Orckit Communications: An 'Optional' Strategy

Jun. 4.07 | About: Orckit Communications (ORCT)

Although I am a strong believer in the old-fashioned "buy and hold" approach, there is sometimes a combination of circumstances which justifies using options as a complementary approach to simply owning a specific stock.

It is my belief that this combination currently exists for a small, rather unknown company called Orckit Communications (NASDAQ:ORCT). Dealing with options is a frustrating and risky task, so holding options often results in uncertainty and anxiety, which in turn lead to irrational decisions, which in turn generally lead to heavy losses. Therefore, it is crucial to approach this field in a cold rational manner, as much as possible. The characteristic which makes options so risky is exactly the same which makes them so potentially rewarding - timing. Since options bear an expiration date, you might bet on the right company but still lose all your investment, whereas stocks rarely "expire", except in cases of bankruptcy. Options are valid for a limited period of time, in which a change in the stock price is generally translated into a much more radical change in the option's value. Hence, making money through options is more challenging, but if one is right in both the direction the stock is headed in, as well as the timing, the rewards can be quite impressive.

I decided not to delve too deeply into the fundamental analysis of the company. The strategy I am offering is relevant only to those who follow Orckit closely and either hold or plan on holding a position in the stock. In a nut shell, Orckit's subsidiary, Corrigent, targets the telecom market with a packet transport switch [PTS] that is designed to support the deployment of very fast next-generation converged networks. The PTS is generally located on the metro side of the network as it enables the transport of huge amounts of traffic as well as smooth migration from legacy networks to next-gen networks. There is no need to explain the urgent need telcos have for faster, more efficient networks in order to support the explosive growth in the demand for bandwidth-hungry services like IPTV and 3G.

So far, Orckit has had few moments of glory in 2005 after KDDI, one of Japan's biggest telecom operators, chose their product for the deployment of their converged network. That success led to the shipment of 150$ M worth of products, which sent shares up more than 300% in 2005. However, during the past 18 months the stock has been performing miserably, losing more than half of its value in 2006. For some reason, Orckit couldn't duplicate their success story with KDDI with other customers, nor did they get meaningful follow-on orders from KDDI itself in 2006.

For the past year Orckit has been seriously engaged with around 6 new customers, most of them in Asia. These opportunities involve long trials and intensive optimization for each customer's need, but none of them bore fruit. Adding to the frustration of the investors was a comment made by the company’s management in early 2006 about at least one new customer by the end of the second half of that year. I still remember the company's president on the Q405 conference call, saying he would be "personally very disappointed" if that didn't happen. When asked about the identity of the new customers he refused to reveal their names but told analysts to simply look at where they had recently opened offices. At the time they had offices in Japan plus two new offices in Korea and India. My natural guess was that they were going to win two contracts: one in India or Korea and one in Japan. Unfortunately, that didn't happen.

The reason the company's management gave to explain the delays was customers' hesitation and conservatism. In one case we know that a customer (allegedly Softbank) was busy with M&A activity which postponed their decision.

Throughout the past year, Orckit’s management kept on assuring investors that all opportunities were and are still relevant, or in other words, that they haven't lost a single opportunity.

During the last conference call on May 8th I had a slight feeling of de'ja` vu when the company's president said that he expects a decision by a specific customer by the end of Q2, followed by a decision by another customer later in 2007. When asked about the customer that is expected to make a decision in Q2, he defined this customer as “imminent” and stated that according to what they know, that customer has to make a decision by the end of June, for reasons unrelated to Orckit.

So now the big question is how this situation is different from last year's situation. How do we know second quarter of 2007 won't end like the second quarter of 2006? It was Karl Marx who said that history repeats itself, first as tragedy, second as farce. I sure hope that with last time ending as a tragedy, this time won't turn up to be a farce. In my opinion, there are several reasons why this time is different:

The first reason is psychological. If I were in management's shoes, I wouldn't dare falsely raising expectations using the exact same terminology. Taking into consideration that these guys are serious and responsible managers who care about their reputation and credibility, the fact that they did use the same terminology, makes me believe that there is an extremely high probability for a decision by the end of June.

The second reason is general market conditions. With virtually every carrier on earth upgrading its network in order to deliver next-gen services like IPTV, high-def content and 3G services, it is obvious that the need for ultra fast metro networks is greater now than one year ago. Since Orckit's potential customers simply cannot wait anymore with their network upgrades, it is reasonable to assume they will have to choose a strategy for their network upgrade soon, whether based on Orckit's technology or not.

