Summary
Ubiquiti has almost all the ingredients of a "perfect" growth stock.
Ubiquiti has a young, smart and energetic owner operator along with a new business model that is enabled by the internet era.
Its explosive growth in the past deserves attention and careful case study from serious investors.
A potential short squeeze could be forming up, setting up another explosive on the technical side.
How Can We Find The Next "Perfect" Growth Stock?
Although I am a value investor, I certainly understand the power of a "perfect" growth stock, something that can become a 10-bagger or 100-bagger, something like Wal-Mart (NYSE:WMT), Microsoft (NASDAQ:MSFT), or Berkshire Hathaway (NYSE:BRK.B) (BRK.B).
Well, Berkshire is more like an investment company, not a single business, but it was a growth stock in its own type. What about the others? Certainly, the rewards are so huge that everyone would be going after them, but is it possible to recognize them when they are still fairly small?
To answer this question, it is natural to look at what these perfect growth stocks have in common. I believe they tend to have two things in common:
- They all have a good manager, someone who is smart, energetic and have a focus on what they are good at. These managers also have a focus on long-term fundamentals. In other words, they tend to have "a lion's ambition" and a focus far beyond the next quarter or the next year's earnings. They also stay with something they feel that they have an edge, and don't just enter a new territory easily.
- These businesses also tend to have a good business model to enable them to grow and fend off competition. In the case of Wal-Mart, it is the efficient operations and scale advantages (negotiating power with suppliers, and economies of scale to further reduce costs). For Microsoft, it is scale economies (small companies can't afford to develop an operating system) and network effect (the network effects among operating systems, apps and users).
Of course, to enjoy the tremendous growth, we must also make sure that we can find these businesses when they are still fairly small. Otherwise, the growth potential will be limited.
The Explosive Growth Of Ubiquiti
What first brought my interest to Ubiquiti (NASDAQ:UBNT) was the fact that it didn't take any external operating capital investment to grow to a size of more than one billion market cap, and that was done within 6 years.
I would say this is pretty rare, and deserves a careful case study from any serious fundamental investor.
What is the chance of any famous business man to borrow $10k from credit cards, start a small business, and turn it to a billion dollar business in 6 years? This type of explosive growth is certainly not easy, otherwise, there would be too many billionaires.
So what exactly happened? At the beginning, UBNT's CEO Robert Pera started to design his own network hardware and sold them at a big discount (which he can afford since he doesn't have much operating or marketing cost at all). What became interesting was that once the quality and price reached a certain tipping point, it suddenly created a new market: a WISP market that can allow almost anyone to setup a wireless network without much upfront investment.
Before UBNT's airmax, wireless network equipment was dominated by the types like Cambium and the equipment can cost thousands of dollars. Not only individuals could afford those expensive equipment, and even businesses could not do much with them on a huge scale, since it may not be economical comparing to the monthly subscription fees they can collect from the customers. With the first few generations of airmax, its speed had tripled and price was only a small fraction of what it used to be. This allowed many individuals in the rural areas to start to build their own networks for family use, and later expanded it into a WISP business.
In Pera's words, UBNT was not looking to take market share from the big players; instead, it created a new market. This new market is a niche market which didn't get attention from the big players (they might think it is too small for any product with big volume). On the other hand, this wouldn't be possible if UBNT didn't have an amazing business model to reduce the cost to minimum.
Almost every investor is well aware of the damage of dot-com bubble in 1999, and the fallacy of the promises of a new economy brought by internet. However, in my opinion, it is not entirely wrong to claim that the internet would bring us a new economy, just not that fast and not in the ways people used to think (you can't just make tons of money from some eyeballs on just any web page).
For example, there are many new business models that weren't possible before the internet era, but they are possible now. In UBNT's case, without internet, it had to go through the traditional business model: spend large amount on marketing and sales, and sell its equipment in regular retail channels. All these things increase the cost of business. With these increased costs and corresponding capital needs, not only it limits the potential of reaching the tipping point of creating a new market, but it also might kill a great business in its infancy. In other words, how could Pera get that much capital to start with?
It might be a good thing that Pera didn't attend any business school, because in this way, he didn't get much influence from those existing traditional business models. By cutting off any "unnecessary" business expense, such as marketing, sales or even technical support, he was able to reduce the cost to minimum, focus on R&D, beat his competitors and even create a completely new market. He also utilized community forums to get feedback of the product and let the community to act as his sales people, or provide some technical support. In my opinion, this is an extension of the "crowdsource" business model.
