Description

MRV Communications is an ignored equity, traded on the pink sheets, that has undergone a major transformation over the past few years.  The transformation, along with large dividends and a lack of research coverage, has made the story hard to understand.  Having just achieved their first quarter of clean profitability in a long while, we believe the current risk/reward is compelling if you are a patient investor who is willing to manage some of the liquidity challenges MRV presents.

The lack of normalized operating history makes it hard to determine the exact magnitude of the upside, but we believe that shares of MRV are comfortably worth 50-75% more than the current stock price, with a number of imminent catalysts that will cause the market to re-rate the name.  On the down side, there are credible protections which make this a low-risk investment.

Capitalization

Stock Price:  $10.80

Fully Diluted S/O: 7.50M

Market Cap:  $81M

Net Cash: $29M

Enterprise Value: $52M

MRV has been around for about 25 years, over which time it developed into a hodgepodge of dozens of companies from Asia to Europe that were hard to manage and harder to bring to profitability.  The company has accumulated massive NOL’s, and also maintains a large cash balance relative to its market cap – likely attributable to the large decline of its stock price. 

Business Description per the Company

MRV Communications is a global leader in converged packet and optical solutions that empower the optical edge. For more than two decades, the most demanding service providers, Fortune 1000 companies and governments worldwide have trusted MRV to provide best-in-class solutions and services for their mission-critical networks.

We help our customers overcome the challenge of orchestrating the ever-increasing need for capacity while improving service delivery and lowering network costs for critical applications such as cloud connectivity, high-capacity business services, mobile backhaul and data center connectivity.

MRV packet and optical product portfolio places the company at the crossroad of key trends

Along with the transformation to packet optical networks, there are four key trends that have been shaping the telecom industry:

Rise of enterprise cloud services and applications that drive more capacity requirements

Massive traffic growth, dominated by video, that drive increased capacity requirements and transmission speeds

New business models that are challenging existing network architectures and require lower OPEX

Customers are demanding more mobility to connect anywhere, anytime, with any device

Products and Solutions we offer

MRV products empower the optical edge. We deliver packet and optical solutions orchestrated with intelligent software to make service provider networks smarter. Our products enable the delivery of next-generation packet services over any fiber infrastructure, facilitating network transformation and increased efficiency while reducing complexity and costs. As a pioneer and technological leader for more than two decades, MRV has been working closely with its customers and partners to deliver world-class packet and optical networking solutions.

The Story

Over the past few years a number of well-regarded value investors got control of the company and sold off many of the international assets, returning substantial capital to shareholders through dividends.  As these assets have been sold for large gains, the investors have been able to shield the company from paying taxes by using their NOL’s.   Now, after many years of hard work, the company seems to be done pruning and is now turning its attention to growing with a focus. 

MRV now operates as a highly specialized networking equipment manufacturer that caters to carrier-class customers.  They specialize in providing world-class equipment within the optical transport and metro Ethernet markets.  While the company has been mismanaged for years, their products are highly regarded by their customers for both their performance and reliability.  While standards for large telecom, CDN and enterprise customers are high, MRV routinely competes against Cisco, Juniper and the likes and wins.  While their products occupy a very narrow niche, they seem to enjoy a very enviable and strong position within that niche.  Their section of the market is growing faster than telecom as a whole as the explosion of data traffic hits both end users and mobile devices.  You can look to the company’s website for a host of whitepapers and case studies to get a better idea of where they compete in the stack and what types of customers they cater to.

We believe that after its multi-year restructuring, MRV has held on to its finest products and is targeting a market that is ripe to grow much faster than telecom cap-ex in general.  MRV’s products allow telecoms and enterprises to push more data through their existing infrastructure, and to do so in a more cost-effective manner.  Whether it is mobile back-haul services or point-to-point connectivity for data centers, it’s hard to argue with the explosive growth in data transmission.

The company effectively operates out of two divisions.  The first sells the networking products and the second is a consulting arm that helps implement and service them.

The consulting segment operates primarily in the Italian market and was on the block last year.  When no satisfactory offers were received, the company eventually decided to retain the division.  This has proved to be a good decision as the segment has managed to improve upon their profits, growing both top line and margins in the most recent quarter.  Given the challenging cap-ex environment in Italy, this is a particularly impressive achievement and increases our comfort in holding onto the consulting division.