Third, Orckit's approach, which has traditionally been quite unique and exceptional is gaining wide acceptance by carriers and telecom vendors. This has been repeatedly stated by management and can also be demonstrated by the ever-growing list of respectable players joining forces with Orckit, such as Cisco (NASDAQ:CSCO) on the standardization side, and VSNL, KDDI and T-systems on the actual integration and trials side.

Fourth, the timing of the statement this year is much closer to the deadline. Last time the company’s management was talking about new contracts by June 2006 on February 2006. This time they set the deadline on May 8th, less than 2 months before the second quarter ends. This fact leads me to believe that they have a better visibility into future contracts this time.

On a personal note, I must admit that one year ago I was even more bullish about Orckit than today. I thought that there was a 99% likelihood for them to win two contracts by June of 2006. Had I done then what I am preaching for now, I would have incurred heavy losses. It was pure luck that I wasn't brave enough, stupid enough or both to actually do it….

My proposed strategy for investing in Orckit

My working hypothesis is that sometime this year they'll win at least one contract, whether the "imminent" second quarter customer or the third quarter customer. Both of those contracts should be translated into orders in the scale of tens of million of dollars. I believe that winning one contract should at least send the stock to the $15 levels while a second contract should bring it to the $20 range.

According to those assumption, I would split the investment into 3: 70% allocated to stocks, 20% allocated to Dec07 $12.5 calls and 10% allocated to Jul07 $12.5 calls.

Let's take for example a $10,000 investment. If we take the Friday closing prices:

$7000 would buy 640 shares.

  • $2000 would buy 16 Dec07 calls.
  • $1000 would buy 23 Jul07 calls.
  • There are 4 possible oversimplified scenarios:

    1) They don't win any contract. In that case the stock might dive to $5, assuming they should still have $30 million in cash and cash equivalent by year end (excluding the 25$ million they recently raised by selling convertible notes). Since the options become worthless, we would be left with a little bit more than $3200in stocks, a 68% loss.

    2) They win a contract in June but don't win the second opportunity. In that case the stock would stay in the $15 levels throughout the year. The stocks would be worth $9600. The 23 Jul07 calls should be in the money with a gain of $250 per contract. 23 times $250 equals $5750. The 16 Dec07 calls should also be in the money with the gain of $250 per contract. 16 times $250 equals $4000. That leaves us with $19,350 by year end, representing a 93% gain.

    3) They don't win a contract in June but win a contract later this year. In that case the stock would reach price levels of $15, but only in the third Q. The 640 stocks would be worth $9600, the 23 Jul07 calls should be worthless. The 16 Dec07 calls should be in the money with the gain of $250 per contract. 16 times $250 equals $4000. That leaves us with $13,600 by year end, representing a 36% gain.

    4) They win both contracts, one in June and another one later this year. In that case the stock should reach price levels of $15 by the end of June and climb to $20 by year end. The 640 stocks would worth $12,800. The 23 Jul07 calls should be in the money with a gain of $250 per contract. 23 times $250 equals $5750. The 16 Dec07 calls should be in the money with a gain of $750 per contract. 16 times $750 equals $12,000. That leaves us with $30,550 by year end, representing a 200% gain.

    In order assess this strategy I will assign each scenario what I see as a rough conservative estimation for its chances to materialize.

    I estimate their chances of winning a contract by June at 60%. A second contract by year end has a 40% of being materialized. If we assume the two events are not linked then the chances Orckit wins both contracts is the product of their probabilities: 24%. Using basic statistics, the probability that they will win only the June contract is 36%, while the probability that they will win only the second contract is 16%. That leaves 24% for the "no contract by year end" scenario.

    In order to get an average hypothetical, theoretical return according to these estimations, all we have to do is multiply each scenario's outcome and its probability, and simply sum it up:

    40%X60%X3200$ + 60%X60%X19, 350$ + 40%X40%X13, 600 + 60%X40%X30, 550
    = 768$ + 6,966$ + 2,176$ + 7,332$
    = 17,242$

    That leaves us with a hypothetical average gain of 72% by year end, assuming the probabilities I used for each scenario are realistic. Unfortunately, I have no guarantee that is really the case.

    Disclosure: Author has a long position in ORCT

    ORCT 1-yr chart