Description

Calix is on the verge of a significant inflection driven by new products and customers wins.  The stock is currently very depressed because it has been hammered by temporary headwinds in the last year and a half.  I believe the headwinds are abating, and the current set-up creates a very attractive entry point which I believe will result in a 2.5-3x return.  Management apparently agrees because they have recently bought a significant amount of stock near the current level.

Business Overview

Calix is one of the leading providers of broadband communications systems and software that enables CSPs (Communications Service Providers) to deliver voice, data, and advanced broadband services from the carrier’s central office to business and residential subscribers (the so called “last mile”). The company is exclusively focused on the access market, including both fiber and copper, primarily with Tier 2&3 providers. 

Calix is the second largest provider of fiber access solutions in North American after Nokia, and it is the third largest provider of copper access solutions behind Nokia and Adtran. Calix has more than 1,400 customers whose networks serve over 100 million subscriber lines in total.  88% of revenue is in North America. It has a diverse customer base including rural telecom cooperatives, RLECs, cable operators, municipalities, electric cooperatives and wireless internet service providers. 

Calix’s largest customer is Century Link at 17% of revenue.  So called “legacy” tier 2 providers including Century Link and others such as Windstream, Frontier, TDS and Cincinnati Bell are less than 25% of revenue in total, down from almost 70% at the peak almost 10 years ago.  Competitively, the tier 2 providers typically split their purchasing 50/50 between CALX and Adtran, but CALX has dominant share with the smaller and more diverse Tier 3 carriers.

In the last five years, Calix has undertaken a dramatic shift in its product portfolio from legacy products to next generation products which entailed an R&D investment of $500mm+.  Calix has essentially built a new company within a company. Calix’s legacy flagship product family is the E-Series which is rack-mounted chassis which sit in a carrier’s data center and support a wide array of basic voice and data services including Gigabit Ethernet, GPON, DSL, etc.  The legacy products are still the vast majority of revenue. 

The next generation products include AXOS, EXOS and Calix Cloud.  AXOS and EXOS are operating systems based on software defined networking that sit on top of the network that radically simplify network operations.  The main promise is that AXOS and EXOS use software modules to virtualize various hardware functions. This allows for greater reliability, faster upgrades, less hardware and simpler networks.  For example, AXOS can push upgrades without having to take hardware offline, and it is hardware agnostic, allowing CSPs to swap out hardware from a different vendor.

 Calix Cloud is an analytics platform and that uses network data and subscriber behavioral data to enable CSPs to improve marketing and support.  It consists of two products: 1) Marketing Cloud which can identify which customers are more likely to churn and which are more likely to respond to an upsell promotion.  Marketing Cloud is geared toward growing revenue. 2) Support Cloud for support calls which provides a trouble shooting dashboard which can quickly identify issues with the network or equipment.  It has automation capabilities that fix many common issues without manual intervention. The result is significantly lower “truck rolls” for service calls and higher subscriber satisfaction. 

Calix’s website has dozens of press releases with customer success stories like: “Multi-company rural broadband provider cuts truck rolls by 42 percent in first 30 days, reducing operating costs by 30 percent and achieving a 173 percent return on investment in six months.”  And, “Pioneer Generates a 59-Fold Return on Profit with First Calix Marketing Cloud Campaign” And, “Range Companies Realize Immediate Reduction of Operating Expenses and Massive Return on Investment from Improving Subscriber Experience through Calix Support Cloud”.

Recent Background

Calix is trading close to its 52-week low because in the last year and half it has been beset by temporary headwinds that have resulted in multiple revenue disappointments (revenue has declined for six quarters in a row!), reduced visibility, and dented sentiment.  We believe Calix is on the verge of turning the corner which is creating the opportunity today. 

The main headwind has been a sharp decline in revenue from struggling Tier 2 carriers such as Century Link, Windstream and Frontier due to financial difficulties at these companies. For example, Calix saw revenue from its largest customer, Century Link, decline from $158mm in 2017 (31% of total revenue) to $80mm in 2018 (18% of revenue), and it expects a further 10-12% decline in 2019.  As described below, we believe revenue declines from these customers, which are now less than 25% of revenue, will be much more moderate. 

In addition, Calix pre-announced a negative Q1’18 and reduced expectations for Q2 due to product shortages associated with moving its supply chain out of China to other regions.  Calix has already ramped with a new supply chain partner and is back to normal in Q3. The rest of the write-up describes why we believe Calix is on the verge of a turnaround. Management apparently agrees because they have recently bought a significant amount of stock near the current level.

 Thesis

 1) CALX has struck gold with its new platforms

Most of our due diligence focused on talking to customers and resellers about Calix’s new platforms and the feedback was universally very positive.  In fact, we were struck by how many networking engineers are raving fans of Calix. The substance is as real as the hype. Here are snippets from a handful of different conversations: “AXOS/EXOS are revolutionary products…  Reliability is much better. Changes/upgrades are hours instead of months.” “Calix’s CEO is super sharp. I would not bet against him… CALX’s new products are cool. I would give Calix high marks for technology and marketing… They are kicking the sh*t out of ADTN [this was from a reseller who sells Adtran]”  “Calix is pretty much the leader of that pack from a technology standpoint.” “Calix is much better in terms of power drain and rackspace requirements because it is more software driven. I’m not surprised that Verizon is using it.” “Calix is best in class. We work with CALX exclusively and would not consider shopping around.”

