- After years of heavy operating losses, DragonWave is seeing greater than 50% revenue growth with a cyclical upswing in 4G/LTE network spending.
- Besides a general upswing in the market, a new contract with telecom Reliance Jio coupled with improvements in the Nokia relationship should lift the stock further in 2014.
- With the stock down more than 90% the last 4 years and all expectations deflated, good execution in the coming months will likely make for a quick multi-bagger.
DragonWave (DRWI), founded in 2000, is a small-cap Canadian company in the telecommunications equipment industry. The company is listed both in Toronto (under ticker DWI) and on the NASDAQ. For prospective investors, both listings have sufficient liquidity to build a position.
When taking a first look at DragonWave, perhaps the first word that comes to mind is disappointment. To say that this company has had a rough go of it over the past several years would probably be an understatement. Like many companies which operate in the microwave backhaul market, DragonWave has gone through severe struggles as capex spending on LTE 4G network roll-outs has been slow recently. This coupled with several company-specific issues, including overreliance on a key customer (Clearwire) who stopped buying several years ago, caused a severe downturn in the company's prospects and revenues. With seemingly no end to the bloodshed and operating losses, most investors and professionals have given up hope on the company.
So what has changed to warrant another look now? It seems that after a long wait, shareholders may now be finally rewarded. DragonWave has just reached an inflection point in its revenue trajectory, and it is now beginning an upward trend which I believe could be the start of a big run. The company has already pre-announced that Q1 revenues (ended May 31st) will be about 60% higher than Q4. In addition a number of catalysts combined together should act as the perfect storm to jolt the company upward:
1. A new big deal has been signed with India's Reliance Jio for at least 5000 Horizon Compact + links to be purchased in 2014, starting in Q2.
2. Sprint, the owner of the Clearwire network that caused the previous boom and bust of DragonWave, was bought by SoftBank last year, and should begin a $16B 4G/LTE investment in earnest in 2014, largely improving on what Clearwire started.
3. The rest of the world is showing signs of a major capex spending cycle for 4G/LTE networks, including microwave products.
4. The Nokia partnership is finally starting to bear fruit, as Nokia is now free of its handset troubles.
5. On July 10th the company will announce Q1 results, which should be excellent and will bring more positive attention to the underfollowed stock.
Each of these catalysts I'll explain in more detail below. Putting them together, I believe the company already has enough revenue growth to turn it back to cash flow positive later in 2014, and this alone could turn this stock into a quick multi-bagger.
Summary of Recent Results
Before jumping into the numerous catalysts I see for the business going forward, first some background as to why DragonWave has fallen on such hard times, and found itself in such a precarious position.
One look at the revenue trajectory and cash on the balance sheet shows it's not a pretty sight, as the company has been burning cash like there's no tomorrow for about 3 years. Revenues have declined precipitously, and meanwhile the highly competitive R&D intensive telecom equipment industry always demands spending on technology. This combined with low gross margins in the hardware business have been a recipe for disastrous results.
(click to enlarge)
This problem has been further exacerbated by a few company-specific issues that caused real problems for DragonWave. For starters, up until 2010 the company had experienced rapid growth due to a large 4G network roll-out by Clearwire, which is now part of SoftBank / Sprint (S) in the US. Clearwire had chosen DragonWave as one of its primary vendors for Microwave technology, and as it ramped up capex spending in the mid to late 2000s, this was a boon for DragonWave.
The problem was that the demand grew so rapidly that DragonWave couldn't diversify its customer base fast enough, and what ensued was a dangerously heavy reliance on Clearwire as a customer - 80% of sales by 2010. Unfortunately for DragonWave this came crashing down in early 2010 after Clearwire abruptly halted their network roll-out. Revenues dried up in a hurry, and the stock which peaked at over $14.50/share began to fall rapidly. By January 2011 it was down to $8, January 2012 under $4, and today it sits at a measly $1.46.
After the Clearwire issues began, company management tried desperately to diversify the customer base, but as the general industry has experienced a cyclical downturn in the last couple of years, new big customer wins have been few and far between. In late 2011 the company decided to make a big strategic shift to try and change this, as management signed a deal to purchase the microwave transport business of NSN (Nokia Siemens Network), which is now solely owned by Nokia (NOK). The idea with this deal was that DragonWave would supply the R&D and product expertise for wireless microwave as an exclusive provider, and Nokia would supply the sales expertise and distribution network. End customers would still deal with Nokia directly. At the time this seemed promising, as it would allow the micro-cap company DragonWave to leverage the huge sales network of global giant Nokia, which is still a $28B company with an enormous reach in the telecom industry.
