Description

We all know that tech and telcom hardware is a tough business. However, if you catch a company on the cusp of a positive cycle with washed out expectations you can get significant stock price appreciation. Calix does not screen as particularly cheap on an EV/EBITDA or forward earnings basis, although its multiple of 0.5x revenue is very low for a tech company with near 50% gross margins. I believe CALX will benefit from a significant telecom broadband access upgrade cycle currently in the early stages. I encourage everyone interested to read the recent write-up on ADTN and the long and short write-ups on DY for more background. Events in the latter part of 2015 give me incremental confidence the long-awaited capex cycle has begun. If my thesis on the broadband upgrade cycle is correct, Calix should show accelerating revenue growth in 2016 and 2017 that will finally reveal its true earnings power. I think the post Q4 earnings selloff in the stock is an ideal time to look at Calix because while the Q1 guidance was just OK for revenue and looked optically bad for earnings, largely due to one-time litigation expenses, the underlying message the company delivered delivered was positive. Now the stock is near the lowest prices since their 2011 IPO.

Calix was founded in the dot com bubble at the height of the last great broadband capex cycle, as DSL and cable modems were rolled out so U.S. households could have broadband Internet access for the first time. The company was an early developer of fiber-to-the-home (“FTTH”) technology, and while their vision was early they are considered a technology leader in the space. The near $550M of accumulated losses on Calix’s balance sheet (compared to current EV of less than $250M) attest to just how early the company was and how much money was spent developing their technology. While Calix clearly disappointed its early venture investors, the company is currently one of two main suppliers of broadband access equipment to U.S. Tier 2 and Tier 3 telecom carriers. It largely splits the market with Adtran, while U.S. Tier 1 carriers are primarily supplied by Alcatel-Lucent. Calix has initiatives underway to expand internationally and finally gain Tier 1 carrier customers. I believe the U.S. Tier 2 and 3 broadband access equipment market is around $600M-$800M per year, with Calix taking share over the last few years. I believe that Calix has comparatively higher share in fiber-to-the-home equipment while Adtran has higher share in copper technologies (i.e. DSL), but both companies compete in both DSL and FTTH.

To understand why I think that U.S. telecom broadband infrastructure is on the cusp of an upgrade cycle, it is important to understand the current broadband competitive dynamic. Traditional DSL technologies utilized by the telecom companies that own legacy copper phone line infrastructure provided sufficient bandwidth for most consumers over the first decade of the 2000s. However, as U.S. households utilize ever greater bandwidth, largely as the result of the increased popularity of streaming video, the 10-40 Mbps available through traditional DSL technology no longer suffices. The U.S. cable companies can offer speeds of 25 Mbps to 100 Mbps or more using coaxial cable, so they have been taking share from the U.S. wireline telcos, one of the primary reasons for the large differential in stock price performance between the two sectors. To make matters worse for the telcos, Google’s 1 GB fiber broadband infrastructure buildout went from one city in 2012 to four cities in 2013 and up to 20 cities currently in announced expansion plans. Clearly, a competitive response from the telcos is needed.

Utilizing advanced DSL technologies such as vectored and bonded-pair VDSL can allow telcos to offer speeds of up to 100 Mbps, and indeed Calix sells such VDSL equipment. But we believe that telcos are increasingly concluding—and Google Fiber is showing—that investment in full 1 Gbps fiber-to-the-home is the way of the future, at least for urban areas and the close-in suburbs of major metro areas. FTTH costs have come down and fiber technology is much cheaper to maintain than copper, and while arguably 1 Gbs speeds are overkill in the present, history shows we will use the bandwidth eventually. Smaller Tier 2 operators such as Hawaiian Telecom and Cincinnati Bell have transitioned the vast majority of their consumer broadband access expenditure to fiber, and claim to be pleased with their ROI and customer win rate. CenturyLink, the largest U.S. Tier 2 carrier (some consider it a Tier 1) and the largest customer of both Calix and Adtran, trialed fiber-to-the-home in Omaha and Las Vegas and has rolled out to additional cities. I do not find this surprising, since Google will compete with CenturyLink in at least four of the announced Google Fiber expansion cities.

Over the past few years Calix’s revenue has grown, but not as much as expected. Expenses have increased faster. So far U.S. telcos have been slow to ramp up broadband infrastructure upgrades and capex budgets have actually slightly declined. However, I believe that evidence is mounting that the long-awaited upgrade cycle is finally underway. First, there has been an important shift in U.S. government telecom subsidies. The old Universal Service Fund scheme which was used to subsidize telephone service in rural areas is transitioning to a broadband subsidy that goes by the catchy name of Connect America Fund II (or CAF-II). CAF-II is a program designed to encourage U.S. telcos (largely the Tier 2s and Tier 3s that make up Calix’s current customer base) to bring higher-speed broadband to rural and other underserved areas by providing capex subsidies. While this is being accomplished by re-jiggering the previous USF funds, the net result of the first round of acceptances for Tier 2 carriers has been a moderate net increase in subsidies. The major Tier 2 carriers accepted the vast majority of CAF-II subsidies offered during the third quarter of 2015, and future year capex estimates were subsequently revised up. The program totals about $2B per year for the Tier 2 carriers, of which we estimate a few hundred million is incremental from current USF subsidies. I further estimate about 20% of this will be used to purchase additional broadband access equipment, which is significant in light of a $600M-$800M annual market and should help both Calix and Adtran return to double digit growth.

