Occam Networks, Inc. is my second submission, and coincidentally, it will be my second idea that overlaps with Cherb’s past submissions. For that reason, I hesitated to even write it at all because I understand that could seem odd.  If the stock was simply statistically cheap, I would have passed.  However, there is now a large quantifiable catalyst for the shares that is enough to overcome my hesitation.  I believe OCNW will see at least a 33% surge in revenues that will occur within the next few months which will lift the company to near profitability and meaningfully affect the company’s valuation.  Best of all, this surge is not in the company’s guidance or analyst expectations.

 

In this submission, I will focus on what has changed since Cherb’s initial write-up so I recommend reading his write up.  But, for a quick summary, Occam Networks develops, markets and supports innovative broadband access products designed to enable telecom service providers to offer bundled voice, video and high speed internet, or Triple Play, services over both copper and Gigabit Point-to-point fiber optic networks. The Company’s Broadband Loop Carrier (BLC) is an integrated hardware and software platform that uses Internet Protocol (IP) and Ethernet technologies to increase the capacity of local access networks, enabling the delivery of advanced Triple Play services.  OCNW traded much higher two years ago and the stock price declined significantly for many reasons, but most recently, because of deficient accounting.  With good reason, the market valued the company at a discount to its peers. 

 

While the stock price has been punished, the book cleaning process has begun (although not yet completed – see below) and the company has continued to make progress within its core business.  One of Occam’s customers, Fairpoint, acquired 1.6mm access lines from Verizon and will use Occam gear to upgrade those lines.  This is very significant for Occam, as its typical customer has less than 50,000 lines.  More importantly, the upgrade has already begun and will ramp quickly.  Revenues should increase to 30mm per quarter in short order.  This is the basis for my idea.  I want to stress that because of management’s past displays of financial incompetence, I cannot recommend a long term investment, but instead, I believe there is an opportunity for a medium term trade.

 

First, let’s discuss the accounting deficiencies.  OCNW’s revenue statements revealed that the company had prematurely booked $33 million in revenues from 2004-2006 although all but $5mm of that revenue was ultimately recognizable by Dec 31, 2006.  On 10/16/2007, Occam restated revenues from $125.2mm to $120.2mm as a result.  The committee also found that the company was booking sales to value added resellers and intermediate shipping vendors in connection with shipment of product at the end of the quarters falling on weekends.  In other words, it appears that they were stuffing the channel.  I don’t know how much of these errors were due to incompetence and how much was intentional dishonesty.  Either way, I think investors should be both cognizant and cautious of this accounting history.  For what its worth, the CFO departed and was subsequently replaced on May 8th.

 

Unfortunately, even as of the most recent 10-Q (3/31/08), there is nasty language:

 

“In addition, our audit committee received a letter dated March 10, 2008 from our current independent registered public accounting firm identifying a material weakness relating to revenue recognition and significant deficiencies relating to segregation of duties, post-closing adjusting journal entries, and accounting for parts and fixed asset purchases. Our chief executive officer and our chief financial officer have further determined that, as of March 31, 2008, our internal controls over financial reporting were not effective to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.”

 

In fact, all of this history kept me away from the stock until this point and I understand that it will probably keep some away from the stock permanently.  I will point out that while the revenues were being booked prematurely, the trend in the strength in business was not discredited.

Recently, FairPoint Communications acquired approximately 1.6mm access lines from Verizon covering Maine, New Hampshire, and Vermont and Occam was selected as the lead access equipment provider for their broadband initiative.  Fairpoint’s 8-k on 4/3/08 has some good information in regards to how much they must spend as a result of the merger.  In the first year, it is $141mm, and then $139 for the following two years. 

While it’s difficult to quantify exactly how much of this spend Occam will receive, access equipment should constitute a material percentage of that spending, and Occam, as the lead vendor, should receive a material percentage of the access spending.  The other vendors are Cisco and Pannaway.  From what I can gather, Pannaway should get a minimal amount of the total spend.  Through various informal sources, I’ve heard estimates for Occam of anywhere from 25%-50%+ of the total spend.  Even on the lower end, the revenues are material for a company who expects 90mm revenues this year excluding FairPoint Revenues.  This 90mm figure was recently confirmed in a JPM presentation, and in the Q1 conference call.  The company acknowledges that they will receive FairPoint revenues and that it has already received orders, but is unwilling to discuss presently because it does not want to disadvantage FairPoint by giving information on their plans.  This seems like a credible explanation.  Bob Howard-Anderson, Occam’s CEO, did say that more information will be given on the next conference call.  None of the analysts who follow the company have included the revenues in their estimates and this is why the opportunity exists.

