Last Wednesday, Zhone Technologies (ZHNE) reported disappointing earnings for its March quarter (see conference call transcript here). In Thursday trading, its shares quickly fell 10% on the news, before rebounding slightly to finish the day down 6%.
So why are the shares still poised to triple?
Extenuating circumstances suggest that the sell-off has created a golden buying opportunity for investors. On the company’s earnings call, CEO Mory Ejabat summed it up in one sentence:
We experienced material shortages and significant operational disruption due to the storm and tornadoes very close to our manufacturing plant.
Indeed, some very disruptive weather occurred on the last day of ZHNE’s quarter, when significant portion of its quarterly shipments take place. Unable to ship product, the company could not recognize revenue from orders it was ready to fulfill. Of course, the revenue wasn’t lost. Rather, it merely shifted a few days into Q2 (as evidenced by its $2 million increase in backlog).
Further evidence was Zhone’s book-to-bill ratio, which was positive for the quarter. Had that backlog been recognized during the March quarter, Q1 revenues would have actually been higher than Q4’s results. In other words, if the storm had hit one day later, the company’s stock price would arguably be up today, not down.
Looking over the earnings transcript, prudent investors should view the company’s overall progress quite positively. Again, the logical conclusion is that ZHNE’s stock should actually be moving up on this news (particularly in light of the fact that its shares have been under pressure for the past several weeks).
Management maintained its full-year guidance, which means that the next three quarters will be stronger than they otherwise would be. The company also continues to win broadband stimulus awards, which will result in guaranteed revenue in the quarters to come (i.e. Harvey Telecom, recipient of $34 million in stimulus award, along with Rochester Telephone Company, a FTTX deployment in Indiana, and Myakka Corporation, which has a $7.8 million project underway in Florida).
Management confirmed that many customers have received budget approval and are moving forward with plans “to use the money to start building”. This is consistent with the bullish commentary we heard from Calix (CALX) on its recent update call.
Gross margins (35.8%) were at the high-end of expectations and management intimated that further margin expansion can be expected in the future. Part of this will stem from the fact that Zhone is only operating at 50-60% of capacity. Thus, as sales grow, the company won’t need to expend funds or management resources on expansion. Management will be able to continue focusing on sales and incremental revenues will flow more freely to the bottom line.
In addition to this, the company generates higher margins from its U.S. business versus international markets. With the broadband stimulus program well under way, domestic business is sure to be healthy for several quarters to come. Thus, it should come as no surprise that the company expects to turn EBITDA and cash positive during the year, exiting the year with more cash than it started with.
In addition to the broadband stimulus projects, the company continues to see strong demand stemming from the proliferation of broadband Internet access throughout the world. Zhone’s MXK product offerings continue to gain momentum of marketplace. Based on its documented success in the marketplace, it’s clear that ZHNE will be an obvious beneficiary of continued FTTb, FTTm, FTTc, and mobile backlog deployments (all of which will be an outgrowth of the current Internet and cloud computing boom). The company is also excited about its fiber cell initiative, which is going to be used as a fiber backhaul solution. According to management, the solution is already gaining momentum via success in early trials.
Adding it all up, it's clear that ZHNE has been building momentum. It is well-positioned to take advantage of the current Internet boom, as well as the broadband stimulus initiative now underway. Yet, the company's market cap is a mere $70 million, with $50 million of that covered by its book value.
Adding in the net present value of its net operating loss (NOL) balance, investors are essentially buying shares of the enterprise for less than $20 million. This compares extremely favorably against Zhone’s $120 million revenue run rate and $20+ million annual R&D budget. This provides extremely limited downside risk for anyone purchasing the shares today.
Meanwhile, as stimulus dollars and new product revenue flow through to the company, its growth rate and EPS will expand rapidly. At present, CALX shares command close to 2x its annual revenue. At 1x revenue, shares of ZHNE will represent a double from current levels. At 2x revenue, the shares will sit above $10, a quadruple from here… and that's before accounting for any revenue growth.
As an added bonus, it wouldn't be surprising to see CALX acquiring ZHNE to increase its lead in this segment. Considering the accretion that would likely result, CALX can afford to pay well over $10 per share and still make a nice profit in short order. It wouldn't be the first time that ZHNE’s CEO sold a company. In 1999, Mory Ejabat was the CEO of Ascend Communications, which sold itself to Lucent Technologies (LU) for $24B.
Thus, there are several ways for an investor to reap an extremely high reward with little risk. With Quepasa (QPSA) and I-Go (IGOI) on a roll, I’m looking for ZHNE to join the run on promising small cap stocks, making this one of my favorite stocks that are poised to triple. You can read my latest thought on Quepasa (Quepasa Shares Still Set to Triple) and I-Go (After Solid Q4, iGO Expects Boost From Texas Instruments Partnership) at Seeking Alpha.