Ubiquiti - It’s been a Long, Long Time
Ubiquiti - Finally garnering a little respect
Ubiquiti (UBNT) released the results of its fiscal Q4 for 2017 Thursday morning. In some ways, for a momentum growth story, it may have been possible to describe the quarter as mildly positive. Revenues were up 23%, about 4% above the prior First Call consensus, and EPS of $.75 for the quarter surpassed the prior consensus outlook by $.01. But the guidance the company provided was anything but dull - and it may have been one of the largest beats I have ever seen for a company of this scale in a single quarter.
Expectations, at least as published by First Call, had been that earnings growth this current fiscal year would be subdued with EPS expected to grow by only 6% with revenue growth of 8%. Instead, the company is now forecasting that EPS for the year, at the mid-point of its guidance, will grow by about 30% to around $4/share with revenue growth, at the mid-point of the forecast range, to be 24%. That kind of forecast, flying in the face of uniformly negative analyst sentiment, a small float and a short interest that was 33% of the float, was what produced the sharp share price appreciation on Thursday. And yet, interestingly, so far not a single analyst has chosen to recommend the shares and as can be readily seen, the valuation actually contracted in the wake of the sharply higher numbers.
Without trying to be dramatic about what is happening, I think it is fair to say that this company, certainly one of the more controversial names that I follow, is basically a story of one man’s vision and aptitude contending against a tide of extreme skepticism and disbelief. Investing in Ubiquiti remains, essentially, a bet on the future judgement and execution of the CEO Robert Pera. More than most businesses, the CEO sets the strategy and is intimately involved in all phases of the company’s operations. At this point, it would be hard to gainsay the results of Mr. Pera’s vision or execution.
I have written about UBNT several times over the past months. The shares have had their share of volatility since my initial article, and even after today’s share price action sit less than 10% above where they were when I first wrote about his company. It is a pretty easy call for me to make to suggest that investors get on the train and enjoy the ride. Overall, the shares are cheaper now in terms of most valuation metrics than they were at the time of my initial article. They have actually slightly outperformed the IGN index (Tech/Networking) which has had appreciation of just a few percent since last December (the date of my first Ubiquiti article).
I don’t propose to spend a long time reprising the different offerings of this company. In fact, as it turns out, many readers of articles on UBNT are users of the product and are more than a bit aware of the company’s overall product positioning and strategy. But just as a high-level summary, UBNT has become a significant factor in the wireless LAN space. The wireless LAN space, overall, is not a robust growth area, nor is it a giant market opportunity. In Q1 2017, according to the report linked here, overall WLAN shipments decreased by 0.8%, although the enterprise market which encompasses the vast preponderance of Ubiquiti’s business at this point grew by 4%. The market, overall, represents about a $9 billion/annual sales opportunity. Ubiquiti is now in third place in the market with about a 6% share, up from 4.3% a year ago. The other major competitors in the space include Cisco (CSCO), the dominant factor in the space with a 43% share. In the 2nd position is the Aruba operation of HPE (HPE) with a 16% share, Brocade (BRCD) and Huawei, fastest growing of all the competitors on a percentage basis.
The report suggests that part of Ubiquiti’s success in this past quarter is due to its robust Latin American operations. Latin America, not usually considered to be a significant market for tech products, actually showed substantial growth of 28% in Q1 2017 after having declined in 3 of the preceding 4 quarters. Ubiquiti’s South American region, which was 15% of revenues last quarter, showed 42% year-on-year growth in the region, the strongest percentage growth of any of the geos that UBNT breaks out.
Why has Ubiquiti gained market share and can it continue?
It is more than certain that many readers will have their own detailed opinions based on personal experience regarding the question posed above. And it is fair to say that there is a very strong probability that some readers with direct experience in procuring WLAN devices are likely to have insights that this writer lacks concerning what is important in the space in terms of how users evaluate products. That said, as investor writing to other investors, the answer to the question is basically that Ubiquiti has had the ability to develop technologies in its space that have offered users better price/performance and are considered highly disruptive - in a good sense by their buyers. In addition, Ubiquiti’s “zero marketing” strategy and the heavy reliance on the Ubiquiti Networks Community as an informal sales adjunct have strongly resonated with buyers.
I have linked to the Gartner Magic Quadrant evaluation of the space that was published a bit less than a year ago. Interestingly, at that time, UBNT was not even considered by Gartner as a competitor, which may be something about Ubiquiti’s non-existing marketing and Gartner’s survey methodology. Although a bit long in the tooth, I have linked to a discussion here that comes from a thread published by the Ubiquiti Network Community.
