Disclaimer: I am long AVNW.

Thesis

Aviat Networks (AVNW, $1.10) is an extremely cheap stock trading below liquidation value and currently has an enterprise value of ~$20M, and likely will return to profitability in the coming quarters. The thesis is:

(1)    AVNW is cheap on an absolute (and relative) basis: liquidation value is ~$1.50 per share with tangible book close to $2 per share; EV is only $16M at the current price. There is likely limited downside due to the cheap valuation and likely significant upside when the industry turns.

(2)    AVNW is the largest player in a brutally competitive, commoditized industry; AVNW is the only unlevered player and the other two players are highly levered and longer term one or more of the competitors may exit or be consolidated, improving the industry margins/competitive intensity.

(3)    Aggressive recent cost-cuts and restructuring plan will likely return AVNW to profits in the coming quarters.

(4)    AVNW, unlike its competitors, has a large base of recurring service revenues that provide a recurring stream of future revenues; this is unique in the industry as the others have <5% of revenue from maintenance /service, while AVNW is approaching 50%. This $100M+ base of recurring revenues is comprised of MLA, network design & Commissioning, network operating center, install, as well as some small software maintenance revenues.

(5)    We believe that AVNW could cut R&D to $25M p.a. and reduce annual SG&A expenses by $15M and therefore generate close to $20M-$30M of annual EBITDA relative to a $16M current EV. Note that AVNW is larger, more service-revenue oriented business than CRNT and DRWI but trades at an EV that is 1/3 of DRWI (even though AVNW is ~3x larger business on sales) and 1/10 of CRNT (AVNW is larger by ~25% in terms of sales when ccompared to CRNT)

(6)    Significant upside case possible if telecom industry capex resumes on a network upgrade cycle restart.

Business Description

-          AVNW was spun out of Harris Corp in 2007 and merged with Stratex. AVNW is the largest pure place microwave radio player in the market, with about a 10% market share. Large vertically integrated competitors include Alcatel-Lucent, Ericsson, NEC and Huawei, that collectively control 60% of the market. Ceragon Networks (“CRNT”) and Dragonwave (“DRWI”) are also pure play, public competitors that are 8% and 3% market share respectively.

-          Microwave radio is used as backhaul to move voice and data from a fiber network to a cell tower or point to point for a private communications network like a police/first responder communication network.

-          Microwave radios exist because each link is much cheaper than using fiber, which is roughly $20,000 per link vs $3,000-$4,000/link for a microwave radio. The cost delta is driven by the fact that fiber has significant labor and install cost (trenching), and takes a long time, so large telecom network operators have shifted to radio to reduce capex. Also, microwave radio is better than copper or fiber in rugged areas, given the high cost of trenching and install. So the two reasons for the industry to exist are that it’s a cheaper substitute for fiber and a more practical solution in rugged terrain areas.

-          Our customer research has shown us that: (1) switching costs for AVNW’s equipment are high since switching would take down networks and many of these networks (such as fire/police) can’t afford downtime; (2) the microwave radios are mission critical for customers so quality matters; (3) AVNW gets high marks for service quality.

Valuation

-          AVNW trades well below liquidation and tangible book value; if AVNW can get to $20M of EBITDA (which we believe is likely due to cost cuts), then AVNW would trade for <1x EV/EBITDA

-          AVNW has roughly $.70 per share of net cash (including a tax receivable), providing solid downside support.

-          AVNW’s EV is only $20M, while CRNT and DRWI have EV’s of $160M and $50M, respectively, but are 1/3 and ¾ the size of AVNW in terms of sales and neither one has history of recent EBITDA profits, whereas AVNW has been EBITDA positive for virtually its entire 7 year corporate history with exception of a few recent quarters.