However, the past few years have gone much slower than envisioned. This was due to a number of factors, including for example: bad timing with the downturn in the industry, some internal issues within Nokia due to labor unrest in the Italian operations, and the general restructuring of the entire Nokia business after its major issues with smartphones. In addition, gross margins on indirect sales through the Nokia channel are much lower, and as this became more than 50% of revenues in recent quarters it caused a big drag on overall DragonWave margins.
It should also be noted that some investors do fault DragonWave's management for poor decision making and for responding too slow to changes in the business. CEO Peter Allen and other top executives have all been at the company since the mid 2000s, well before the downturn occurred. Although I'm sure they have made their fair share of mistakes, I don't believe they should be faulted completely for the mess that has occurred. In the face of criticism management has halted the upward march of operating expenses, and since early 2013 they succeeded in reducing annual expenses from over $80m down to $52m, a reduction of 35%. One look at some major competitors, such as Aviat Networks (AVNW) and Ceragon Networks (CRNT), shows these companies also struggled with revenue declines and operating losses recently. One competitor, Alvarion, even went bankrupt in 2013.
Amidst these many headwinds, DragonWave hasn't been able to stop the downward spiral until now. This, however, is now changing in a big way, as numerous catalysts are coming together in 2014. Let's now go through each of them.
Catalyst #1: Deal with India's Reliance Jio Infocomm Will Propel 2014 Revenues Higher
Starting already 2 years ago, India's richest man Mukesh Ambani announcedplans for a $10B 4G network at Reliance Jio, one of the largest telecoms in the country. Like any investments in 4G/LTE, this has been slow to develop until just recently. In just the past month, Reliance has publicly announced that they will offer 4G services starting in 2015. In support of this the company will need to use microwave to support the roll-out and will be doing their previously announced major infrastructure expansion in 2014, which should prove to be a major catalyst for DragonWave. It was already made public that Reliance has chosen DragonWave and competitor Ceragon Networks to be the main suppliers for microwave products, signing a framework agreement about 1 month ago. DragonWave will initially supply 5000 of its Horizon Compact+ links, and over the coming year could receive orders for a lot more. On the day this was announced DragonWave's stock saw a 16% increase, and it can be expected to see much more than this near-term increase as this move will likely push the start of a new major wave of CapEx spending on 4G/LTE as competitors will follow suit.
To put this into context, recently there was a $9B spending spree in India on new spectrum by several of India's major telecoms. With Reliance Jio now publicly announcing their push forward on 4G, we can bet that the others will not want to be left behind. There is generally a bit of "monkey see monkey do" response in this industry, as once a major market player decides to ramp up infrastructure spending the others quickly follow in order to ensure they stay competitive. DragonWave management has stated recently that they have "never been involved in as many bids and trials" as they are in India at the moment, and the company has even opened a service and repair center in Delhi as a result. With an initial 5000 units being sold as part of this deal and likely many more to follow, look for this deal alone to keep revenues in the back half of 2014 in Q2 and Q3 at the heightened levels already announced for Q1 (60% over Q4, $28m+). This puts the company on track for yearly revenues over $115m, nearly 30% higher than last year. Even better, other major investments projects around the world could contribute even more, as I'll describe below.
Catalyst #2: Sprint has now been bought by SoftBank who should finally begin the bulk of their $16B 4G/LTE investment
DragonWave is expecting that the purchase of Sprint by SoftBank is finally about to bear fruit in terms of plans to finish what Clearwire started several years ago. Softbank has signaled its intent to spend $16B on the 4G LTE networks of Sprint to make it a more serious competitor to Verizon (VZ) and AT&T (T). Sprint already is spending about $8B in 2014 alone, but to date most of this investment has come on its other 2 spectrums, and not the one they acquired from Clearwire. Sprint controls 3 major spectrums, including 1.9GHZ, 800MHZ, and 2.5GHZ. The latter they acquired from Clearwire. As of mid 2014 according to the company's annual report, they are largely complete with the 4G LTE roll-out on the 1.9GHZ, and they have plans to further expand it on the other two. Specifically related to the 2.5GHZ, the company has stated recently that they plan to expand 4G LTE on 4600 more legacy Clearwire cell towers. A few years ago Clearwire had already completed this on 5400 towers, using DragonWave as their preferred supplier for Microwave backhaul technology. This initial roll-out brought about $175m in revenue to DragonWave in only a few short years. At roughly the same rate, DragonWave could see another $150m in the coming 3 years if Sprint starts to purchase their microwave products again.