Aside from CAF-II funding, other evidence of a new investment cycle in broadband infrastructure appeared in 2015. Dycom provided the most dramatic example. You can refer to the long and short Dycom write-ups on the VIC, and while the short write-up has produced a better return to date the fundamentals seem very strong so far. Dycom provides specialty contracting services to major U.S. telecom and cable companies, and in particular they are engaged in digging ditches and laying the fiber necessary for new FTTH and VDSL installations. Historically a GDP grower, Dycom’s revenue significantly accelerated in 2015, from 0% Y/Y in the October 2014 quarter to 29% in October of 2015. Even more incredibly, total backlog increased 68%. While Dycom’s stock has pulled back in the current market turmoil, its 2015 peak was up over 250% from where it started the year. In its conference calls, Dycom management is adamant about a significant broadband infrastructure upgrade cycle surpassing even the one in 2000—and their numbers seem to bear this out. Notably, this has largely occurred before CAF-II disbursements and among customers who are net losers from CAF-II in the context of flat to declining capex budgets. I believe Dycom’s results are directionally indicative of what will happen to Calix over the next two years, as laying fiber and installing cabinets must be completed before broadband access equipment can be procured and subscribers connected. Recent public comments from Adtran and industry research house Gartner have bolstered my conviction that the U.S. broadband access equipment market should accelerate.

Calix’s stock has largely traded flat over the last two years as investors have waited for the cycle to kick in. The company has also irritated investors by increasing spending to address additional international, Tier 1 and VDSL opportunities, resulting in declining pro forma earnings since the last peak in 2013. I think that investors have been overly focused on the present and not on the likely acceleration in revenue right under our nose. Calix reported scant 2% Y/Y growth in 2015, and analysts have growth forecast to increase to 8% in 2016 and another 8% in 2017. I believe these estimates are too low, and Calix could grow in the mid-teens to low 20s percent by the end of 2016 and for full year 2017. By 2017 the company should be showing earnings leverage instead of the opposite, possibly reporting double digit operating margins and pro forma EPS of $0.80 to $1.00. This could result in a doubling of the stock or better. Having followed this company for a while, I find humor in the fact that the stock peaked in 2011 at over $20 per share due to excitement about the CAF-I program and broadband stimulus, despite the fact that the dollars involved were an order of magnitude smaller than CAF-II. This time around sell-side analysts seem to have not changed their estimates at all as a result of CAF-II. Once bitten, twice shy.

I could go on about the opportunities Calix has for winning foreign carriers, cable companies as they transition from coaxial to FTTH and U.S. Tier I carriers totally separate from the coming increase in spending from Tier 2 and Tier 3 telcos, but they are not necessary for the investment to be successful. If you listen to its public comments, Calix talks less about the upgrade cycle than they talk about their new product releases, especially the new software-defined networking platform for access. Calix has been investing in these opportunities, and if they do not work out I believe they could cut expenses to achieve double digit operating margins on a smaller (but growing) revenue base. With $1.41 per share of cash and a low EV/revenue multiple, I believe the risk/reward is excellent and if Calix cannot succeed as a standalone company it could be an interesting acquisition candidate for Cisco or Arris.

After 16 years of involvement CEO Carl Russo remains the company’s largest shareholder at 12% so shareholder interests should be aligned. The company normally only guides one quarter out, but on the Q4 call they were very clear that they expect revenue growth to accelerate in 2016 while expense growth should moderate. Calix bought back zero stock from the time it went public through Q1 2015. The company then bought back $3.4M of stock in Q2 2015, $7.7M in Q3 and then a whopping $16M in Q4 2015. No insider sold stock in 2015 despite much higher prices than current. Calix is also holding its first analyst day ever in NYC in March. When you put all the pieces together- 2 years of expense growth faster than revenue, their first stock buyback, zero insider sales and their first analyst day ever- it appears to me that management expects an acceleration in revenue and better times ahead. Based on what I see in the industry, this expectation seems well grounded, and I expect the stock to reap the benefits over the next two years.

Disclosure: The fund I work for is long CALX and may buy or sell shares at any time without notice.

Risks:
•    Telecom carrier broadband capex does not accelerate as I expect due to economic conditions or access to capital
•    Calix loses share to Adtran or Alcatel-Lucent
•    The company continues to grow expenses faster than revenue

Catalyst

• Accelerated revenue growth from U.S. FTTH upgrades
• Winning of a Tier 1 U.S. or international carrier