Allot Communications And Deep Packet Inspection

| About: Allot Communications (ALLT)
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The proliferation of data on broadband networks from the emergence of social media, P2P and VoIP puts a tremendous strain on telecom infrastructure. Throw into the mix cloud applications being served up by companies like (NYSE:CRM) and AthenaHealth (NASDAQ:ATHN), you come to understand we are in an era of massive mobile and broadband transformation. Add the embryonic Chinese market into the picture, and the pie gets even larger. In fact, China has 988 million mobile users, many who will be upgrading to smartphones and tablets as their standard of living grows.

An average smartphone user generates multiple times the data traffic as the owner of a plain vanilla cell phone. Because of this, there will be an enormous opportunity for telecom software and gear providers like Allot Communications (NASDAQ:ALLT) which specialize in Deep Packet Inspection (DPI). To paraphrase their annual report, "Deep Packet Inspection is basically an intelligent bandwidth management solution that transforms broadband pipes into smart networks. Traditional network infrastructure devices, such as routers and switches, do not have sufficient computing resources or the required algorithms to distinguish between different rapidly evolving applications. DPI works in tandem with already installed equipment.".

A recent Investor's Business Daily article sheds more light on the subject: "Allot relies on its proprietary DART system - Dynamic Actionable Recognition Technology ... DART is a traffic-inspection system. It sorts the innocent from the malevolent and routes the traffic to the right destination in the most-efficient way. DART also tracks data usage by subscriber. DART helps address the issue of data hogs, those few that soak up a disproportionate share of available bandwidth. This helps ISPs provide the service that everyone needs, perhaps by charging the hogs (mostly peer-to-peer users) for their unusually high usage."

To highlight just how much wireless broadband is growing, we can look no further than the semi-annual Allot Communications' MobileTrends Report H2, 2011. This shows there was explosive growth in the wireless sector from July through December of last year, and foreshadows more growth to come:

  • Mobile broadband traffic grew by 83% in the second half of the year with a CAGR of 234% during 2011.
  • VoIP & IM traffic grew by 114%, perhaps substantiating recent reports on SMS and international voice calls decline.
  • Video Streaming traffic continues to dominate mobile broadband, with a share of 42% of total bandwidth.
  • Android Market traffic grew by a phenomenal 232%, almost four times faster than the Apple App Store, increasing its momentum to become a true Apple App Store rival.
  • YouTube now accounts for 24% of the total broadband traffic; 14% of total YouTube traffic is high-definition.
  • WhatsApp now accounts for 18% of the IM total bandwidth, a dramatic increase in popularity from only 3% in H1, 2011.
  • Facebook messenger is an all-time 'killer app' on mobile; rising from zero to 22% of total IM traffic in just four months.

Because of the market potential in DPI, there is a firestorm brewing with Allot's competitors. Their principal rivals are Cisco (NASDAQ:CSCO) (through the acquisitions of P-Cube and Starent Networks) and Sandvine (OTCPK:SNVNF) in the service provider market, and Blue Coat Systems (NASDAQ:BCSI) (through its acquisition of Packeteer) in the enterprise market. They also compete with a number of smaller competitors such as CloudShield Technologies and Procera Networks (NYSEMKT:PKT).

You don't have to live in Silicon Valley to surmise that Cisco is the 800 pound gorilla in this space, but they are a large company. Investors in Cisco may get price appreciation (and a small dividend) by owning the equity, but my belief is that you may make more money in pure-plays like Allot. In fact, the stock has increased from $4/share in 2010 to its current valuation of $18/share. During that same time period, Cisco has lost share value by about 20%. Smaller companies are nipping at Cisco's heels and taking market share in various sub-sectors in telecom infrastructure. An example is Aruba Networks (NASDAQ:ARUN) in Wireless Local Area Networks.

Allot is a globally positioned organization and as last reported, they derived 60% of their revenues from Europe, the Middle East and Africa; 22% from Asia and Oceana and 18% from the Americas.

There are many red flags for a small company like Allot. They have a beta of 2.29 and, if the market corrects, the stock will fall harder. In addition, they trade only about 350,000 share on an average day. Until last year, Allot hadn't been profitable in years, but that is typical with a young growth company. Just take a look at Nuance Communications (NASDAQ:NUAN) and their decade in the red from 2001-2010. One client also accounts for 30% of sales.

The Investor's Business Daily article also cautions: "Be aware that $22 million in sales makes Allot a tiny company, as does its $454 million capitalization." However, the company has also reported triple-digit earnings growth for five straight quarters and sales growth has also averaged 39% in that time range. Allot Communications only made $.26/share the past 12 months and with a price of $18, we get a P/E ratio of 69. Expensive, but if they continue to cook on all four burners, that ratio will come down as Allot increases their bottom line.

Investing in a moneymaking machine isn't that common if you are screening the S&P 500. For every Apple (NASDAQ:AAPL), there are about 499 other stocks that may give you a hefty paycheck by doubling or tripling over a five year period (which is a great return), but not be considered a winning lottery ticket. To get the really incredible gains, you usually have to take your chance on young companies to put you in the winner's circle. Allot Communications could be one such company, but I wouldn't buy it at this level. The market has come too far, too fast and is need of backing and filling. You may feel differently.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.