Harmonic: Attractively Valued Based On Price-To-Research Ratio

Jan.10.12 | About: Harmonic Inc. (HLIT)

Harmonic Inc. (NASDAQ:HLIT) is cheap based on its PRR (Price Research Ratio). R&D may be regarded as a commodity, and when a stock that appears attractively valued by other metrics also trades at a low PRR, it's a confirmation that the investor is getting value for his money. I wrote HLIT up favorably in June 2010, with the stock at $5.76, calling for $10 within two years. It hit $10.05 early in 2011 and has since returned to the $5 area, where I have once again taken a position.

This article updates valuation, to include a discussion of R&D. The previous article includes a discussion of the company's operations and the Omneon acqusition, since completed. The slides (pdf) for the 3Q 2011 Earnings Conference call are informative, and a transcript is available here on Seeking Alpha.

Price Research Ratio

The PRR is the market cap divided by the TTM R&D expense: for HLIT, it stands at 5.88. Ken Fisher, who developed the concept in Chapter 5 of "Super Stocks," suggested that investors buying growth-oriented technology stocks should do so at PRR's between 5 and 10, and avoid paying more than 15 on that metric.

The proliferation of video content, and the explosion of mobile devices, has created a rush to process and deliver video by cable, fiber optic or wireless, to every possible screen. HLIT's R&D, which is 18.6% of revenue, is directed at this sizable opportunity. As such, EPS is of less immediate concern than the value being created by R&D.

Management Discusses R&D

CEO Patrick Harshman, from the company's November 2011 presentation at the UBS Global Technology and Services Conference:

Now part of the value proposition of the Company to our customers is our heavy strategic focus on video. We think we’re the largest company out there solely focused on innovative video technology. Our R&D investment is approximately 100 million – we think the largest in the industry against competitors large and small; and this is approximately double from what it was just a couple of years ago, and this is a very powerful message for our customers as is, of course, the fact that we’re drawing now on a very rich array of underlying video technology building blocks spanning historic Harmonic’s business, Omneon business, and our Rhozet business particularly for video on demand over-the-top.

This is part of the value proposition for investors as well as customers.

Valuation

Because HLIT doesn't have a stable earnings history, it's appropriate to value it on a Price/Sales basis. The company has a 5-year average P/S of 1.9, suggesting a price target of $9 per share.

Non-current liabilities stand at 12.8% of stockholder's equity. The current ratio checks in at 3.54, providing $1.44 beyond what is required to operate the business in a prudent and orderly manner. It sits on the balance sheet as cash and short-term investments.

The financial strength, combined with the substantial R&D investment, supports the valuation derived from P/S.

Strategy and Tactics

The company experienced some disruption of its production due to the flooding in Thailand. The integration of the Omneon acquisition did not proceed as rapidly as management planned, and that portion of the business did not show growth during 2011. The integration is now complete, and the effects of the Thailand flooding should wear off by the 2nd quarter.

Beta stands at 1.4. The stock has been bouncing around the $5 area and as the above news develops it may be possible to accumulate at favorable prices while awaiting further growth and/or a swing to profitability. I'm long at today's prices.

While patience may be required, it is possible that HLIT will revisit its highs in the $9 to $10 area.

Options

The stock is optionable, with an implied volatility of 62.4%. There is an adequate amount of open interest on the 5.0 call, with a bid/ask spread of 10 cents. A covered call strategy, selling the 5.0 strike, would work here, and would be more attractive if the stock trades back under $5.00.

I've had success in the past playing this situation with diagonal spreads. Here's a snip of my current trade, a diagonal that was converted to a vertical by rolling the upper leg. If HLIT is above $5 at the April expiration, the trade will have an IRR of 112%. Otherwise, rolling would be an attractive option, to collect the time premium on the 5.0 calls.

(Click chart to expand)

Click to enlarge

The premiums are attractive with volatility where it is, and the options trades don't require a large move to earn decent profits.

Disclosure: I am long HLIT. I may add my current position (discussed above) on dips.