2) Verizon win is ultimate validation of Calix’s technology

Verizon started to deploy AXOS in January 2018 and is CALX’s first Tier 1 customer ever, which is a very big statement.  Moreover, Calix is likely going to be the sole supplier for the foreseeable future which is remarkable in an industry where carriers always dual source in order to play vendors off of one another.  Calix has said that Verizon will be a 10% customer in the second half of 2019.

The history is that Verizon conducted a vendor run-off that culminated in the selection of two providers for lab tests in 2017, Calix and a team of Adtran and Ericsson.  For nearly two years Adtran promised to investors that this would be a big win and drive incremental revenue. Fast forward to today and Adtran has said not to expect any Verizon business anytime soon. 

Verizon is using CALX in its initial 30 city deployment of NG-PON2. NG-PON2 is a revolutionary new optical transport technology that allows business, residential and wireless signals to be sent over the same wavelengths in order to increase fiber capacity.

3) Revenue headwind from struggling Tier 2 telcos is close to a floor

Calix’s revenue has been declining for six straight quarters due to financial difficulties at three of its formerly large customers: Century Link, Windstream and Frontier.  Each of these are legacy telco’s which are losing share and struggling under heavy debt loads. Windstream recently filed for bankruptcy and Frontier is in the midst of a debt restructuring.  Calix has said that legacy Tier 2 telcos are now less than 25% of revenue in total, and that Century Link is 17% of revenue, implying that Windstream and Frontier are less than 8% of revenue. For Century Link, Calix has guided that revenue will be down 10-12% this year and relatively stable thereafter.  The reason is that Century Link’s spending is now down to a maintenance capex level for supporting its >$1bn installed base of Calix equipment. 

4) Close to a revenue inflection

Management forecasts that Calix will return to year over year revenue growth in Q4 due to the stabilization of the struggling Tier 2 carriers and the ramp at Verizon.  We believe Calix can return to double digit revenue growth by 2021. Calix has a $600m long term revenue target vs $441mm in 2018. Additional growth drivers include: 1) ramping with City Fibre in the UK. City Fibre is a fiber overbuilder in the UK that has $3.5bn of funding and is in the process of building out a network to pass 5mm subscribers.  City Fibre is using Calix exclusively. We believe it can be a +/- $50mm revenue customer. 2) Growth with other fiber overbuilders that are expanding their networks including TDS and Metro Net. 3) Growth with a new class of Tier 3 customers including rural electric cooperatives and municipalities that are using their right-of-ways to lay fiber and taking advantage of lower network build costs thanks partly due to the advantages of Calix’s platform.  As evidence of Calix’s traction in the market, it has been adding roughly 30 new customers each quarter for the last two years.

5) The new platforms are much higher margin

The new platforms are more software oriented and so they carry significantly higher gross margins.  Calix’s published target is for gross margins “>50%” versus 46% in 2018. The CFO has said the 60%+ gross margins are possible overtime.  As evidence of the mix shift to higher margins, gross margins were flat year over year in the first half of 2019 despite revenue being down 10%.  Normally a sharp revenue decline would result in significant pressure on the gross margin, but this was offset by the mix shift to higher margin next generation products.  Calix is also committed to roughly flat opex, so Calix should have strong operating leverage driving to its target of >10% operating margins. I model EBIT margins increasing from 0% in 2018 to 15% in 2022. 

6) CEO Carl Russo is extremely well regarded

Carl Russo became CEO in 2002 and is the architect of the strategy to build a company within a company to focus on the next generation products.  He has a phenomenal track record. He was President and CEO of Cerent which he sold to Cisco for $7bn in 1999. Prior to Cerent, he was COO off Xircom which was later acquired by Intel.  He is the third largest shareholder of Calix with a 6% stake.

7) Strong insider buying

There has been a healthy amount of insider buying from May through August which points to what we think is Calix’s pending inflection.  The investment firm Voce Capital owns 2.6%, sits on the board, and has been adding to its position. The Chairman Donald Listwin has bought over $300K of stock since May.  Director Kevin Denuccio has bought $235K, and the CFO bought over $80K.  Most of these transactions were in the $6-7 per share range where Calix is currently trading.

Issues

 1. Tougher industry

Telecom equipment has historically not been a good industry due to customer concentration, lumpy revenue and low margins.  These negatives are all present at Calix, and are largely the reason the opportunity exists today. 

 2. Modest cash balance

Calix has $35mm of cash and $25m of debt and its FCF is currently barely break-even.  It has $25mm available on its revolver and the CFO is confident they could increase their revolver availability if needed.

 3. Competition

While Calix has the lead for its next generation products, it is likely that other vendors will eventually catch up.  My assumptions for Verizon in particular assume that Calix only gets 50% of the business.

Valuation

At the current price of ~$6, Calix is trading much closer to its 52-week low of $5.60 vs its 52-week high of $11.30.  The valuation is 0.8x revenue vs its historical average of 0.7x although I’d note that CALX was significantly money losing at times in the past.  It has a clean, net cash balance sheet. To frame the upside, I assume Calix gets to +/-$550mm of revenue in 2022 with a 56% gross margin. I believe these assumptions are somewhat conservative based on management’s commentary.  I assume opex grows modestly from $201mm in 2018 to $230mm in 2022. This results in EBIT of ~$80mm with a 15% margin, and EBITDA of ~$90mm. Using 8-10x EBITDA in-line with more mature networking companies like Ciena, Juniper and Cisco results in target price of $15-17 for a 2.5-to-3 bagger.

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

Catalyst

Revenue inflection