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Unfortunately, we’ve seen this story several times before: “One Client Wonders.” A small technology firm comes up with a product, they find one really good customer and sales go through the roof. So do expenses. Company execs beat their chests and party till dawn, celebrating their butt kicking market dominance. Spending on sales and marketing go crazy high as the company opens sales offices everywhere. Cash in the bank, everybody flying business class. Sales meetings in Hawaii. WOO-HOO! Engineers hired like crazy. The stock soars. Stock options for all. G&A costs jump.

Then suddenly, almost inevitably, it happens. THE client stops buying. What next? Start whipping the sales team for more results. Scour the world for someone to replace the big client. Hiring freeze and small incremental staff reductions. Start burning that cash in the bank. Sales chief walks the plank. Get another superstar. He leaves six months later.

Now the company desperately needs new cash? Go to the finance market with hat in hand. Take any deal offered. Give haircuts to the equity holders that would make a new army recruit blush. Go through quarter after quarter of optimistic projections and regular disappointments. Dilute the stock to nothing. Blame it on the CFO.

Is Dragonwave destined to follow this sad story, or do they have something planned we don’t know about?

Company Background

Dragonwave (NASDAQ:DRWI), is a Canadian based manufacturer. Founded in 2000, the company is a provider of wireless ethernet equipment used in emerging Internet protocol (‘‘IP’’) networks. They design, develop, market and sell proprietary, carrier-grade microwave radio frequency networking equipment. Their products principally perform the backhaul function in a communication service provider’s network, connecting high-traffic points of aggregation such as high-capacity wireless base stations (3G+ cellular, WiFi, WiMAX, Long-Term Evolution (‘‘LTE’’)) and large ‘‘out of territory’’ enterprises to nodes on the fiber optic core network.

Market

The wireless backhaul business, although decades old, has found some new life in the past few years as cellular carrier companies are having to ramp up their data capacity rapidly to accommodate smartphones and iPads. At the same time, most mobile carriers are planning to convert to HSPA and LTE, and while carriers are upgrading their cell towers, they tend to upgrade their backhaul at the same time.

Maravedis, a market research company that has long focussed on the backhaul market reported in May, 2011 that the microwave backhaul equipment market is expected to surpass US$ 12 billion by 2016. During 2010 they stated PtP microwave backhaul market reached US$ 4.74 billion.

They also estimated that “During the next 5 years the microwave market will continuously grow, mainly driven by the need for operators to deploy new base stations to provide good quality of experience over LTE networks.”

Significantly, they stated that “pure packet will account for 90% of annual microwave radio shipments by 2016.”

Significantly for Dragonwave, the 2nd runner in the race for world 4G dominance is WiMAX technology, a technology similar to LTE. By far the biggest WiMAX network rollout in the world has been underway by Sprint (NYSE:S) spinoff Clearwire (CLWR), and Clearwire chose to use Dragonwave equipment for backhaul of parts of a new WiMAX based network.

Company Position

Dragonwave has only a negligible share in the wireless backhaul business. They, along with Ceragon (NASDAQ:CRNT) were leaders in building cost effective microwave and innovative products that were optimized for IP packet traffic. The older more established companies like Aviat (NASDAQ:AVNW), Alcatel Lucent (NYSE:ALU), Fujitsu, Ericsson (NASDAQ:ERIC), NEC and Nokia (NYSE:NOK) tended to favour the legacy TDM traffic based devices, and were late to the party with IP optimized devices. Dragonwave was disruptive in an industry that is several decades old, and they have prospered by having the right product, competitively priced, at the right time. However, the older line companies are gradually getting caught up as they produce more competitive products.

Dragonwave’s market share is still only a small fraction of the total market. If they can turn around and execute well, there is much more market to be exploited.

As of a May 2011 company filing: “We commenced commercial deployment of our products in 2002 and, as of February 28, 2011, have shipped approximately 33,100 product units (i.e., links). To date, our wireless carrier-Ethernet links have been purchased and deployed by customers in more than 70 countries. In the fiscal year ended February 28, 2011, we delivered products to 211 customers, including Clearwire LLC (United States), wi-tribe Pakistan Limited (Pakistan), Altitude Infrastructure (France), Wind (Canada), and Barrett Xplore (Canada).”

Clearwire is the one big customer, which overshadows all other sales by a wide margin. Per the May 2011 company filing: “We have been dependent, and expect that in at least the next twelve months we will continue to be dependent, on a key customer. This customer represented approximately 60% of sales for the year ended February 28, 2011 versus 80% of sales for the year ended February 28, 2010.”

Growth

Revenue YOY in the first quarter May 2011, took a huge drop $48.7 million in 2010 to $11 million in 2011, as Clearwire revenue dried up.

The company did not disclose how much of the Q1 drop was due to Clearwire, but it would appear from the above statement (that 60% of the revenue came from the “key customer”) that non Clearwire revenue was also down in the 2011.

Transparency

We would appreciate more transparency from Dragonwave on key customer versus non key customer revenue, so that we can track how the rest of the business is doing.

Cost Control

The company burned through $ 14.1 million dollars in cash in the first quarter, leaving $64.6 million in cash and cash equivalents.

Unfortunately, spending on R&D, Sales & Marketing and G&A continues at a rapid pace. Opex totalled $ 13.959 million in a quarter that had only $ 4.64 million in gross margin.

Risk Assessment: Speculative

We assess Dragonwave’s risk level as speculative.

On the negative side, the company is spending as if the good old days were still here. Unless the Clearwire business returns in a hurry, the current Opex rate is hard to understand. It is not clear how the clear how the Clearwire or the non Clearwire business is doing.

On the positive side, the market for microwave backhaul is a solid one, with good growth prospects over the next several years as carriers upgrade their backup at higher than historic rates.

VineSecurityJournal.com’s Proprietary Pricing Model

We assess stocks primarily based on their fundamental value. We estimate the revenue and earnings to be generated by a company over the next 10 years. We look at the risk in the business, look at the assets and liabilities, and we discount the value of the future earnings according to risk level. For companies with medium to high risk levels, we discount the value of future earnings more aggressively. Our assumptions of revenue growth rates, and long term net profitability have a huge impact on valuation. Finally, we compare the value of those future earnings to the stock price. Are the shares “on-sale” – or are they expensive?

In the case of Dragonwave, it is nearly impossible to predict any positive earnings without some dramatic income statement changes. Putting in delicately, the current stock price seems “optimistic”. Dragonwave needs to show that they have a credible plan to get out of the One-Customer-Wonder death spiral.

Can they turn the cash bleeding around?

Conclusion There is only one scenario that makes sense to us, a painful one time big cut to Opex, so that cash can be preserved. This is no time to be going back to the financial markets for more financing. Unless Dragonwave does that soon, we fear it will be too late for investors.

Sell, There are easier places to make money.

Source: Dragonwave: A Remake of the 'One Client Wonder' Story