Procera Networks: Investment Surge Set To Yield Meaningful Profits

| About: Procera Networks, (PKT)
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One of the strongest signs of confidence that a management team can send to investors is boosting a company's level of business investment to capture future growth and market share. Procera Networks (NYSEMKT:PKT) is doing just that, and we believe that the company's surge in business investments is poised to yield meaningful profits for investors. For those unfamiliar with Procera, the company produces intelligent policy enforcement solutions for mobile and broadband networks and private network managers, such as educational and governmental institutions. With a clean balance sheet, rebounding earnings, and continued revenue growth, we believe that Procera will create value for its investors, and believe that investors should add to or initiate positions. Unless otherwise noted, financial statistics and managerial commentary will be cited from one of the following sources: Procera's Q1 2013 earnings release, its Q1 2013 earnings call, or its latest 10-Q.

Q1 2013: Deploying the Balance Sheet

Procera's most recent quarter encapsulates perfectly the company's willingness to utilize its solid balance sheet to drive growth. With $116.22 million in cash & investments (and no debt), Procera's cash & investments total $5.65 per share, equivalent to almost 39% of its current market capitalization. And Procera has not shied away from deploying that cash to grow its business. In Q1 2013, total revenues grew by 14.91% year-over-year to $14.171 million, with growth coming in both product (5.92% growth) and support revenue (50.22% growth); product and support revenue accounted for 73.47% and 26.53% of sales, respectively. Although Procera beat revenue estimates for Q1 2013 by $.72 million, the company posted a wide miss on EPS; Procera lost 16 cents per share in Q1 2013 (compared to EPS of $0.13 in Q1 2012), versus an estimate of a 6-cent loss. However, as the company laid out on its earnings call, there are several reasons for this, including strategic decisions made by the management team to position the company for future growth.

Notably, Procera's gross margin for the quarter fell sharply, coming in at 54.6%, versus 70.5% in Q1 2012, and 65.1% in Q4 2012. The sharp decline in gross margins was due to a strategic decision to support a "long-standing MSO customer in North America" and a rollout of new big data applications. CEO James Brear declined to give specifics on the technology that Procera deployed, but noted that the company views this as a matter of strategic importance. And in late May, Procera announced that it had received a multi-million dollar follow-on order from the same MSO to utilize its technology in its big data initiatives. We expect the company to provide more color on this when it reports Q2 2013 results on August 7. Furthermore, Procera is guiding for a rebound in gross margins; CFO Charles Constanti is forecasting that margins will increase sequentially in Q2 2013, and that longer-term gross margins (for 2013 as a whole) will be in the low-to-mid 60% range. Investors should hew towards analyzing full-year gross margins as opposed to the margins in any single quarter due to lumpiness in the mix of software relative to hardware. Occasionally, Procera sells hardware before accompanying software licenses, thereby distorting its revenue recognition and therefore its quarterly gross margins. Procera's lowered gross margins were not the only source of its quarterly loss. The second contributor to the company's losses was a surge in operating expenses across all parts of the company, most notably research & development. Procera's pro forma R&D expenses soared over 126% year-over-year. Part of the increase in R&D expenses can be traced to Procera's January 2013 takeover of Vineyard Networks (a Canadian enterprise deep packet inspection company, for a total of C$28 million, of which C$15.4 million was paid in Procera stock), with the remainder due to organic growth in R&D spending. Total operating expenses surged 59.15% in Q1 2013, due mostly to continued hiring of new employees across all divisions, including R&D, sales, and support. However, Procera's expense growth is set to slow throughout the remainder of 2013, and the company's management team notes that the bulk of its organic investments for 2013 are now complete, which will drive growth in the 2nd half of 2013 (more detail on this later).

From an operational standpoint, we believe that Procera's surge in business investments has already shown meaningful dividends in Q1 2013 alone. During the quarter, Procera added Orange Switzerland (divested from France Telecom in February 2012) as a customer, deploying its PL8820 intelligent policy enforcement systems across its network. In addition, Procera added Tier 1 telecommunications companies in both the United States (defined by Procera as a "top five DSL operator") and Russia during the quarter. Procera's total mobile operator customer base now stands at 39, of which 8 qualify as "Tier 1" operators. During the first quarter of 2012, 27% of revenue was generated from new customers and 73% from follow-on orders, and CEO James Brear reiterated Procera's forecast that by the end of 2013 its revenue will be split evenly between new customers and follow-on orders. On a consolidated basis, Procera added 21 total new customers in the quarter, including 7 mobile service providers. In our view, Procera is executing well on its various strategic initiatives, and we believe that Q2 2013 and the remainder of the year will continue to display the benefits of Procera's meaningful investments.

