- This idea was forwarded to me by a contact who used to help with our fund.
- Over the next several years, Ceragon Networks will have two independent drivers of growth behind it, acting as a tailwind to its share price.
- In addition to the prospects of above-average growth staring directly ahead, Ceragon shares trade at a discounted valuation to the broader averages, even after accounting for a sizable discount.
- After conducting my own research and due diligence on the company, I have become somewhat convinced that Ceragon could make for a very logical takeover target by a larger competitor.
This idea was discussed in more depth with members of my private investing community, Valuation 360.
Ceragon Networks Provides an Essential Need for the Wireless Industry
Ceragon (NASDAQ:CRNT) is a leading "wireless backhaul" specialist in the communications equipment market.
The company is a market leader in wireless backhaul - both in terms of its technological capabilities and as well its leading market share amongst its peer group in the "best of breed" segment.
Speaking straightforwardly, "wireless backhaul" technologies are used to increase wireless network coverage and implement wireless network densification for telecoms.
The vast majority of Ceragon's customers are Tier 1 and 2 telecoms, but the company also does a small bit of business with oil and gas companies and utilities.
This article will focus exclusively on the telecom side of Ceragon's operations as this is the part of the business which drives growth and profitability for the company.
In a period where wireless users are increasingly demanding more from their networks and service providers, Ceragon offers solutions designed to improve the infrastructure of wireless networks in order to deliver more robust voice, data and other multimedia services to their wireless customers.
Rapid subscriber growth and the proliferation of advanced smartphones, tablets and other high data consuming devices have significantly increased the amount of traffic that must be carried over a cellular operator's backhaul infrastructure. As a result, existing transport capacity is heavily strained, creating a bottleneck that hinders service delivery and quality.
Source: Ceragon's 2016 Annual Report
In emerging markets, the issue telecoms face is one of adding coverage in remote areas but also one of addressing capacity constraints in densely populated urban areas, as thousands of new users are added each day, using increasingly more data-driven services - putting more demands on operator's networks.
In developed markets meanwhile, telecoms face the challenge of implementing their new 5G networks, which will require approximately 100 times the capacity per device as compared to the 4G technology currently in place.
Both of these catalysts should drive demand for Ceragon's wireless backhaul technology over the next five years and, in doing so, should serve to drive the company's value higher over that period, potentially making Ceragon an attractive takeover target for a larger competitor (discussed more below).
Understanding the Difference Between Wireless Backhaul and Fiber Optic Solutions
In addition to competing with other wireless backhaul providers in the market, Ceragon also competes with companies that offer fiber optic solutions as a means to the same end.
Sales in Ceragon's addressable market are effectively split 50/50 between wireless backhaul solutions and fiber optic solutions, with the consensus being that this distribution is not expected to change anytime soon.
Essentially, fiber optic solutions can in certain cases provide a better long-term return on investment - but also carry with them somewhat prohibitively higher upfront costs:
Though fiber-based networks can easily support the rapid growth in bandwidth demands, they carry high initial deployment costs and take longer to deploy than wireless.
The return-on-investment from fiber installations can only be expected in the long term
Source: Ceragon's 2016 Annual Report
Meanwhile, wireless backhaul providers like Ceragon offer telecoms with a more "nimble" solution:
Unlike fiber, wireless solutions can be set up quickly and are more cost efficient on a per-bit basis from the outset.
Source: Ceragon's 2016 Annual Report
At the end of the day, both solutions have their own advantages and disadvantages, and it's pretty easy to understand why telecoms as whole would be content to effectively "hedge" their bets between the two offerings, effectively diversifying their risk between the short and long term.
It's also worth adding, however, that in times when capital (and prospective returns) among telecoms is relatively scarce - for example, in times of restrictive monetary policies or periods of intense competition in wireless markets, it could be expected that wireless operators would be in favor of wireless backhaul solutions over fiber optic solutions - given the lower capital outlay upfront.
The Catalyst: 5G Network Rollout
Ceragon stands to benefit from the continued rollout of network infrastructure in emerging markets - notably India, which is expected to account for 27% of the 753 million new mobile subscribers forecast to be added by 2020.
Ceragon already generates close to a third of its revenues from India, but I believe that the rollout of 5G will be the bigger driver of growth for the company over the next five years.
As the company's investor presentation (below) shows, Ceragon expects over 1 billion devices to be connected to the 5G network by 2025, covering over a third of all connected devices globally.
The slide below, which was sent my way by a contact at the "Toronto Student Investment Counsel" suggests that the backhaul market is expected to grow by 13% annually over the next four years, driven by investments in densifying backhaul networks to support the rollout of 5G.
The slide below (also from "TSIC") shows that all but one of the Tier 1 operators are scheduled to roll out 5G networks and all but one of those operators (Verizon (VZ)) happen to already be existing clients of Ceragon.
The table also cites a report from SNS Research estimating that 5G spending will account for 5% of telecom capex spending in 2020, but that the figure will grow to 40% by 2025.