Further evidence of this kick-starting is that recently there have been some management changes at Sprint, and it appears the company is finally ready to start pushing this investment later in 2014. Steve Elfman, the architect of Sprint's network vision plan is gone, as well as the VP of Networks Bob Azzi, as presumably the new top brass from SoftBank has pushed for changes in order to improve execution. DragonWave CEO Peter Allen also expressed his optimism, that they are expecting this build-out to continue in earnest in the 2nd half of 2014. Due to interoperability and general compatibility with new products, it will make sense that DragonWave product lines play a big part in the renewed expansion plans. Also it should be noted that the former CTO of Clearwire, John Saw is now fully in charge of the implementation and construction of the network roll-out at Sprint. His familiarity with DragonWave should be a plus for the company. I think now is the time we'll see increases in equipment spending accelerate as Sprint management is pressured to play catch-up with its US competitors who are largely seen as more advanced in their 4G networks.
Catalyst #3: Rest of World Showing Signs of a Major CapEx Spending Cycle
Independent of the Reliance Jio deal, and potential pick-up from Sprint, DragonWave already had announced in their last conference call in May that their Q1 revenues would increase by 50%+ over Q4, as they are seeing robust demand in a number of key markets. A summary of positive shifts include:
- Both direct sales and Nokia channels sales are growing rapidly, signaling broad-based demand
- Strong Asian demand including China, which is shifting policy and moving for a major 4G expansion. Also big deployments are being made at 2 carriers in Indonesia
- Major spectrum auction in India for $9B is propelling billions of dollars on infrastructure spending, not only from Reliance Jio but also from Vodafone, Bharti, and Idea
- After divesting its Verizon stake for $130B, Vodafone is beginning a huge $32B "Project Spring" investment across Europe to bolster its 4G capabilities and upgrade its 2G and 3G networks.
- Middle East and Africa also showing increases in spending from regional operators
Spending trends on telecom equipment are always lumpy and often come in big spurts. Longer term in the next 5 years, the growth of spending on carrier Ethernet equipment is actually only seen at a CAGR of about 3%, according to Infonetics Research, as can be seen in the chart below. But what always occurs is that there are large cyclical infrastructure roll-outs which propel spending into double-digit growth for short periods, and then decline in other years. Looking at the trend shift in sales that DragonWave is seeing from Q4 to Q1, it clearly looks like a new uptrend has started.
Also competitors Aviat and Ceragon both indicated improving sales in 2014 in their conference calls last month, also implying double-digit quarter-over-quarter revenue growth.
(click to enlarge)
Catalyst #4: Nokia Relationship Ready to Start Bearing Fruit
In April 2014, Nokia announced the promotion of Rajeev Suri to the CEO position. This is quite significant, as Suri was previously a head of the Nokia networks unit (formerly NSN) having worked his way up for over 20 years in that business. Clearly the company now has a renewed focus on expanding its telecom networking business, as this now makes up the majority of revenues and should indicate a drastic shift in priority. This should be very good for DragonWave, as Nokia - which is in charge of sales for their joint relationship - is going to be investing significantly more than before on growing their customer base. It should be remembered that when DragonWave first signed the deal with Nokia in 2011, the company was in the midst of its smartphone battle and was reporting huge losses, job cuts, and lots of restructuring plans. Although Nokia Networks was always doing much better as a business than the handset unit, clearly the entire company focus including that of CEO Elop was on how to fix their fall from grace as the premium phone supplier. Now that this business has been sold to Microsoft (MSFT), Elop is gone, and Nokia has received a large cash infusion, it now has several billion to spend on investments for its networks business.
Looking specifically at the DragonWave - Nokia relationship, sales should really be set to accelerate for these reasons:
- According to leaked documents from Nokia top management, the company sees a $95B market opportunity in mobile broadband, and it will focus much of its new cash in gaining market share and becoming a specialist in this market by 2016. This will improve sales for microwave products as well, benefiting DragonWave.
- Nokia is working with the big China mobile operators in their extensive 4G-LTE roll-out. China is directly spending 160 RMB ($26B) on LTE networkexpansion in the coming 2 years. CEO Allen already indicated strong demand is developing in China.
- After the initial integration period with Dragonwave for almost 2 years is now complete and growing pains are worked out, the microwave strategy should be well aligned amongst sales teams in Nokia post restructuring and will now lead to more wins.
Catalyst #5: Company Poised to Beat Analyst Estimates with Q1 Results on July 10th
Using traditional multiplier or cash flow models with DragonWave is tricky, based on its operating losses and lack of positive cash flow for some time.
