Aviat's Acquisition Of Redline Is A Positive For The Bottom Line
- Aviat Networks has made a proposal to acquire Redline Communications, a Canadian wireless company that specializes in virtual fiber.
- The acquisition not only provides the U.S. company with an end-to-end solution in a rapidly growing industry but is also accretive to its gross margins.
- There is more in terms of marketing and cost synergies after the deal gets done by August and the management executes.
- On the other hand, there could be short-term pains when third-quarter financial results are announced on May 4 due to supply chain concerns and higher inflation.
- Over the longer term, Aviat is a buy and can deliver a potential upside of 18% based on its lower valuations.
I provided insights as to how Aviat Networks (NASDAQ:AVNW) is transforming into a Wireless-as-a-Service model back in July last year. The U.S. company's proposal to acquire Redline Communications (RDLCF) in April this year seems to have been made in response to current macroeconomic conditions where high inflation is resulting in escalating staff recruitment and a constrained supply chain is leading to higher component costs.
As shown in the chart below, investors rewarded Redline with a 25% upside as the company's share price rose from $0.49 to the current $0.68-$0.70 range, which is approximately equal to the $0.71 per share to be paid by Aviat in an all-cash transaction.
As for Aviat, its stock followed the acquirers' classic downwards path and is currently trading for about $31.25. The aim of this thesis is to show that the company deserves better and I start by providing insights as to the reasons Redline constitutes a suitable buy.
Redline is a major provider of wireless communication services which enable people to connect to each other as well as monitor distant assets from a central location. Its products like the RDL-3000 XP edge provides secured wireless connectivity in harsh terrains and extreme temperature ranges where military and oil companies operate. Requirements are also for reliability across long distances for personnel who have to be constantly moving from one place to another in a nomadic style.
In addition to government and oil and gas (O&G), there are also other industry verticals like mining which use Redline's gear. Furthermore, its products are also used by mobile service providers looking to develop their enterprise business.
The company has made a name for itself in Virtual fiber (VF). This technology allows for high-speed networks to be set up at remote locations without the need for digging trenches and laying down physical fiber. Instead, a Redline base station installed atop a tower mast can rapidly establish connectivity with drilling rigs for both voice and data communication using the point to multipoint protocol. The VF can also be used to transfer video surveillance as well as IoT sensor data to the corporate data center thousands of miles away.
Going a step further, Redline's solutions also enable teams that are constantly on the move to seamlessly communicate in regions deprived of cellular mobile coverage. For investors, VF can be envisioned as extending the private network of big oil companies whose activities span across large remote locations.
Now, it is precisely strength in private networks for O&G, an industry that is witnessing huge investments like oil and natural gas companies throughout the world expand drilling activities which is one of the main factors which motivated Aviat to make an acquisition proposal. The latter can now expand its market share in private networks, wireless point-to-point solutions as well as projects around 4G LTE and 5G.
Acquisition synergies for Aviat
More importantly, especially with regard to rising interest rates resulting in higher borrowing costs and shifting investors' attention toward more value stocks, the acquisition should engender more profitable growth for Redline's product range as part of a combined entity. The company currently does not deliver operating profits as it spends a lot on sales and administrative costs. Thus, SG&A represented more than 50% of its revenues during the last three quarters. Along the same lines, it also spent nearly a quarter of its revenues on research in 2021. This is the reason its EBITDA margin is negative as shown in the table below.
Thinking aloud, high sales and research spending normally point to strong competition, and in the case of Redline, there are the likes of Cambium Networks (CMBM) and Proxim Wireless (OTC:PRXM), and others.
Coming to acquisition synergies, an eventual deal should be immediately revenue accretive for Aviat considering that the Canadian play generated $19.5 million of total sales in 2021, but there is much more when considering the bottom line.
In this respect, with sales of nearly fifteen more times than Redline in 2021, Aviat whose annual revenue in 2021 was $289 million has more scale. Furthermore, the U.S. company spent $56 million just on SG&A which includes marketing expenses last year compared to only $3 million for the Canadian company. Therefore, Aviat stands to benefit from marketing synergies as it optimizes marketing spending while at the same time, its sales teams now have a wider portfolio of products to propose to customers.
Looking from the technology acquisition perspective, the benefits for Aviat are significant considering that if the development had to be organically carried out through its own R&D team, this would not only have taken years but also cost more due to a tighter job market, especially for IT skills.
Another noteworthy point is that compared to peers, Redline's gross margins are the highest at 59.7%. This level was reached for the fiscal year 2021, after trending higher since 2018. Interestingly, the Canadian company's margins are even higher compared to Aviat's by more than 23% as shown in the table above, which signifies that it has considerably improved production efficiency despite the fact that it disposes of a relatively lower revenue base on which to spread its fixed costs.
Valuations and key takeaways
Looking ahead, there should be economies of scale as the combined entity purchases higher volumes of semiconductors and other electronic components to manufacture communication gear.
This ultimately means more cost synergies and for this purpose, the arrangement agreement drafted by Aviat specifically mentions that the deal is expected to be "immediately accretive to its gross margin, EBITDA, non-GAAP EPS, and free cash flow". Now, given that Aviat generates 15 times more sales than Redline, it's 59.7% gross margins could contribute as much as 4% (59.7/15) to Aviat's fiscal 2023 income as the transaction should close by August. I mention 2023 as the company's fiscal year 2022 ends in June this year.
On top of that, there are marketing and cost synergies that can further add to EBITDA margins which were 10.7% in 2021. Thus, I consider that the Aviat-Redline combination should result in future earnings gains, which signifies that Aviat's forward P/E of 11.5x is on the low side. Moreover, a look at valuations as per the table below reveals that these are lower relative to the IT sector by more than 18%. Consequently, the stock can potentially climb back to the $36-$37 range, which it last reached in September last year.
Moreover, with $42.3 million of cash on the balance sheet as of the end of last year, the $12.9 million acquisition is expected to be paid for without contracting debt. For this matter, Aviat only had $3.5 million of debt during the last reported quarter. Tellingly, debt is a key metric to consider in a rising interest environment and Aviat's debt-to-equity ratio of 1.82% is very low compared to peers.
Pursuing further, I am bullish on the stock as with the Redline acquisition it now has an end-to-end offering for wireless, especially in the fast-growing O&G industry as stakeholders try to diversify supply chains away from Russia. For this purpose, integrated product offerings as a result of the acquisition are synonymous with more profitable growth.
However, there could be some short-term pains when third-quarter 2022 financial results are announced on May 4 due to potential supply chain interruptions, which according to the executives were supposed to start moderating only between April and June. The company had also modified its product design earlier on to exclude problematic suppliers but remains susceptible to the risk of last-minute shipment cancellations. Also, higher labor costs could impact earnings.
Finally, Aviat, which has been selected by Dish Network (NASDAQ:DISH) as a key supplier of 5G microwave transport, is a buy as the acquisition opens new avenues for growth together with the prospect of increasing profitability. As for Redline, I have a hold position since its stock has already risen by about 25% since the potential acquirer revealed its intent.
This article was written by
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