The Glass Is Half-Empty: Time to Short Acme Packet

| About: Acme Packet, (APKT)

This is the second part of my "Glass is Half-Empty" series on stocks that could be ripe for some near-term profit-taking. Those of you who read my sell thesis article on NFLX understand some of my near-term concerns about recent trading activity by some 2010 high-flyers post their recent fourth quarter earnings and forward guidance. Another stock that hit my screen is Acme Packet (NASDAQ:APKT) - one of the best performing SMID-cap names in 2010.

I should begin by saying that for long-term fundamental investors, Acme Packet looks like an attractive, niche company in a rapidly growing market. They have a huge opportunity ahead of them, and on the fundamentals, there's actually a lot to like here. But the stock is currently priced accordingly by the market. In other words, it is a classic small-cap earnings momentum story -- one that could maintain a high multiple for a long time and ultimately result in a higher stock price than the one that we observe today. But likewise, near-term multiple compression is increasingly a risk due to something as simple as merely good rather than great quarterly results. As I will argue below, I believe the time has come for long-only holders to consider trimming their positions in APKT and/or buy some protection, and look for a better entry point on the stock.

APKT trades at 54x 2011 consensus EPS estimates, and 41x 2012 earnings estimates. Note that APKT has already provided 30% revenue and earnings growth rate targets for 2011, both of which are now baked into FY2011 consensus earnings. At least one sell-side analyst has (in writing) recently justified a positive rating and APKT's valuation on a 3-5 year EPS view. I have made a career of investing in small-cap companies, and I can tell you that looking out even three years to justify current valuations on small-cap stocks is a VERY dangerous and imprecise game. More times than not, this is a signal that near-term a stock is priced for perfection.

Beyond valuation, there are a couple of fundamental warning signs that bear watching that could result in a near-term slip in quarterly results.

My experience is that even the best of breed small-cap communications equipment providers will experience an occasional quarter or two where something slips, especially those like APKT, which derive ~80% of their revenues from the unpredictable and lumpy service providers vertical, and ~80% of revenues from product sales rather than services. A minor slip doesn't necessarily derail the longer-term thesis on the stock, but it can result in some short-term pain for shareholders as they try to figure out how deep and how long any delays or push-outs will be.

Where could APKT falter? First, deferred revenues have been growing at about half of the year-over-year rate of total booked sales. Moreover, the absolute deferred revenue number in dollar terms was down quarter-over-quarter in the latest September quarter. Management and the sell-side alike have been trying hard to convince investors that this is not a forward indicator of their pipeline strength. Perhaps, but the numbers don't lie: deferred revenues still make up roughly 50% of the forward quarter's estimated revenue, and about 10% of the full-year 2011 consensus estimated revenues. Thus, it's not as meaningless as management would have you believe on a pure statistical basis. I certainly find it hard to justify paying 54x forward EPS estimates for a technology company that is (at a minimum) seeing the second derivative of deferred revenue growth slow. Again, it's a warning sign that definitely bears watching.

Second, APKT has done a good job of managing its working capital in recent quarters - perhaps too good. For example, management continues to guide days sales outstanding (DSOs) to 50-60 days, while in their recent quarter DSOs were below the low end of their guide, at 49. Thus, there is potential for some give-back here in working capital efficiency as 2011 progresses.

Also note that management recently raised its gross margin target to the low 80s% and upped their operating margin guidance to the mid-30s%. Last quarter, APKT in stellar fashion produced a gross margin of 83%, and operating margins increased sequentially by nearly 500 basis points to 37.7%. So what's not to like? Well, they could be a victim of their own success. The company is already producing results in excess of management's guidance, so either management is sandbagging the full year (clearly, investors are betting on this scenario), or we are staring down the barrel of a reversion-to-the-mean quarter at some point this year.

Consensus estimates have already baked in 84% gross margins and 37% operating margins - a continuation of last quarter's exceptional results, and above management's guidance. I can't think of any non-software, small-cap communication equipment companies -- even including FFIV -- that have been able to sustain this high of a level of margins quarter in and quarter out, and over multiple years. Maybe APKT will be the exception to the rule, but clearly there is no room here for anything but continued operational excellence.

Importantly, the company already provided the street this positive upside guidance for 2011 when they reported last quarter's results (see Q3 earnings call transcript here) -- which to me means there is little reason to expect a meaningful positive surprise on forward guidance when they report on February 1. Again, one has to wonder how much will be enough to placate investors.

One other notable factor to watch is that APKT's distribution channels are roughly split 50/50%. While the company may have reasonably good insight and visibility on their direct sales, there isn't a company in tech land that can claim nearly as much true vision when it comes to their indirect sales -- no matter what they tell you.

As far as competition is concerned, currently APKT has over 60% market share in the Session Border Controller (SBC) market. This is a very large market share for such a relatively small company. Importantly, APKT counts as its competitors both CSCO (NASDAQ:CSCO) and Huawei. While it is not hard to imagine APKT having the best stand-alone product on the market, the question remains how long these well-funded competitors will allow APKT to hold such a large majority share. CSCO is already building SBCs into their routers, which is of concern.

Moreover, Sonus (NASDAQ:SONS), a small competitor that holds nearly 10% share of the SBC market, is allegedly rolling out new product in 2011 that could better compete with APKT. Again, while the threat does not appear imminent, investors seem fairly complacent about the strength of APKT's current market share position. Longer-term, there just seems like more potential risk of loss than upside to the market share estimates, especially relative to what investors are currently pricing into the stock.

At the end of the day, this is not a call that APKT is going to lay an egg on their earnings on February 1. It will probably be a good quarter, but my question is whether it will be good enough to appease shareholders while the stock digests its multiple over the coming months? My belief is the stock will pause and may well decline on anything but 1.) stellar results and 2.) new and positive information on their forward guidance for 2011. Short of that, I believe the stock should trade at a modest premium to a fairly generous sustainable growth rate of 30-35%. Even if we put a premium 40-45x forward multiple on 2011 earnings, that values the stock in the low-mid $40s. And that assumes no real "whammies" in the results, which would absolutely clobber the stock.

Again, this is a shorter-term trading call. To the extent any of my concerns manifest themselves, I would probably be looking to find an entry point to go long the stock. But in the meantime, I think the smart money to be made here will be on the short side, and I am positioned accordingly.

Disclosure: I am short APKT.