The Road Ahead: Diversifying Product Lines, and a Diversifying Revenue Base

Procera raised its guidance for 2013 on its Q1 2013 earnings call, projecting revenue growth of "at least" 30% on a year-over-year basis, ahead of prior guidance for 25-30% revenue growth, and is also forecasting that it will gain market share during the course of the year. Vineyard Networks is also set to grow; Vineyard's Q1 revenue was $370,000, but that is set to more than double in Q2 on a sequential basis, and management is projecting continued growth throughout the remainder of 2013. CEO James Brear noted that the company raised guidance to account for increased confidence in closing several new deals by the end of 2013. Procera is also making great strides in growing its customer base, with 18 direct product trials now underway or set to begin within the next two months. Notably, three of which are with what the company describes as "mega-carriers". In addition to its efforts to expand its customer base, Procera is also continuing to roll out new products. The company introduced ContentLogic in January 2013, which is an enhancement to the company's deep packet inspection technology. ContentLogic allows Procera's customers to analyze their traffic and correlate up to 100 million URLs to better optimize their networks to ensure optimum speeds. Over the past several months, Procera has not only strengthened its internal product offerings, it has also strengthened its partnership efforts. In late February, the company announced a partnership with Tilera, which specializes in scalable processing, and noted that they had achieved 200 Gbps (an industry best) of deep packet inspection performance by combining technologies from both companies, which will enable Procera to better meet the needs of customers who require high throughput and near real-time results. And in June, Procera announced partnerships with Napatech, a leading network intelligence adapter manufacturer and Openet, a leading transaction management service provider. The Napatech partnership blends together Procera's Network Application Visibility Library software (which allows for real-time application classification and metadata extraction) with Napatech's network adapters, which can allow customers to build application-aware network appliances without the need for specialized servers, all at 80 Gbps. And the Openet partnership revolves around Revenue Express, a new solution designed to allow mobile operators to rapidly configure revenue-generating services via a low-cost prepackaged and standardized solution. Procera notes that Revenue Express is aimed at Tier 2 and Tier 3 mobile providers, and will market Revenue Express as a tool to gain a competitive edge, with particular emphasis on the system's flexibility, integration, and reliability. Procera's slate of new products and partnerships is meant simply to grow the company's overall business, although that is certainly a crucial goal. The company's expanded slate of products and services is also designed to push the company further towards the mobile market, and further away from more traditional cable operators. On its Q1 2013 earnings call, Procera was asked about customer mix, for this has been a source of some concern amongst investors. CEO James Brear offered up the following answer regarding the company's customer base, stating that,

"We'll probably end the year with mobile growing the fastest. I will not discount cable. There's still a lot of activity in the cable market globally. And so that'll still become -- I could see cable maybe being 40% of revenue rather than 50%, but then mobile moving up into the 30%, 35% range. And then the fixed operators, I feel that as 15% to 20%."

In Q1 2013, Procera's two largest customers (for which it discloses data) were Cox Communications and Shaw Communications (NYSE:SJR), accounting for 22% and 17% of Procera's revenue, respectively. However, that is down slightly on a year-over-year basis, when Cox and Shaw together accounted for 41% of Procera's total revenue. With 39% of Q1 2013 sales coming from 2 customers, there is clear incentive for Procera to diversify its revenue base, and in our view, the company's multi-channel investments have set the stage for a more diversified revenue base in the quarters to come. We expect more color on the company's diversification efforts on its Q2 2013 earnings call, which will occur on August 7.

Financials, Forecasts, and Peers: Looking Favorable Upon Procera

As we noted above, Procera's pristine balance sheet is one of the aspects that brought this name to our attention, and it enables the company to aggressively invest in its business. Procera ended Q1 2013 with $5.65 per share of net cash & investments, and nearly 39% of the company's market capitalization is in cash. And as the company's revenue continues to grow, and as EPS rebounds in the second half of the year and 2014, Procera's balance sheet will strengthen further, giving the company more opportunities to invest in its business, or possibly return capital to shareholders. The table below breaks down consensus forecasts for Procera (multiples are based on the company's closing price of $14.49 on July 11, 2013).