Further driving the "5G theory" forward, the following comes from fellow Seeking Alpha contributor John Zhang, who wrote in "Ceragon Networks: Poised To Soar After Painful Industry Shake-Out",
Moreover, the upcoming transition to 5G-standard equipment should benefit Ceragon disproportionately relative to peers, particularly since their wireless backhaul platform has one of the fastest transmission rates, highest throughput and spectral efficiency among competing products. Hence, the anticipated 5G CapEx cycle ramp could enable significant margin expansion and out-sized profits.
I don't pretend to be an expert in Ceragon's technology - in fact, far from it.
But it seems as though the absolute value of spending on 5G investments over the coming decade could be the proverbial "tide that lifts all boats" - helping to provide a boost to Ceragon, but also padding the coffers of the communications equipment at large, and potentially paving the way for M&A activity.
Ceragon: Trying to Be "Everything to Everybody"
However, before I get into the specifics that lead me to believe that Ceragon makes for such a compelling takeover target, I want to address the shift that has taken place at the company in recent years.
Even a cursory review of Ceragon's financial performance will tell you right away that something of significance has happened over the past five-year period.
For example, in 2012, Ceragon had sales of $447M or 52% higher than the $294M recorded in 2016.
So, what happened?
Basically, five years ago, in 2012, Ceragon was trying to be "everything to everybody."
Back then, the company was bidding for contracts by offering "bundled" solutions to telecom providers that included a breadth of products and services intended to meet all, or many, of their wireless network needs.
In doing so, Ceragon found itself competing head-to-head against much larger competitors such as Huawei Technologies Co, L.M. Ericsson Telephone Company (ERIC), NEC Corporation, Nokia (NOK), and ZTE Corporation (OTCPK:ZTCOF).
These companies are broadly considered as "generalists" in the industry, meaning they do a little bit of everything.
In the years leading up to 2012, this "bundling" strategy had worked just fine, and Ceragon had doubled its sales over the previous five-year period.
But it was around 2012 that Ceragon's market began going through a "shakeout" that was largely spearheaded by Huawei, which began aggressively pursuing a price-cutting strategy to gain more market share - particularly in the low-to-mid value-add part of the market.
Ceragon's larger competitors like Ericsson, Nokia, etc. followed suit - because they could afford to.
Yet many smaller companies with weaker balance sheets simply couldn't withstand the accumulating losses, and the result has been that many of Ceragon's smaller competitors have left the market over the past five years.
Ceragon meanwhile racked up a loss of $184M between 2011 and 2014, issuing equity and borrowing on a revolving facility to make up the shortfall.
In order to survive, the company went through several restructuring initiatives which have ultimately been successful in reducing operating costs by $55M since 2012. And in doing so, restored the company to profitability, including a 7% operating margin in 2017.
Ceragon: Becoming a "Best in Class" Operator
Ceragon has been able to accomplish this transformation thanks to a strict focus on becoming what it refers to as a "best in breed" strategy (read: best in class).
Following the price war earlier in the decade, the company came to realize that it simply could not afford to compete with its larger, lower-cost competitors by continuing to offer "bundled" solutions in the market.
Instead, Ceragon now focuses its efforts on its core competency as a market leading wireless backhaul specialist.
In order to understand the advantages of Ceragon's "best in breed" strategy, it helps to have an understanding of how the bidding process typically works in the wireless backhaul market.
Essentially, the market for bids is split between two categories of customers:
- Network operators who view the wireless backhaul solution have a "commodity" and are content to bundle it with other solutions.
- Network operators who commit to investing the time and effort to select the best wireless backhaul solution that will meet their wireless backhaul needs, in terms of the ability to improve their business operational efficiency, services reliability and their customers' (subscribers') quality of experience.
In the sense that Ceragon offers a market leading or "best in class" product in the market, it makes sense that the company would concentrate its business on those customers that are willing to pay a premium price tag for the best offering (the former, of the two groups above).
The company summarizes this strategy in its February 2018 Investor Presentation:
While Ceragon's "best in breed" strategy has been critical to returning the company to growth and profitability - including 13% top line and 37% bottom line expansion in 2017 - it's also this best in breed strategy that leads me to believe the company could make for a great takeover target by one of the larger players in the market.
5 Reasons Why Ceragon Makes Sense as a Takeover Target
With the company's balance sheet back in order, including repayment of its credit facility in Q4, profitability restored, and a best-in-class product, there are five factors disclosed in Ceragon's most recent annual report that lead me to believe the company could very reasonably become a takeover target.
Particularly in light of Ceragon's small size - the company has a market capitalization of only $225 million and no debt - it wouldn't require much for the likes of a Huawei, Ericsson, etc. - all multi-billion dollar companies - to swoop in and take out Ceragon's shareholders.
The larger company would effectively be gaining two distinct advantages in acquiring Ceragon:
- Adding valuable competencies to its product line
- Removing a viable "niche" competitor in the process
#1. Consolidation in the telecommunications industry
In its annual report, Ceragon discloses:
The increasing trend towards mergers in the telecommunications industry has resulted in the consolidation of our potential customer base.
