On October 15, I was flush with a sizable addition to my brokerage account from a Sycamore Networks (SCMR) special $10/share dividend. This was almost immediately followed by a seemingly positive earnings report where Sycamore beat street estimates. Everything was starting to look rosy, I thought.
Then, within days, management announced it was selling off part of the company, issuing a new $2/share special dividend, and most shockingly, was announcing it would wind down the business. A company with a massive war chest in cash was calling it quits. True, I have made a small profit off the share movement and dividends, but nowhere near what I would have expected.
Why did I not see it coming? I blame it on a disconnect between my investment theory and the reality of the company. There are lessons to be learned here, and I hope I am not yet too old to learn from my mistakes.
The short history of Sycamore is that it is a niche provider in digital network technology. It was founded in 1998 and spent the first few years as a high P/E tech flyer. Sycamore finally broke through to profitability in 2000 before the market meltdown of 2007-2009. It provides hardware and software utilization optimization solutions for networks. The company spent the normal time as fast grower losing money, then turned the corner to actually making profits, before the market in network services became crowded with competition. The greater market has many bigger operators like Alcatel-Lucent (ALU), Ciena (CIEN), Cisco (CSCO) and Tellabs (TLAB) dominating the landscape. Many are providing their own network maximizing solutions. In fact, all of these companies are seeing margins and profits squeezed as they have struggled to transition from a technology that once was growing exponentially in the 1990s-2006, to one that is mostly level 2007-2012. With the big fish struggling and fighting for business, it is tough for a smaller fish like Sycamore to compete.
Despite the problems with its core economics, there were a couple things to love about the stock. The main item was Sycamore stood on a massive cash position it now could not use. This gave it lots of options as far as acquisitions, new product development or cash return to shareholders. In fact, it did issue a series of large special dividends to shareholders, including $12/share just this year in two distributions.
The second was management's belief in its developing IQStream technology. The product was receiving strong reviews and it was felt it could be a game changer revenue-wise. In the meantime management trimmed costs.
The cash position at Sycamore is now a bit cloudy at this point. Reported cash before this year's slate of special dividends was about $12.87/share. Since then Sycamore has paid out a $10 special dividend and is about to payout an additional $2/share for a special dividend on November 12. The company did announce it had come to an agreement to sell its Intelligent Bandwidth Management business to a subsidiary of Marlin Equity Partners (Marlin) for $18.75 million, or about $0.65/share.
It looks to me that most of the cash is gone, and what is left will be needed to fund the winding down operations. I worry that revenue will dry up - few want to buy from a company that is going out of business unless it is for a great discount - which will mean that negative cash flow will likely widen as the company winds down.
Sycamore's board therefore has flung itself from a massive cash position to one where it is difficult to see how much will be returned to investors. Not to mention how long this process will take: based on nothing but gut instinct, I expect the process to take 12-24 months before shareholders will receive whatever final distribution there will be.
Right now the company is burning through about $4 million a year due to negative cash flow. This was absolutely no problem in the past when it was sitting on $250 million. Now, the piggy bank looks to be somewhat under $20 million after the special dividends. But I am also worried that revenue will sharply slow now that the company is a dead man walking. That $4 million negative cash flow could easily multiply. Overall, this is astonishing, hard to wrap the mind around, given the recent and seemingly positive earnings report combined with Sycamore's historically strong cash position.
However, buried in the company's 4Q 2012 SEC 10K filing are a number of clues that everything was worse than investors hoped. Management's words, when taken as a whole, provide clear clues about just how amiss the underlying situation was. According to management:
We believe the portion of the bandwidth management market that we serve is in secular decline and continues to be challenged by high customer concentration, the project-oriented nature of purchasing patterns and uncertainty with regard to the level and timing of capital expenditures by service providers. Further, the limited number of customers and large number of suppliers continues to result in intense competition in this market. We believe that these factors limit the number of meaningful new opportunities for these products and will restrict revenue growth in this area of our business. Accordingly, our investments in this business have been and will remain focused on customer support and sustaining engineering efforts, including limited feature development tied to tangible revenue opportunities.
Most of the hopes for Sycamore has been the idea that the company was bouncing back. For example, from Standard & Poor's investment rationale on Sycamore, where it considered Sycamore a buy after the $10 special dividend, S&P talks about the analysts' hopes for future revenue:
...we believe it could pick up. We think the majority of SCMR's growth prospects are dependent on the success of its new IQStream mobile broadband optimization solution.
I agreed with that opinion. However, the company was spitting out clues that the future was not so rosy. Again, according to the most recent 10K:
Trial activities for our IQstream Mobile Broadband Optimization solution remain ongoing. Our trial activities to date have been useful in demonstrating IQstream's core platform capabilities. However, the pace of market acceptance remains slower than anticipated due to extended product evaluation time frames, mobile operators' heightened interest in a more integrated, end-to-end mobile optimization strategy and competitive pricing pressure from providers of traditional backhaul bandwidth services. As a result, we have not yet recognized revenue for these products.
The market acceptance was slower than expected. I took that as part of the legacy of corporate unwillingness to make any decisions until after a solution to the looming fiscal cliff. I expected (actually, hoped) that once the presidential election was settled, whatever happened budgetary-wise would happen. Once companies knew what tax and spending realities would be for 2013, then those organizations would start to move forward. Evidently, Sycamore's board and management lost faith in that future.
The Gloom of Winding Down
The final notes on Sycamore Strategy left this chilling conclusion:
Given the conditions affecting our businesses, we have intensified our pursuit of strategic alternatives. These alternatives include: asset sales or other business combination transactions, the discontinuation of products or product lines and recapitalization alternatives, such as cash distributions.
Like others, I took this to mean that the company would continue to tighten costs as well as use its hefty cash position to broaden its position. I targeted into the "pursuit of strategic alternatives" as in strategic alliances or possibly expanding into new niches. I was so used to Sycamore's pattern of cash distributions that the very idea of management winding down the business completely escaped me.
In the end, the signs were there and I ignored them. partly it was because I was so used to the idea of Sycamore's special distributions that I did not catch the signs that the board was turning negative to their entire business model.
I expect that after the $2 special dividend is paid that investors and traders will start leaving Sycamore in droves. There may be some arbitrage plays in the future, depending on how far he price drops in relation to whatever the liquidation value ends up being. Currently, I am short Sycamore and I will see how it goes from there.
As far as lessons, I preach to keep a neutral eye when reading SEC reports. There is loads of information just waiting in the details and footnotes for those willing to read and understand. In this case, though, I was looking for reasons to buy. I found positive hints where there was only vagueness, while I ignored the repeated warnings over the difficult economy, massive competition, and struggling market niche.
I think it is time to reread some SEC statements. What else have I missed?
Disclosure: I am short SCMR.