Procera Consensus Forecasts (in Thousands of $)

Year

Revenue

Year-Over-Year Change

EPS

Year-Over-Year Change

P/E Multiple

P/E Multiple ex-Cash

2012

$59,627

+34.38%

$0.51

+24.39%

N/A

N/A

2013

$77,010

+29.15%

$0.04

-92.16%

362.25x

221x

2014

$96,570

+25.4%

$0.44

+1,000%

32.93x

20.09x

Although Procera's revenue growth is set to slow in 2013 and 2014 from 2012 levels, the company's EPS is set to recover, and importantly, the company's sales growth is still outpacing that of many of its competitors, as we show below, and its balance sheet strength (measures by the percentage of market capitalization held in cash) is also superior to many of its competitors. Procera's 10-Q lists several competitors, including Cisco (NASDAQ:CSCO), F5 Networks (NASDAQ:FFIV), Ericsson (NASDAQ:ERIC), Allot (NASDAQ:ALLT), Brocade (NASDAQ:BRCD), Citrix (NASDAQ:CTXS), and SAIC (SAI). Our peer comparison will exclude SAIC, for its Cloudshield unit, which competes with Procera, is largely immaterial to the company's overall results, and because SAIC is valued primarily on the basis of its defense and services exposure (note: yearly revenue and EPS figures are based on each company's fiscal year, and P/E multiples are based on each company's closing price on July 11).

Procera Peer Comparison (in Thousands of $)

Cisco

F5

Ericsson*

Allot

Brocade

Citrix

2012 Revenue

$46,061,000

$1,380,000

$33,848,000

$107,100

$2,237,770

$2,586,123

Y/Y Change

+6.58%

+20%

+0.4%

+37.66%

+4.21%

+17.21%

2013 Revenue

$48,590,000

$1,460,000

$35,260,000

$110,630

$2,190,000

$2,960,000

Y/Y Change

+5.49%

+5.8%

+4.17%

+3.3%

-2.13%

+14.46%

2014 Revenue

$51,210,000

$1,620,000

$36,510,000

$134,510

$2,210,000

$3,340,000

Y/Y Change

+5.39%

+10.96%

+3.55%

+21.59%

+0.91%

+12.84%

2012 EPS

$1.85

$4.37

$0.53

$0.59

$0.66

$2.87

Y/Y Change

+14.2%

+15.61%

-35.92%

+28.26%

+32%

+15.73%

2013 EPS

$2.01

$4.45

$0.78

$0.35

$0.65

$3.09

Y/Y Change

+8.65%

+1.83%

+47.17%

-40.68%

-1.51%

+7.67%

2014 EPS

$2.11

$5.04

$0.91

$0.65

$0.67

$3.53

Y/Y Change

+4.98%

+13.26%

+16.67%

+85.71%

+3.08%

+14.24%

*Ericsson does not report results in dollar terms, therefore 2012 results have been derived by taking Ericsson's reported average SEK/USD exchange rate for 2012

Procera Peer Balance Sheets & Multiples (in Thousands of $)

Cisco

F5

Ericsson

Allot

Brocade

Citrix

Cash & Investments

$47,388,000

$1,185,670

$10,807,346

$134,766

$764,298

$1,404,948

Debt

($16,248,000)

$0

($5,975,112)

$0

($599,277)

$0

Net Cash & Investments

$31,140,000

$1,185,670

$4,832,234

$134,766

$165,021

$1,404,948

Shares Outstanding

5,344,336,014

78,799,170

3,223,000,000

32,561,977

443,780,216

187,123,694

Net Cash & Investments per Share

$5.82

$15.04

$1.49

$4.13

$0.37

$7.50

July 11 Closing Price

$25.87

$76.09

$11.98

$13.23

$6.18

$66.81

% of Market Cap in Cash

22.50%

19.77%

12.44%

31.22%

5.99%

11.23%

2013 P/E Multiple

12.87x

17.09x

15.36x

37.8x

9.51x

21.62x

2013 P/E Multiple ex-Cash

9.98x

13.72x

13.45x

26x

8.94x

19.19x

2014 P/E Multiple

12.26x

15.09x

13.16x

20.35x

9.22x

18.93x

2014 P/E Multiple ex-Cash

9.5x

12.11x

11.53x

14x

8.67x

16.8x

As the three tables listed in this section show, Procera's revenue growth for both 2013 and 2014 is set to outpace all of its publicly traded competitors, and its balance sheet is the strongest in its peer group when measured by the percentage of market capitalization held in cash. From a valuation perspective, Procera does trade at a premium to its peer group, but we believe such a premium is warranted, given the company's revenue growth. Furthermore, Procera has the most potential to deploy cash, given that nearly 39% of its market capitalization is in cash. Should the company implement a share repurchase program, it could provide for a meaningful boost the company's EPS.

Conclusions

We believe that at current levels, shares of Procera Networks are undervalued. The company has made enormous investments into its business, and these investments are set to yield meaningful dividends in the quarters and years to come. With solid revenue growth, recovering EPS, and a pristine balance sheet, Procera's current share price is not reflective of its long-term potential. In our view, investors should add to or initiate positions in Procera Networks ahead of its expected EPS recovery, which may induce the company into returning capital to shareholders, thereby providing investors with yet another reason to own shares of Procera Networks.

Disclosure: I am long PKT, FFIV, CTXS, CSCO, SAI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.