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We are recommending a speculative long position in Sycamore Networks (OTCQB:SCMR) as we believe downside is limited by its substantial cash balance (over $15.00 in net cash on the balance as of the most recent quarter, compared to a recent stock price of $17.05). We believe news of telecom operators adopting SCMR’s new product, IQStream, could serve as significant near-term catalyst.

Background: Historically, Sycamore Networks sold bandwidth solutions products, including optical switches, multiservice cross-connects, and multiservice access platforms, to wireline and wireless network service providers throughout the world. Competition in its core business was intense and the bargaining power of its customers was high due to significant customer concentration. As a result, SCMR has consistently lost share to larger rivals such as Cisco (CSCO), Alcatel-Lucent (ALU), and Huawei (Private) and has reported GAAP net losses in each of the past four years.

Why We Like the Stock

  1. Disciplined expense management: To management’s credit, SCMR has been very diligent in minimizing expenses not associated with R&D. While it continues to use cash, the company has reduced its cash burn to $3.5 - $4.0 million a quarter. Thus, we believe its substantial cash balance ($442.5 million as of the last quarter) should remain intact for several quarters.
  2. Smart new investors: In its Q1 11 SEC filing, legendary value investor Seth Klarman’s firm, The Baupost Group, reported a 100,000 share holding. In its Q2 11 filing, Baupost increased its stake to 225,000 shares. Its estimated average cost was $23.04, 35% above SCMR’s current stock price! Any familiar with Mr. Klarman’s record will know that it is a rare and wonderful event to purchase a company held by Baupost at such a discount to their purchase price.
  3. Potential catalyst in its IQStream Product: A problem with investing in companies trading at or near net cash levels is the lack of a near-term catalyst. In SCMR’s case, its new product, IQStream, could be that catalyst. The IQStream is designed to help wireless telecom operators manage bandwidth constraints during peak periods of usage. Management has not provided financial details regarding IQStream, but it did state that at least one telecom operator had moved from a lab trial to field trials. An actual contract signing or more detailed information provided in the upcoming earnings call could provide a significant boost to the current share price.

Valuation

SCMR is currently trading at 1.1 times cash. Measuring upside is difficult to the newness of SCMR’s technology and the lack of financial data available, but we think it is safe to that risk-to-reward is compelling at this level. SCMR is set to report Q4 11 earnings on August 29th. We are expecting the stock to rally on favorable news and/or a new IQStream contract signing.

Risks

  1. IQStream flops;
  2. SCMR loses its financial discipline;
  3. Management opts to spend cash on an acquisition rather than returning cash to shareholders.
Source: Sycamore Networks: Favorable Risk/Reward Trading Near Net-Cash Levels