Description

My top value pick in the networking software industry at the moment is Optibase (Nasdaq:OBAS) which makes software and hardware that enables streaming video over broadband networks. The company is based in Israel but North America accounts for about 47% of the company's sales.

The stock is currently trading near its lows (around $19) due to the NASDAQ meltdown in March. I believe that nothing about the business has slowed since March as demand is rising for video over broadband and Cisco’s purchase of privately held PixStream for $369 million today (08/31/00) validates Optibase’ strategy. I believe that analyst’s estimates for next year’s growth are too low and that demand for new products will create considerable upside to analyst estimates.

At the current prices of $19 or so, the market is valuing OBAS in the following manner (based on my view using DCF valuation):
1. The market expects OBAS to show 26% EPS growth for the next 5 years (as it has done so for the past 5 years).
2. The market then expects OBAS’ EPS growth to drop to 6% in a steady slope downward over the next 5 years as the company matures and then stabilize at 6% growth for the foreseeable future.

I believe that this view is pessimistic on two fronts:

1. The market is projecting Optibase’ 25% past growth into the future when the future for video-over-broadband is much brighter today than in the past. In fact, I would argue that the company’s products are about to take off in a world where bandwidth is going to be cheaper and video-over-broadband will be the killer-app that will propel increasing demand for such bandwidth.

2. The market assumes that the current volatility in the stock would hold with an implied beta of 3.1 resulting in an unbelievable cost of equity of over 25%, which I believe, is too high.

I believe that the stock’s volatility would decrease over time as its story is better understood. Thus a modest reduction in Beta alone which I believe is likely, will result in a higher valuation for the company.

In addition, the company has a tiny float and a small number of shares outstanding which has stymied institutional investors from accumulating the stock. I believe that any future sales by the company to raise cash in fact will not be a negative and may help to raise liquidity in the stock.

Valuation:

Based on a comparison of the company to its peers, I have found that OBAS has a discounted valuation to its peers, which is not warranted. The stock can be priced as high as $32 based on the industry P/E ratio and priced as low as $20 based on its long-term growth rate. However, what is interesting about this valuation is that the company holds close to $10 per share in cash, which makes the discount altogether baffling.

Additionally, Cisco just purchased privately held PixStream today for $369 million. Since PixStream is privately held, we do not know its revenues. However, PixStream was founded in 1996 and has only 156 employees placing a value of $2.4 million per employee. If the same type of valuation were placed on Optibase we would arrive at a valuation of $307 million for OBAS, which would essentially double its stock price.

I believe that the current sell-off represents a good opportunity to accumulate OBAS’ shares since the stock is undervalued relative to its peers and is worth at least $30 in my opinion (based on relative valuation and DCF valuation). I believe that once the company’s growth prospects become clear in the third quarter, the stock will trade up.

Company Summary:

Optibase Ltd., based in Israel, provides high-quality, cost-effective solutions that enable the preparation and delivery of MPEG-based digital video over ATM and IP-based networks. For the 3 months ended 3/31/00, revenues increased 25% to $7.4M. Net income decreased 1% to $1.3M. Revenues reflect an increased customer base and new product sales. Net income was offset by higher research and development and SG&A expenses. OBAS has grown revenues consistently at 25% over the last 5 years.

Catalyst

 OBAS is likely to outperform the market when “Video over the Internet” becomes a compelling value proposition for all businesses
 Cisco bought privately held PixStream for $369 million today (08/31/00). Optibase, which is larger and more established than PixStream is trading for a total market cap with cash of $169 million, which we believe, is a bargain. The company holds more than $85 million in cash alone.