Why does Ubiquiti win? It basically comes down to price, performance and innovation - what you might expect. At the end of the day, Ubiquiti is able to sell its products for less because it has out-innovated its competition in terms of how its products are designed and because it has been an extremely responsive company when it comes to adding features most desired by competitors. The company’s competitive moat is disruptive price/performance. In evaluating UBNT as a competitor, it is key to understand that the company will primarily rise and fall depending on its latest product releases and refreshes and the pricing leverage it has because of its unique business model. So far that has worked out just fine - it will always be a risk in investing in a company such as this.
What is the secret sauce behind the company’s ability to get to the market with products that materially disrupt the competition
As mentioned, Ubiquiti as a company and as an investment has not been without controversy. The founder, Robert Pera, was a child prodigy - he is said to have provided networking and database services to local businesses during high school. He apparently had an admirable academic experience and has an EE degree with an emphasis on Digital Communications and Circuit Design as well as a Japanese Language degree.
During this most recent conference call, Mr. Pera made what amounts to a speech regarding Ubiquiti’s special sauce and technology roadmap. It seems clear that Mr. Pera is not best pleased with the current analyst coverage or understanding of his business and he was waiting to make this speech even if was not quite responsive to the question at hand. This company's conference calls do not feature scripts or prepared remarks and this proved a way to put Mr. Pera's thoughts into a reasonable context. I really do not think I can add all that much beyond what the CEO said.
OK, thanks. I’m going to take a step back with regards to your yearly guidance question. So, I know we probably are getting a lot of attention right now and with some potential long-term investors. I want to give them …my view of where the company stands and my vision for the future. So, first of all, I believe up to this point in time, Ubiquiti as a company has been misunderstood by a lot of people. I believe we have a group of core competencies that gives us great competitive advantage in the market. Specifically, our ability to target markets, our vision and (presence) in in market…our business model, which revolves around touchless evangelism…I would say how we allocate our resources and get a great (return) on investment from our resource allocation and finally which we do not get enough credit for, is our design capabilities. And I believe, we’re one of the few companies right now in the hardware space that could execute on beautiful technology inside and out. For everywhere from industrial design to hardware design, mechanicals, mobile app software, band end software; front end-beautiful front-end user interfaces and great user experiences. So, together, those core competencies have given us a really unique, competitive advantage…and has allowed us to weather lots of storms and a lot of adversity. And it has been frustrating to see a lot of critics poke at our core competencies as something that (is) flawed.
That’s something that (will) be short lived. And I believe it’s the strength of the company and our ability moving forward to grow and to become more profitable is a matter of improving our product development efficiency, and that will lead to more revenue growth, hopefully accelerated revenue growth from (this) point forward.
The CEO went on to talk about operational efficiency to go with product design efficiency and his focus on Asia in terms of finding partners to help the company execute. The answer goes on to talk about some very specific product trends for Ubiquiti that I will not quote here - the transcript is readily available and I am not sure that the specifics of the roadmap will better enable investors to handicap the shares. I do not pretend to have some deep insights regarding Ubiquiti’s Network Management System and its plans for a fiber network. But I do think it is worth noting that in closing, Mr. Pera talked about lowering the price point down to something sub $100, "somebody could start setting up a GPON (Gigabyte Capable Passive Optical Network). And once we get there, I think we’ll further democratize…the GPON ISP industry so that’s the vision.”
That’s a lot of words, no doubt, but seriously, that is what this company is all about. If you believe that this company has the capabilities the CEO discussed in his answer - or speech if you prefer, both at a strategic level and at a tactical level, the decision to buy/own the stock is easy. My own judgement is that thus far, Mr. Pera has delivered more often than not on his strategy and his vision. That is so despite some the missteps and false starts seen by this company.
Overall, the fact is that UBNT really has differentiated itself, more or less as the CEO said and it does employ differentiated tactics compared to other competitors. Really, if touchless evangelism works as it has, why not suggest that it is a tremendous business advantage. As someone with a long-term marketing background, I simply have to love the phrase “touchless evangelism” - a concept that has befuddled much of the analyst community. Many people do not believe in the concept - others look at the empirical results and just have to accept that it is working for UBNT at this time and in its chosen markets.
With regards to some of the other attributes pointed out by Mr. Pera, how can an author, any author really, evaluate how things like targeting markets, long-term vision and resource allocation will continue to work out for this company. It is most certainly a bet on the leadership of this company and its CEO to the same extent that a dozen years ago, investing in Apple (NASDAQ:AAPL) was a bet on Steve Jobs or to a certain extent, the way currently investing in Microsoft (MSFT) is making a bet on Satya Nadella and investing in Amazon (AMZN) is making a bet on Jeff Bezos. The difference, I would say, is that investors do not have to pay all that much to make the bet on Mr. Pera for a variety of reasons.
A brief look at some detailed financials
One thing to note before launching this discussion is that UBNT has not and probably will not use stock-based comp at any time in the foreseeable future. So, it has a much higher quality of earnings and a much cleaner cash flow metric than its competitors and peers which use stock-based comp almost as an opioid.