Pera mentioned in his blogs that Xiaomi, Tesla (NASDAQ:TSLA) and Ubiquiti will be the three businesses that would benefit from the "information transparency" brought by the internet era. I have studied Xiaomi's business strategies and found it really fascinating. Although it didn't have enough resource to develop an operating system (like Apple) to enjoy the network effects, it started to build mobile apps in order to have a user base to leverage from, before it enters the mobile hardware business. It also used online flash sales to completely skip the retail channels in its early years which both saved the retail cost and reduced the need of working capital. Like UBNT, it also relies on its community to get feedback, release weekly software upgrades, and save on marketing/sales/tech-support costs.
In my opinion, these new business models can bring potential new disruptors into many traditional or high tech industries, and it is critical for growth investors to recognize the power of these business models.
The Perspectives Of Future Growth Potential
Although I fully subscribe the philosophy of growth investing, namely that you can pay a high premium for a truly unique business and let the high growth to cover up your "sins" after several years, deep in my heart, I am still a value investor who cares about the protection on the downside, and not willing to pay a high premium no matter how promising it seems to be.
Fortunately, UBNT is one of those rare growth stocks with huge potential and yet being traded at reasonable price levels (P/E is 18 right now). Of course, there is always a catch when such things happen, especially in today's "still overvalued" market.
Since I had several articles to cover UBNT's product lines and valuation in detail, I am not going to repeat the same discussions here. But in summary, in my view, UBNT can still have a modest P/E right now only because of two reasons:
1. Its growth has slowed down in the last year and only achieved flat revenue and earnings in the last 5 quarters.
If we take a look into the segment details, the airmax product line was actually shrinking significantly. The service provider segment showed a slight decline only because the airfiber and edgemax product lines were growing fast. On the other hand, the new enterprise segment, mainly the Unifi AP, but also includes the UVC (unifi video camera) and Unifi Switch has been growing pretty fast in the last year (up more than 100%).
In my view, the decline of airmax was due to the following reasons:
a. The nature of non-recurring revenue.
As a non-recurring revenue from hardware sales, airmax had a huge surge in demand when it was first introduced in 2011, but that demand started decline gradually after the demand was satisfied over time. Without opening up a new market in new territories, such as China, India or other developing countries, or bring in upgrade revenue with a significantly better product like airmax AC, the demand for the existing older generation airmax may continue to decline.
In fact, I believe this is the primary reason that shorts started to short this stock in 2013.
b. Currency and local economical/political headwinds.
Since USD has appreciated significantly in the last year, it might make distributors more hesitate to get new stocks and therefore suppress demand in the near term. Also, there are some economical/political headwinds in Iraq, Brazil and Russia. These temporary factors also affected the local demand in those regions.
c. The delay in the development of airmax AC.
Airmax AC was delayed for a year since its announcement in late 2013. Even after it was released in late 2014, there were still two issues that slowed down its adoption: AC's CPE is $32 more expensive than non-AC version ($99 vs. $67), and there was no backward compatibility support. In the last earnings call, Pera said he was going to address both issues. It seems that Nanobeam-AC-16 is coming and only priced at $12 more than non-AC version. A few months ago, Litebeam was also introduced at $49 each, although this is a lite version with limited features. (For readers who wonder why CPE pricing is so important, this is because each Access Point can carry 30 - 50 CPEs in a point to multiple point setup. So the WISPs are much more sensitive to the pricing of CPE than the pricing of access points.)
If these two issues are resolved, and Airmax AC sales can finally ramp up, this could be a very strong driver for mid-term revenue growth.
2. This business is considered to be in a hardware industry.
Hardware business is usually valued lower than software business mainly because they are more capital intensive and their margin is lower. However, for Ubiquiti, in Pera's words, it is really a software company, but realizes the revenue in hardware. The company doesn't manufacture hardware directly, and its main cost is on the software development. Its ROIC and margins are also similar to the software companies. Since it outsources manufacturing to 3rd parties, it can easily ramp up scale without much capital or fixed costs. Similarly, there is little sunk cost if UBNT has to scale down or eliminate a product line. Therefore, I would argue that this company should deserve the same valuation as a software company.
The Short Interests
Based on my experience, we have to show some respect to the shorts and be very careful when there are significant short interests in a stock.