Although there is a lot of visibility on Q1 results already, I still expect this to be a catalyst for further gains as the positive news should help the stock to get recognized again. I also think that analysts haven't fully factored in revenue growth yet, so the company is definitely on track to beat on the top line, and possibly also on the bottom as well.
Based on recent commentary from management and sales trends we are seeing, I've given my estimates below for Q1 2015 and the full year:
Q4 2014
|
Q1 2015E
|
FY 2014
|
FY 2015E
| |
Revenues
|
$17.8m
|
$28.5m
|
$90m
|
$140m
|
COGS
|
$15.2m
|
$23.4m
|
$79.3m
|
$109.2m
|
Gross Margin
|
14.5%
|
18%
|
11.7%
|
22%
|
SG&A
|
$6.8m
|
$6.9m
|
$30.2m
|
$29m
|
R&D
|
$4.8m
|
$4.9m
|
$19.9m
|
$19.5m
|
Loss before amortization of intangibles and other items
|
($9.2m)
|
($6.7m)
|
($39.5m)
|
($17.7m)
|
Net Income
|
($11.4m)
|
($8.2m)
|
($34.3m)
|
($20m)
|
Net Income per Share
(Diluted)
|
(0.20)
|
(0.14)
|
(0.83)
|
(0.36)
|
Although the company has already publicly mentioned 60% revenue growth from Q4, average analyst estimates are for only about 50% growth, indicating that revenue estimates have not been factored up. So barring no change between now and July 10th, I expect the company to definitely beat on the top line, and as a result of fairly static expenses from Q4 the company can be expected to meet or beat bottom line estimates by a small margin. In its last conference call the company CFO confirmed that the company was near a steady-state on operating expenses in the $12-$12.5m range per quarter, with only a slight uptick expected in the event of significant growth. They were actually below this level in Q4, and I have estimated just under $12m for Q1 with a slight increase expected in the second half of the year, keeping this line more or less static. Management I believe will be quite conservative here before increasing expenses again, as they are still licking the wounds from the past few years.
On the revenue side, in my forecast I have assumed that the top line will stay above the heightened level starting in Q1 with some additional growth expected in the second half of FY2015, because this is when I would expect the combination of capex spending from Reliance Jio and Sprint to really start to boost the company. For the year I still forecast that operating margin will be negative, however the majority of cash flow losses would occur in the first 3 quarters ($6 or $7m expected in Q1 alone), and by end of 2014 I think the company can be close to cash flow breakeven. In order to accomplish this, the first step is that the company will first achieve a bit more leverage on gross margin expansion, as they should reach their target 20-25% range based on favorable cost reductions from contract manufacturers combined with higher direct channel sales driven by Reliance Jio. In addition based on historical norms, approximately one-third of the loss from operations we can expect to be standard non-cash items. With my forecasted net income expected to be -$20m for the year, the actual negative cash flow I forecast to be less than -$15m, with almost half of that coming in Q1. Q2 and Q3 will therefore see much smaller cash burn, with Q4 the expected breakeven point.
So one pertinent question then is where does this put the company in terms of valuation and stock price? Well the last time the company had earnings and revenue of this level, the stock was over $10/share!
While I don't expect that within 1 year from now the stock will be a 5-bagger, as margins are now much lower and the balance sheet much weaker, this illustrates how far and fast a small cap stock like this one can shoot up if a sustained upswing in the revenue cycle does take hold. My realistic expectations are that the stock should return back to the $3 range, or double the current price, which seems very reasonable considering the expected earnings in Q1 2015 should be more than 50% better than 1 year ago (loss of 14 cents vs. loss of 31 cents), and at that point the stock traded near $3. At this point in time a year ago the company had just reported very low gross margins of only 5%, as well as difficulties it was having in its Nokia business. It announced some forecasted improvements in liquidity at the time, lower operating expenses plus gross margin improvements and within a few months the stock was up to over $3. All of this when the company was hesitant to give any revenue predictions, as clearly there was a lot of business uncertainty. This is in stark constrast to this year, where they have enthusiastically announced the expected 60% growth in revenues for Q1. I think once the market wakes up to this fact, the stock will rebound in a hurry.
Now due to the balance sheet and financing uncertainty, the stock does deserve to be discounted for sure, so I don't expect the stock would trade much higher than $3 until they can show sustained positive cash flow from operations. This will require a combination of further cost optimization with manufacturing as well as a much higher mix of direct sales. Sales from the indirect Nokia channel are only about half the gross margin.