Importantly, to begin to quantify these revenues, Occam discloses their open purchase orders from with contract manufacturers.  At March 31, 2008, this was $15.4, up from $8.4 million on Dec 31, 2007, or an increase of $7mm.  For reference, here are the last 5 quarters of purchase orders (top is Mar08 and bottom is Mar07):

 

The increase from Dec07 to Mar08 is probably due to FairPoint revenues, and if it isn’t, then the business ex-Fairpoint is even stronger than given credit for.  Since it’s not often that a project will ramp immediately to full capacity, I believe that $7mm per quarter is just the beginning.  I’m less sure about what the higher end of the revenues from this project will be but I think $15mm is a reasonable high end estimate of normalized revenues.  Since FairPoint must spend the money and over certain timeframes, the revenues could increase to full potential in short order, perhaps the next 3 quarters or so.

Here is a link that I found helpful (page 26 especially):

Not only is this project material for Occam in terms of revenues, but if successful, this could serve as a valuable reference account for Occam when selling to other Tier 1 customers.  To management’s credit, despite their incompetence in accounting, they have grown the business and appear to be technically competent, having won product of the year awards twice from Telephony Magazine.  I think the possibility is very real that Occam can move from a supplier for Tier 2/3 carriers towards Tier 1 accounts.  At the current share price, the market does not appear to be factoring in that optionality.

I’ve highlighted the FairPoint revenues because this is imminent and significant.  It’s important to point out that there is organic growth in their other business and I’m not factoring that in.  If they could lift the cloud hanging over their accounting problems, I believe the shares could double on just their base business, but don’t expect the accounting problems to disappear overnight.

The company has also initiated its first field trails of its new GPON products.  Occam has guided that GPON revenues could become 15-20% of revenues by the end of this year.  Some of this is factored into guidance for this year, but if successful, this initiative could meaningfully impact the revenues in 2009 and beyond.

Ultimately, if revenues continue to grow, I think the smartest route for the company would be to find an acquirer.  An acquirer could eliminate the accounting problems, and provide liquidity for the VC investors that still hold a position in OCNW.  It’s a thin stock and a liquidity event may be welcomed.  I don’t have any specific insights on this topic other than to say it makes sense.

 

Using my number of $30mm for additional revenues for FairPoint + using the company’s guidance of $90mm for 2008 and gross margins of 40%, here is what the prospective annualized income statement:

 

If this income statement materializes, the company should be generating positive cash flow of 10mm. 

Using the higher end of the range from my write-up, you’ll see the company can easily achieve profitability. 

Diluted shares outstanding is 20mm as of 3/31/08.

EV = 53mm (based on $4.30 share price) and market cap = 86mm.

For technology companies, it’s no secret there is much volatility associated with valuation techniques.  I believe the market would value a stock such as OCNW at 2-3 times revenues absent the accounting concerns.  With the accounting concerns, that number should be on the lower end of the range. 

For the sake of conservatism in this write-up, I will use a 1.5x multiple.  Using 1.5x revenues of 120mm, I get a share price of $9.  While I wouldn’t build a higher valuation into my risk-reward calculations, I think the potential exists for significant upside.  For example, if revenues were to grow to 150mm and the market values those revenues at 3x, we’re looking at a $20+ stock.  A few things have to go right for that scenario to happen, but it’s certainly not out of the question.  For some context, just a little over 2 years ago, the quarterly revenues were ~$15mm and trending higher and OCNW shares were $20+.

Earnings wise, the path looks a little different but the final destination looks similar.  Using 120mm in revenues, earnings will be 0.  Using 150mm in revenues, 40% gross margins, holding operating expenses constant at $48mm, and assuming $0 taxes (NOL will shield for a while), I end up with 12mm in earnings, or $0.60 a share.  I could include interest income from their idle cash, but my numbers are crude as is so I simply marked them at $0.  For a fast growing technology company, I think 20x earnings is an appropriate multiple, but I’ll use 15x earnings because of their accounting history.  That would lead to a $9 stock. 

Of course, I think if someone were to use an earnings based model, that person would look out to 2009 or beyond and discount it back.  Clearly, revenues are growing and depending on assumptions, it’s not hard to get to much higher EPS numbers with a model. 

 

While it’s important to understand the operating leverage of the business model in an optimistic scenario, I think it’s more important to recognize the base case valuation should be approximately double the current share price.  I believe that there is enough value here to minimize risk of loss and make this enterprise value look extremely inexpensive.

I’d rather not put too much emphasis on comps because I think Occam’s situation is somewhat unique, but for reference, I would consider BigBand Networks, Inc. (BBND) as a reasonable comp.  They are in a similar sector, came public around the same time and have disappointed the market.  BBND’s EV/sales is 1.12 compared to OCNW’s EV/sales ratio of 0.6 excluding FairPoint revenues and 0.45 including FairPoint revenues. 

Despite having some risk, I think an imminent catalyst combined with a depressed valuation provides the foundation for a powerful short to medium-term move in OCNW’s share price.

 

 

 

Risks:

-GPON initiative disappoints and the percentage of current year’s guidance that includes GPON is not realized.

-FairPoint revenues are delayed.  (Since the market is not factoring in the revenues, I don’t think a delay would negatively impact the stock price.  Rather, the stock would simply fail to increase.)

-Accounting and financial statement controls.  These problems have been in the open for some time and while not completely cleared, I think the worst is already known.