In this case, there are more than 30% of short interests comparing to the float (2/3 of the shares are owned by Pera). As a rule, if I couldn't figure out why these shorts want to short this stock, I wouldn't want to touch it either. Based on Pera's history and his action (he didn't sell shares and didn't take salary or bonus either), I don't think financial fraud is likely. I believe shorts were pessimistic about this company's future only because the Airmax has no recurring revenue and they believed the demand was declining as well. However, that was 2013, and things have changed a lot since then.
It was surprising to me that there were many pleasant surprises in this year. First, we had AF-5X released in February, which was extremely well received by WISPs due to its excellent performance and low cost. The airfiber team did a phenomenal job to release such a high quality customized radio in a short time.
Recently, the pricing of Unifi AC was also pretty amazing to me. Basically, Ubiquiti was able to release the new generation of Unifi with improved qualities and features, and yet cut the price by more than half. Frankly, I used to worry about the competition from Ruckus' Xclaim, but given the Unifi AC's features, superior pricing and existing market share, I don't worry about that at all now. The new Unifi AC LR (long range) also received very good reviews from early adopters, and the noise problem in the old Unifi AC also seemed to be fixed in this release.
For sure, the new Unifi AC will bring a lot of new demand and become a significant revenue driver in the near term and mid-term.
Another good news is that Airmax radios finally got FCC approval to be used in UNII band. Although this would only affect sales in the US region, it is still a good revenue driver, and more importantly, it gave a lot of relief to the US WISPs.
Looking back, I think shorts were right on betting the decline of Airmax revenue, but they forgot that it is simply too risky to bet against something with the explosive growth potential, and something that can bring on new products (like Unifi) and disrupt a new industry without much capital requirement.
Risks
While we should recognize Ubiquiti's potential as the next "perfect" growth stock, we should also realize that the risk is also not small, comparing to many other high quality value stocks.
First, UBNT lives in an industry with non-recurring revenue and relatively short product cycles. The competition is high. Although UBNT has its unique strength to live between the low-quality commodity producers and the high-quality high premium producers (its product is both cheap and with fairly high quality), we have to realize that this industry also changes pretty fast.
A fast changing industry is not all bad news, as it gives a disruptor like UBNT a chance to enter. It just means we should be aware that the downside protection of its earning power is weak, and there is not much protection from the book value either.
The company has good cash balance, and its R&D doesn't cost much either. So we can be pretty sure that this company will survive most of the economic storms and industry down turns, so there will be another day for it to come back if its earning is indeed impaired for any reason.
That said, a 30% - 40% maximum downside is acceptable to me if the upside is double, triple or even more. I just need to size the position accordingly based on its risk profile.
Catalysts
There are many mid-term and near term catalysts that could set up the tremendous upside for UBNT:
1. I noticed that the borrowing cost for shorting UBNT has shot up since 8/12. Now it is around 23% interest rate. This means a potential short squeeze may be forming up. If it really happens, the fundamentals, the technicals and the stories will all get aligned, setting up a full explosion for the upside.
2. We will find out what are up in Pera's sleeves in the upcoming Las Vegas Conference. Since Pera won't show up in the conference without good stories to tell (he didn't attend the conference last year), there should be something to look forward to. Some of these products may be in a completely new industry which gives another chance for an explosive growth.
3. New Unifi AC, plus Airmax with cheaper CPE and backward compatibility may bring in more revenue in the next few quarters.
4. UBNT will continue to improve the existing product lines such as UVC, Unifi Switch, and Edgemax which can build on top of the networking effects of SDN (software defined network), and utilize the "link and lever" business strategy (leverage the existing user base to enter adjacent businesses).
5. In the FCC web site, I found a new product named as "SWX-R5MU". Since "MU" could stand for "Multi-user", this might be a new generation of Rocket 5 that has MU-MIMO in it? (MU-MIMO is a new technology with only limited applications so far. If Ubiquiti does have some products along this line, it will be big news.)
Conclusion
As I mentioned above and before, UBNT is a high-risk, yet even higher-reward opportunity. It is more suitable for growth investors or "quality" value investors, than deep value investors.
That said, the term "high risk" is based on a value investor's standard. Its downside is still much more limited comparing to most of the other growth stocks due its modest P/E ratio. Its upside is also much greater than the popular names such as Netflix, Amazon or Facebook. This is because its P/E multiple still has some significant room to grow, and it is still much smaller than those high flyers. By some standards, it is still considered as a small cap, and therefore, the growth potential is much greater than those high flyers too.
By Mingran Wang
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