Other Positives - Strong on R&D, Extension of Credit Facility through 2016
DragonWave has retained a strong R&D function which by all accounts has produced a very competitive set of microwave products. Technology wise the company continues to innovate in the face of operational difficulties. For example on June 17th the company announced that 2 of its products, the Horizon Quantum and the Horizon Compact+, were the first devices of their kind to receive FIPS certification for cryptography, both of which offer technology that no other certified competitor products can offer in the critical communications market (e.g. dual channel capability for the Horizon Quantum). The critical infrastructure including secure communication markets are growing at more than 10% per annum according to market research reports.
DragonWave is also now well positioned with a complete end-to-end networking solution, as previously its focus was solely on packet radio equipment that it used as part of the Clearwire 4G/LTE expansion. More and more carriers want complete solutions, and now that DragonWave's has worked through the growing pains of its integration with Nokia, it should be ready to capitalize on its much more complete product portfolio, nicely summarized below:
(click to enlarge)
The company acquired the Harmony products (green above) from Nokia, which combined with the Horizon packet microwave products (red), this gives much more complete coverage and allows the company to better compete with the likes of Ericsson (ERIC) or Alcatel-Lucent (ALU). The company also has the Avenue products for small cell (yellow above), which should be a promising growth area in the next 5 years. DragonWave has one of the most complete set of products for small cell.
Another positive to take note of is the company's recent increase of its credit facility from $20m to $40m as negotiated with Comerica Bank and Export Development Canada a few months ago. This facility is also extend until June 2016. This signals that the banks were confident in the business plan they saw, with results improving quickly in Q1. This is especially true as they forgave 1 covenant that was breached and agreed to add another 2 years to the revolver. This together with the improving business should lower the near-term risk that the company tries to raise more capital.
A Great Opportunity, But Not Without Risks
While I am bullish on the turnaround prospects for this company, it should be made very clear that an investment in DragonWave is a high-risk high-reward scenario. If revenue growth continues to shoot up in 2014 as all signs show it has the potential to do, then the stock will likely at least double by the end of the year, as the company should achieve sufficient scale to breakeven on cash flow from operations.
However the big concern near term is on the company's balance sheet. As of last check there was only about $19m remaining in cash. With quarterly operating losses and cash burn expected to be as much as $7m again in Q1, the company begins to get dangerously close to the $10m threshold. Although the banks agreed to extend the credit facility for another 2 years, there continues to exist a covenant that the company must maintain $10m in short-term assets deposited at one of the banks. However I think the uptick in revenues and receivables will help significantly to mitigate this risk. As of the last quarterly results they had drawn down $15m of this facility, so they still have $25m available for use, and with the already pre-announced expansion of revenues and subsequently trade receivables growth they should be able to tap further into the credit facility and keep cash burn to a minimum. (The $15m already drawn is shown as long term debt on the balance sheet, and annual interest rates are reasonable at about 6% currently).
Nevertheless this is an important risk to be aware of as there is not a lot of room for error. If they have any further delays in revenue growth or any setbacks in margin improvement, this means that essentially the only option will probably be to again go to the capital markets to generate equity financing and cause shareholder dilution. Although management seemed confident that they have enough near term flexibility with the 2-year extension on their credit facility, I would still rate the risk of near-term equity financing as medium. The company did already sell more shares recently in 2013 where they raised about $23m, which increased share count almost 50%, so for sure they will look to avoid doing this again in 2014 if at all possible, but any hiccup in their growth plans might leave the company without any other options.
The Bottom Line
With the microwave backhaul market looking positive and some big capex spending appearing to be on the way, look for DragonWave to ride the "wave" upwards in the next 6 months. A reiteration of the positive developments in their upcoming conference call on July 10th should help to jumpstart the stock and begin the long journey of bringing the company back into favor on Wall Street.
Now while reading this one might ask why bet on DragonWave, and not other competitors such as Aviat Networks or Ceragon Networks, as these companies are seemingly in a somewhat better financial position? There are also other upstarts in the microwave backhaul market which have very promising long-term prospects, for example Ubiquiti Networks (UBNT) and its relatively new AirFiber line. My answer to this is that while I believe perhaps all of these companies will likely benefit from a cyclical uptrend, DragonWave seems best positioned for the biggest bounce near term, as the company has made no secret about their 60%+ growth in Q1, as well as the expected windfall from the Reliance Jio contract. This combined with the potential new business from Sprint and Nokia, and I think DragonWave is likely to see the most price appreciation in its stock.
While maybe not for the faint of heart, I believe the stock is an excellent out of the box investment with the definite potential to be the big winner of the year in a small-cap tech portfolio
By Mathew Dow
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