Catalyst

-          Return to profitability driven by cost cutting:

• AVNW’s management has announced a large restructuring, cutting quarterly opex to $27M, we think they likely can cut this number to $22-24M when you consider that AVNW’s Selling & Admin overhead runs 300-1,000+bps higher as % of sales vs Alcatel-Lucent, Ericsson and NEC:

• Our logic is that based on speaking with industry participants, roughly 60% or $20M of AVNW’s $42M of annual R&D is for new products and likely not something they can cut. About $5M is for sustaining, customer-required/driven capex for large customers like Verizon. So we think, AVNW can cut R&D to $25M or a reduction of $17M which works out to another $2M reduction in quarterly opex beyond what they have stated, allowing them to achieve $25M.
  • We also think AVNW could cut another $2M potentially from corporate overhead via relocating their current, expensive massive corporate headquarters , which management has already begun doing, as they have sublet half their existing headquarters. If you drive by their corporate headquarters in Santa Clara, you can see a sign subleasing out the entire 120,000+ square foot corporate HQ’s:

-          The exit of the secondary players that are highly financially leveraged and losing money: DRWI and CRNT.

-          Potential for industry consolidation: why do three pure play microwave specialists spend $110M per year in the aggregate on R&D? They have nothing to show for it as the industry has collectively lost $50M per annum for the last years. Consolidation would bring about higher prices/profit margins, huge sales force synergies, overhead synergies and cut R&D budgets by 75%.

-          Potential for capex cycle to reignite in N America (Sprint/T-mobile/Softbank), Europe (Vodafone), India (Reliance, Bharti)

Secular trends

-          Huawei, in particular, has been extremely aggressive in using low cost/price to drive market share in the microwave business. This has driven gross margins to exceptionally low levels, this likely continues unless consolidation happens.

-          We believe there will be a wave of consolidation via the weaker players exiting or potentially M&A or both.

Why is AVNW so cheap?

-          AVNW recently swung from making positive EBITDA from FY07-13 to EBITDA losses for the past three quarters.

-          Illiquid, small market cap. Only one sellside analyst covers the stock.

-          Management has not hit guidance recently.

-          Lumpy/volatile annual results due to deep cyclicality of the business and industry.

Risks

-          Weak competitors receive more equity and/or debt financing and keep margins low:

• Would delay AVNW’s return to profitability.
• Would cause AVNW to burn more cash.

-          Bad industry:

• Hyper competitive
• Commoditized
• Total industry profits likely negative over last 5 years

-          Industry risk

• Capex cycle stays weak for another year

-          Return to profitability driven by cost cutting:

• AVNW’s management has announced a large restructuring, cutting quarterly opex to $27M, we think they likely can cut this number to $22-24M when you consider that AVNW’s Selling & Admin overhead runs 300-1,000+bps higher as % of sales vs Alcatel-Lucent, Ericsson and NEC:

• Our logic is that based on speaking with industry participants, roughly 60% or $20M of AVNW’s $42M of annual R&D is for new products and likely not something they can cut. About $5M is for sustaining, customer-required/driven capex for large customers like Verizon. So we think, AVNW can cut R&D to $25M or a reduction of $17M which works out to another $2M reduction in quarterly opex beyond what they have stated, allowing them to achieve $25M.
  • We also think AVNW could cut another $2M potentially from corporate overhead via relocating their current, expensive massive corporate headquarters , which management has already begun doing, as they have sublet half their existing headquarters. If you drive by their corporate headquarters in Santa Clara, you can see a sign subleasing out the entire 120,000+ square foot corporate HQ’s:

-          The exit of the secondary players that are highly financially leveraged and losing money: DRWI and CRNT.

-          Potential for industry consolidation: why do three pure play microwave specialists spend $110M per year in the aggregate on R&D? They have nothing to show for it as the industry has collectively lost $50M per annum for the last years. Consolidation would bring about higher prices/profit margins, huge sales force synergies, overhead synergies and cut R&D budgets by 75%.

-          Potential for capex cycle to reignite in N America (Sprint/T-mobile/Softbank), Europe (Vodafone), India (Reliance, Bharti)