The Turnaround

Over the last few quarters, MRV embarked on a strategic plan to invest in engineering and sales for their core product.  While this had led to some inevitable margin compression on these lines, the latest quarter began to show positive sales traction as well as a transition from segment profitability to company profitability.  We fully expect this trend to continue and that incremental sales will start to fall to the bottom line at a good clip, while the NOL’s protect the company from any meaningful tax expense.  As this plays itself out in the numbers and the company is removed from the pink sheets, we think the market will rerate MRV at a much higher valuation. 

Normalized Earnings Power and Comps

As I stated earlier, with the massive transformation of the company, it is hard to use historical numbers as a proxy for forward-looking performance.  Instead, we will try to back into a range of values and demonstrate a higher price while also credibly laying out what we believe is extremely good downside protection.

The above numbers are taken straight from the 10-Q filed last week.  They demonstrate the tremendous progress in controlling SG&A as well as balancing top line growth with investing in engineering and sales. It seems reasonable to believe that the Integration business will, at a minimum, stay at its current level but is more likely to grow as Italy and Europe begin to play catch-up on cap-ex.

The 10-Q also breaks out the business by segments, and the Integration unit is booking a healthy profit of about $1.5M for the quarter which is about the level of unallocated corporate overhead.  The Networking group is about break-even, but remember that they have significantly ramped engineering over recent quarters.  As those costs subside, we will see the top line grow and we anticipate a good amount of leverage to drop to the operating line.  Once normalized, we estimate about 50-60% of Network revenues will translate to operating profit.

So working backwards, we believe that the business would trade for about 8x EBIT and are looking to justify an EV of about $104M (2x the current EV).  This would imply about 104/8 or $13.0M of EBIT.  In order to get there, we would need $26M of additional revenue.  At the current growth rate that’s about 2  years of growth, and that assumes no growth from the integration unit (which historically has grown). 

While we think those growth numbers will prove conservative given that 50% of revenues come from Europe and they have already delayed cap-ex, we don’t think it will take 2 years for this to re-price.  As soon as the company can show clean profit numbers for a few quarters and growth, we believe the market will re-rate the stock.  Another key catalyst is a relisting to a major exchange, which is imminent in tandem with these events and will help to broaden the investor base.

In addition, the company is buying back significant amounts of stock, which should prove to be very accretive given the large cash balance.  

On a revenue basis, there are a few companies in the space that are pre-profit, about the same size, and trading at 1x revenue.  Conversely, MRV is currently trading at about 1/3 of revenues.

In short, we believe that MRV can be a safe double, perhaps a bit less, but with very solid downside protection.  Let’s take a look.

Downside Protection

We believe you have four specific forces supporting the current share price.

1. Valuation: This has been outlined above.

1. Tangible Book Value: With about $7 of tangible book value and about ½ of that number in cash, we think that there is good downside protection to the stock.  With a stock that is about to be producing FCF, it is hard to see the stock drop below the $9/share range.

1. Stock Buybacks: MRV has been a buyer of its stock for the last few years.  It has excess capital and a board with a good understanding of capital allocation and stock buybacks.  Their latest 10-Q states that they have been buying stock at $10/share and above, with plenty of funds left on their existing buyback program.

1. Acquisition Target: Frankly, it is hard for us to understand why this is a standalone business at this point.  There are a number of duplicative costs in the SG&A line such as public company costs.  On top of that, there are a number of cash-rich acquirers from whom this could easily be an accretive target.  Cisco, Tellabs and Juniper are names that immediately come to mind.  If the price gets too low, MRV will start showing up on investment banker’s pitch decks.  We suspect the board will want to burn off the NOL’s and also bring the operation to consistent profitability before shopping it around.  If it does get acquired, we think it will be for a nice premium.

Below are some of the comps in the space on an EV/Revenue basis as well as Price/Tangible BV.  The first three names are the most similar comps, with Cyan being the best comp.  Cyan is showing robust revenue growth, and frankly we think some consolidation in the space is warranted given the enterprise sales cycle etc.  Despite the similarities to MRV, none of the first three names are close to being profitable.  MRV’s profitability, coupled with the low multiple and liquidity, supports both our valuation thesis and downside protection inherent in MRV.

•  Source Cap IQ, have not validated these multiples.

It is worthwhile to go through the Cyan presentation, as it is informative in helping validate the market size and growth potential.

http://investor.cyaninc.com/investors/events-and-presentations/events/default.aspx

Summary

MRV represents the opportunity to own a niche, best in class player in a growing industry with decent barriers to entry.  They enjoy an existing loyal customer base and their value proposition is immediately accretive to most customers.  With strong downside protection and modest upside assumptions, we believe you can achieve about 50-100% on your money in the next 12 - 24 months, with the value realized by a slew of identifiable catalysts.

Catalyst