Source: Ceragon's 2016 Annual Report
While there are many reasons for consolidation within the telecom industry (namely, high fixed costs), the net effect on Ceragon and its competitors is that consolidation of its customer base gives telecoms better collective bargaining power when they submit requests for a proposal for wireless backhaul solutions.
This in turn leads to a natural response by the market:
#2. Consolidation within the communications equipment industry
If telecoms are consolidating and gaining bargaining power over the communications equipment providers, the natural response for the communications equipment market is to consolidate - if only to try and keep pace.
Also from Ceragon's 2016 Annual Report:
Current and potential competitors may make strategic moves such as mergers, acquisitions or establishing cooperative relationships among themselves or with third parties that may allow them to increase their market share and competitive position.
#3. Ceragon's competitors already are selling the company's products in the market today
When I read in Ceragon's annual report that "generalists resell Ceragon products as part of their own portfolio", I was more than a little taken aback.
While I can't be exactly certain which of Ceragon's products are and aren't being sold by its competitors, it suggests to me the following:
- The company already has a working relationship with some of its competitors (this could be expected to lead to M&A activity).
- Perhaps Ceragon's generalist competitors are testing the company's products in market - as a "proof of concept" strategy - before making a larger investment in the company.
#4. The competitive environment for Ceragon's technology will become more intense over time
In its annual report, the company discloses that it will on an ongoing basis have to deal with "increased downward price pressure."
Ceragon goes on to explain:
Particularly as we increase our customer base to include more Tier 1 customers … we may experience declining average sales prices for our products. Our future profitability will depend upon our ability to improve manufacturing efficiencies, to reduce costs of materials used in our products, and to continue to design to cost and introduce new lower-cost products and product enhancements.
Source: Ceragon's 2016 Annual Report
While this is certainly not welcome news, it does lead naturally to point #5 (below), suggesting to me at least, that there is an at least above-average chance that Ceragon could be acquired by a larger "generalist" competitor:
#5. Generalists are larger, with more resources and may use M&A to improve their competitive positions
No one is better positioned to deal with the threat of downward pricing pressures as outlined above in point #4, than a large, industry generalist with "longer operating history and greater financial, sales, service, marketing, distribution, technical, manufacturing and other resources."
These generalists have greater name recognition, a larger customer base, may be able to respond more quickly to changes in customer requirements and evolving industry standards, and have greater resources to invest in the development, promotion and sale of their products. Many of these generalists also have well-established relationships with our current and potential customers and have extensive knowledge of our target markets, which may possibly give them additional competitive advantages.
Source: Ceragon's 2016 Annual Report
Points No. 4 and No. 5 in combination suggest to me that while Ceragon has a strong position in the wireless backhaul market today, that position may prove less durable over time.
And while that doesn't mean the firm doesn't have real value, it does suggest that Ceragon's technology may eventually be worth more in the hands of a larger competitor who's in a better position to be able to "defend" it.
Effectively, this theory would make a Ceragon takeover a "win-win" for both parties - the best kind of deal.
I believe there are several factors that together help to make Ceragon a solid investment today:
Ceragon returned to profitability in 2015, reporting a nominal gain of $1M but followed that up with $11M profits in 2016 and was just shy of $16M in 2017.
The company is expected to bring in $0.23 of EPS in 2019 (+15% year/year) according to Yahoo and experience tells me that the market tends to like these kinds of stories.
Good value in the shares
Despite improving fundamentals, the market has been slow to take notice of this small-cap technology company.
Despite recent performance and forward-looking estimates that suggest above-market growth, the company trades at a below-market multiple, even after accounting for a size discount.
Two catalysts, or "growth drivers," acting as tailwinds
The amount of spending on 5G in absolute terms should help to provide a lift for the company over the medium term (3-5 years) meanwhile if it's true that "the upcoming transition to 5G-standard equipment should benefit Ceragon disproportionately relative to peers" that only serves to fuel the thesis.
Emerging markets also provide an opportunity for the company as wireless carriers there continue to build out their networks. However, this is "no free lunch" as emerging markets also carry with them additional risks related to regulation, market inefficiencies, and a relative lack of transparency.
An attractive takeover opportunity
While I'm not in the business of speculating on M&A activity, when something like this crosses my desk, it's almost too difficult to ignore.
Mind you - even without a takeover, Ceragon's shares still present good value at today's prices.
But particularly when I look at the consolidation taking place in adjacent markets and that a partnership between Ceragon and a larger suitor would seem to be a "win-win" scenario down the road - I tend to think this is a good bet to take.
Disclosure: We do not currently own shares in Ceragon. We will continue to monitor the company closely in hopes of finding a more advantageous entry point.
The above research does not constitute investment advice nor is it a recommendation to take action in any investment security.
You are encouraged to conduct your own research and due diligence before taking investment action, including a careful review of the risks associated with the security in question, an evaluation of the security for suitability within your own set of circumstances and consultation with a professional financial advisor if you have one.
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