The single most controversial metric for this company is gross margin. Last quarter, gross margin was 45%, consistent with the prior quarter and about 340 basis points less than the level of the prior year. The matter of this 340 basis points has been the subject of lots of electrons. Management says that its gross margins are a bit depressed at the moment because so much of its revenues are coming from new products which are at the start of manufacturing cost/learning curves. Investors certainly can find a great deal of contrary observation.
The fact is that it is relatively normal for a company like this, with relatively few products, to see margins contract and expand as it introduces new products. The question was asked often enough on the conference call. Either the CEO was obfuscating to a degree rivaled by our politicians or one has to believe that the products being developed have been disruptive and will continue to be so. The empirical evidence and some of the specifics during the call suggest that the preponderance of the evidence suggests that the latter premise is the most likely.
Specifically, UBNT is projecting that gross margins will remain at 45% in this current quarter and then start to rise to as much as 50% over the coming years. As the company is projecting for earnings per share growth of a bit more than 30% at the mid-point, with revenue growth of about 24%, and as there isn’t much room to further trim opex ratios, straightforward math suggests that gross margins are going to have to show a noticeable increase in the last 3 quarters of fiscal year 2018.
Selling, general and administrative expense was a meager 4.4% of revenues last quarter and that is actually down a touch from the 4.6% of revenues in the prior year’s quarter. Research and development at 9.4% of revenues was up from 8% the prior year, although far below the norms of all of UBNT’s competitors. Management attributed the rise in research and development expense to some one-time payments versus the prior year. That said, the company has hired significantly in the research and overall area. Company-wide, headcount grew by 11% last quarter and by 35% for the year as a whole. Most of the headcount increase is said to be in the research and development component.
For several quarters now, the company has seen outsized increases in receivables and in inventories. Management has spoken to those increases since they started and said they were part of a plan to deploy capital to boost growth. The growth is running reasonably hot and there is no reason that I have to suggest that some of that isn’t the result of holding greater levels of inventories and selling to larger service providers and providing them would extend payment terms. Using some working capital - of which this company has more than enough - to leverage growth seemingly makes lots of sense. Given that revenue metrics have been favorable, there is no reason to believe that using working capital to invest in inventories and receivables is a risky undertaking.
In the last quarter, net cash rose by about $40 million while receivables increased by $14 million and inventories increased by a bit more than $9 million. In percentage terms, receivables and inventories rose by around 10%, while revenues rose by 5% sequentially, not a particularly worrisome set of metrics.
UBNT is a hardware company, albeit one with a radically different business model than almost every other IT hardware company extant. Obviously, that makes the shares a bit difficult to value using comps. Simply put, at this point, UBNT gets loads more leverage on its revenue dollars than is the case for its competitors/peers.
The company currently has a fully diluted share count of 81.3 million and that level has continued to fall slowly due to share buybacks. This past quarter, share buybacks were minimal. I think the company will continue to repurchase shares based on management commentary during the call.
At today’s closing price, the company has a market capitalization of $5.3 billion and an enterprise value of a little less than $5 billion. The EV/S calculation yields a metric of 4.64X using the mid-point of the company’s guidance. That may seem a bit elevated until one considers that the earnings to come from this revenue are forecasted to be $4.00 per share at the mid-point. So, the P/E is a very reasonable 16X, again based on the company’s forecast for this current fiscal year.
The company has an exceptionally low level of capex which really doesn’t figure into cash flow at this point. And as it is a hardware company, deferred revenues do not represent more than a negligible component of the balance sheet. The company is forecasting to report profits this coming year of $325 million, and it will probably see inventories and receivables rise by another $100 million. So, it seems reasonable for free cash flow to reach $220-225 million this current fiscal year. That would represent a free cash flow yield of 4.4-4.5%.
It is well to remind readers that this company has a valuation based on no stock-based comp which again significantly influences comparisons with other vendors.
One final item to note. In response to a question, Mr. Pera said that current forecasts were not really predicated on new product releases - that would be icing on the cake, he commented. Given the rather lengthy discussion of the company's plans with regards to product introductions, it seems reasonable to suggest that the current forecast is more of a floor than a specific expectation.
As it happens, at least according to the revised First Call estimates published this day, analysts continue to estimate that the company will not achieve its now current forecast for either revenues and particularly for EPS. Stubborn bunch, I suppose, but it is this mismatch between analyst projections and the company forecast that provides a significant potential for share-price upside. It seems reasonable to expect that at some point, the company will attract a cohort of positive analysts who are willing to believe the story, regardless of the controversies involved in doing so. But there is clearly no “irrational exuberance” involved by brokerages in considering the valuation of this name.
I continue to hold the shares and I expect to see a more positive share price trend with rising valuations going forward.
Disclosure: I am/we are long UBNT.
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.