Description

Aviat Networks (AVNW) is a microwave backhaul network provider that trades at less than 10x forward earnings. The company has strong tailwinds from the 5G upgrade cycle, shifting business away from Huawei, and rural mobile networking build out bolstered by legislation and government funding. It’s a small cap stock that hired a CEO in 2020 when EBITDA margins were mid/low single digits who has begun executing a vision for growing the company. 2017-2019 EBITDA was between $5-8 million per year, and AVNW is on track to do $50 million in calendar year 2023. With secular tailwinds and a fragmented, underinvested-in industry, opportunities for organic and inorganic growth will be plentiful for the foreseeable future. 

Industry Dynamics

For the last decade or more as bandwidth demand increased, fiber was the clear choice where possible when building a backhaul network because it was the fastest medium available, and it could handle nearly unlimited amounts of data transfer and for many backhaul applications 3G/4G was clearly inferior. 5G, though, is 100x faster than preceding technologies, and while there were concerns as to whether microwave technology could handle the increased throughput, high/wider spectrum bands have been used and now in many cases microwave technology offers clear advantages, and mobile 5G subscriptions are expected to grow by a 41.2% CAGR between 2021 and 2027 according to ABI Research. Microwave is much cheaper and quicker to deploy than fiber, which can be more than double in cost per link. Data transfer capacity is still higher for fiber, but the latency for microwave is actually lower, because the electro-magnetic microwaves travel faster through the air than light does through a fiber optic cable. Microwave is also more suited for rural applications where terrain is a concern or fiber simply doesn’t make sense from an ROI perspective. Globally the microwave/fiber split is about 65%/35%, but public service provider split in the US is just 20%/80%. 

The biggest players in the microwave backhaul business are vertically integrated multinational telecom companies like Huawei, Ericsson, and Nokia, whereas Aviat is a pure play on the industry. Because microwave was historically thought of as a low-growth, mature business line, it hasn’t been the main focus of larger enterprises, which paves the way for a skilled operator to come in, take share, and reap the benefits of new tailwinds. 

Moving away from Huawei and ZTE

Foreign security concerns with China have led to an increased push to reduce reliance on Chinese network providers both domestically and around the globe. In particular, the US passed the Defend our Networks Act (also called “Rip and Replace”), which prevents rural network providers from using networking equipment manufactured by Huawei and ZTE, and funds the cost to replace the equipment. The act has directly benefited AVNW (the company has called out $35 million in revenue share gains directly from the legislation), and will likely lead to share gains in the US market for AVNW going forward. The company has also won a large contract with Bharti Airtel in India, displacing Huawei equipment, and has indicated that operators around the world have expressed concern about security such that significant replacement business should play out over the next 3-4 years. 

RDOF

The Rural Digital Opportunity Fund adopted in 2020 is an initiative by the FCC to bring broadband to rural areas, with over $20 billion in potential funding. It has taken a little while to play out, but the company indicated on the most recent quarterly conference call that they began seeing activity starting to ramp from early design phases, and they expect it to peak in 3-4 years. With 35-40% market share in rural broadband, the company is well positioned to capitalize. 

I have been very impressed with CEO Pete Smith, who started in January 2020. He came to the company with experience in commoditized low-tech businesses (most recently at Jeld-wen and Honeywell in the past). He seems to have a good eye for evaluating the needs of customers and improving products to meet those needs. His compensation isn’t excessive either and is mostly in RSUs and options tied to EBITDA and revenue levels ($650k salary and ~$2.5 million total in FY2022). His vision is to grow through acquisition and become a dominant player in the space, and he’s executed well thus far. 

On May 9th, Aviat announced that it will acquire NEC’s microwave backhaul business for $70 million ($25 million of stock + $45 million of debt), which will add $150 million in revenue, diversify the customer base away from private networks to service providers, and take the company to #3 in global (ex-APAC) market share for microwave backhaul. While the acquired business is currently operating at about breakeven, post-synergies the combined business is expected to reach 11-13% EBITDA margins ending in year-two. 

Aviat will earn $3.30 this year (FY 2023) and is expected to earn $3.70 next year. Backlog will increase again this year which it has for several years running, and free cash flow over the next 12 months should surpass $50 million, which amounts to nearly a 15% FCF yield to equity. Ultimately, I think the 15% EBITDA margins are attainable, which would put the business running around $80-90 million in EBITDA by FY2026, or <5x enterprise value.

Catalyst

RDOF legislation

Huawei transition

5G buildout

NEC acquisition