, 2 years ago. Investors have been quick to dismiss this WiFi/ WLAN story as any other single product small-cap hardware story. Concerns, so far, have revolved around competition, commoditization and high valuation, but it is worth taking a closer look at this time.

With highest gross margins in the space, company's product and service offerings are not just different than other players in the space but margins are also much higher than a typical fast moving consumer facing tech hardware offering. Ruckus has done a good job at focusing on the service provider market and verticals, in the enterprise market, demanding higher end offerings. There have never been doubts about the macro demand trends in this industry and with analytics, software and services becoming key differentiators, doubts over commoditization hold little merit, at least in the near future.

The stock, which looked expensive a couple of years ago, enjoys little to no acquisition premium, even when the industry is much more consolidated than a few years, there is history of big equipment companies like Cisco (NASDAQ:CSCO) acquiring smaller players like Meraki and Ruckus should be an attractive target, especially for its service provider market offerings.

Even ignoring the acquisition argument, with growing revenues, decent operating leverage, good new business momentum and efforts to contain tax increases after the expiration of NOL's, there seem enough fundamental catalysts to take the stock higher, especially after the poor performance of last two years.

Competition: Less of a concern than ever

Overall, except the SOHO market, which is not the company's focus area, the industry seems consolidated between fewer players, who all seem to be focused on catering to selective verticals, geographies and solution complexities. With dwindling interest in the space from Motorola and HP (NYSE:HPQ), the market is mainly concentrated between specialists like Ruckus (RKUS), Aruba Networks (NASDAQ:ARUN) and Ubiquity (NASDAQ:UBNT), and divisions of big equipment players like Cisco and Qualcomm (NASDAQ:QCOM).

Technical arguments about individual technology of these companies may stretch beyond the scope of this write-up, but from an investment standpoint, Ruckus' focus on the higher end, puts it more directly against Cisco and Aruba. Almost 90% of the company's access points are shared between service providers and enterprise, both of which require a relatively higher level of analytics and solution complexity. Gross margins and R&D spending, as the worksheet below shows, points to the same.

 

Gross Margins (GAAP)

Operating margins (GAAP)

R&D spending 2013 ($M)

RKUS

69%

5%

$62

UBNT

44%

34%

$21

ARUN

68%

0%

$140

Click to enlarge

Going forward, service provider and enterprise segment, where the company is very well positioned, should carry forward the current revenue growth momentum. In the service provider segment, the company has close to 170 customers and adding 10-15 new customers every quarter, over the last few quarters. Technically, the key differentiators may be the company's analytics engine, which allows custom reporting or tracking statistics going back, but entrenched relationships with equipment vendors like Alcatel (ALU) and scale in the segment should allow Ruckus to maintain its lead. This specialized knowledge of the segment is something that allows the company to win deals like the Google's planned launch of a large scale Wi-Fi network in the Cloud. Enterprise segment should benefit from the comeback of the Chinese business for the company.

Besides the enterprise and service provider segment, launch of product in the 802.11ac category, where Cisco probably holds close to 50% market share and Ruckus was late to the game, should help the company gain its share of the market share and contribute to the top line growth, especially with the upgrade cycle going on.

There seems limited commoditization risk in the near term

Big investor concern has been eventual commoditization, as more low-end network equipment manufacturers join the fray causing prices to collapse with the margin pressure following. But the fundamentals suggest otherwise, since there has not been any major evidence of any pricing pressures and margins for all players catering to the non-SOHO market, somewhat irrespective of the growth rate, are holding up nicely.

Ruckus: Serious about R&D

Growth

Q2 2014

Q1 2014

2013

2012

Revenue

27%

31%

23%

79%

R & D spending

27%

32%

41%

76%

Click to enlarge

Why? Part of this is due to consistently focusing on the R&D, as the worksheet above shows, but part of it is due to focus on the suitable verticals, segments and geographies. Overall, verticals and segments that require a high level of analytics and for high-density neighborhoods favor Ruckus solutions, which is why verticals like hospitality, warehousing and logistics seem to be working especially well for Ruckus. Similarly, the large enterprise customers should be accepting SmartCell Gateway (NYSE:SCG) and Virtual SCG products, designed for the service provider market, and any development regarding integrating W-Fi into cellular network architecture may also require Ruckus expertise in the field.

Earnings power should be shining

There is decent leverage in the model, part of which is already evident in the numbers, as the worksheet below shows. Important to note that Non-GAAP operating margins are close to 9% in the most recent quarter.

GAAP

Q2 2014

Q1 2014

2013

2012

2011

Gross Margins

69%

68%

67%

65%

61%

Research & Dev.

23%

24%

24%

20%

21%

Sales and Marketing

30%

31%

30%

26%

27%

General & Admin

10%

11%

13%

9%

7%

Operating Margins

5%

1%

0%

9%

6%

Click to enlarge

Even though gross margins are close to the peak level, there are improvement opportunities at the operating margin level, which has room to reach 17-18% level in the medium term, and back of an envelope calculation lead to the following leverage potential.

Earnings leverage analysis (Approx.)

Increase of

Metric

EPS increase

1%

Revenue

3-4 cents

1%

Gross margin

5-6 cents

1%

Operating margin

5-6 cents

Click to enlarge

Using the leverage and working through the numbers, estimates look conservative.

IF target achieved

2014

2015

Revenue Growth

26%

21%

Revenue

$331

$401

Gross Margins

68%

69%

Operating Margins

12%

16%

Net margins

10%

13%

Shares Outstanding (NYSE:M)

95

96

     

EPS

$0.36

$0.53

Stock price

$12.00

 

P/E

34

22

Click to enlarge

Risks watching out for

  1. News flow regarding reference design wins or second sourcing usually add volatility to the small cap tech hardware names and Ruckus may be no different
  2. Missing or being late to another product cycle like 802.11ac may make matters worse
  3. Share dilution via stock based compensation and inability to control taxes may eat substantially into the earnings number

Conclusion

Long been a "show me" story, but strong fundamentals asking for a closer look. Investor concerns about competition, commoditization and lack of earnings power are unfounded, instead the company is gaining ground by focusing on verticals and segments, where it has an edge, spending accordingly on the R&D and managing the operating cost structure closely. The stock may finally work as earnings growth gain momentum. Strategically, Ruckus is a good takeover target, especially for someone wanting to expand presence in the promising service provider market, but not priced in the stock yet. Target of $17-18 is based on 25-27 next year's expected EPS, excluding cash of almost $2 per share.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.