Procera Networks (Nasdaq: PKT) is an interesting investment at the current price of $8.89 per share. Although the company doesn’t generate cash flows and it is difficult to pinpoint exactly how much the company is worth based on a traditional DCF, I think that at this price, the investment represents an asymmetrical risk reward.

The downside is limited because of:

1. the high level of cash on the balance sheet  - more than $5 per share in cash, which represents close to 60% of the stock price.
2. the minimal cash burn rate.
3. the low probably of an acquisition that would eliminate the cash (management says that the company would like to have at least $100 million on its balance sheet to show the customers that they are real).
4. the low enterprise value.

The upside is harder to quantify, but I think that there are multiple ways to win when the company resumes its organic growth rate and if the company gets acquired.

Our target price is around $15 per share (69% upside), and our downside case is $7.5 per share (15% downside).

At least 2 insiders seem to agree. In particular, director Thomas Saponas bought 50K shares at $8.68 after the company released Q1 numbers, after already buying another 50K around $11.35 on 3/7/2014. He had sold most of his shares above $20 in 2012, so hopefully he will be right again. Another director bought 5,700 shares at $8.66 per share after the Q1 release.

Procera provides software and hardware that allow telecom operators to gather intelligence on how their networks are being used, enabling these operators to take appropriate action. There are three standalone companies that compete in the space: Procera, Allot, and Sandvine. Larger companies (Cisco, for example) also have competing offerings. Basically, these companies provide detailed real-time information on network traffic. They are called DPI (deep packet inspection) vendors.

These DPI vendors are used in parallel with another class of software that allows networks to set subscriber policies (which enables service providers to manage data growth and deliver personalized services). These are called PRCF (Policy and Charging Rules Function) solutions. These policies enable service providers to manage data traffic by applying real-time bandwidth controls that adapt to changing network conditions and subscriber context.

To provide some historical background, a number of these PRCF solution providers were standalone companies until recently, but they have all been acquired by larger companies. Amdocs bought Bridgewater in June 2011. Cisco bought BroadHop in December 2012, and Oracle bought Tekelec in March 2013. These acquisitions made strategic sense. Cisco combined its DPI offering with BroadHop policy offering. Amdocs and Oracle combined their billing solutions with policy solutions. Since operators like to provide different packages (policy functions) based on different subscription packages (billing functions), it did make sense to integrate billing and policy functions.

The DPI vendors provide the information that feeds into the policy function. One aspect of my thesis is that the same integration requirements that pushed policy providers to be acquired by larger companies will eventually lead to the acquisitions of these standalone DPI providers. As part of my research, I spoke to former employees, an industry analyst, and investment bankers, and among them there is general consensus that the question is not if but when these companies will be acquired. There are many potential buyers, from network providers such as Juniper, Cisco Ericson, F5 Networks, and Alcatel Lucent, to billing vendors, such as Oracle or Amdocs.

From a valuation perspective, Sandvine (SVC on the TSX) has an enterprise value of around $400 million and LTM revenue of around $123 million for an EV to Revenue multiple of 3.3. Allot Communications (ALLT on Nasdaq) has an enterprise value of $288 million and an LTM revenue of $100 million for an EV to Revenue of 2.9. Finally, PKT has an enterprise value of only $78 million and LTM revenue of $75 million for an EV to Revenue of 1. Although there may be some reasons why PKT should trade at a discount to the other 2 players (less profitable, quality of the customer base), I think that the discount is too steep and an EV of $78 million for this company is too low. Based on my discussion with different industry participants, I think that M&A would take place between 2x and 3x Revenue. Assuming 2014 revenue around $84 million (consensus) and a 2.5x EV to revenue multiple, the stock would be at $15.5 per share, which is our target price. Our downside case assumes a multiple around 0.5x Revenue.

The opportunity exists because the company has missed its Q4 2013 and Q1 2014 growth projections.  The CEO used to talk about 30% revenue growth but has now brought these numbers down to 15%.  After missing numbers twice in a row, the company is in the penalty box. The stock was as high as $25 per share during the last 2 years based on these higher expectations. Revenue in Q1 2014 was flat compared to last year. The company has guided to 15% revenue growth rate for 2014. The company has guided 13-14% growth rate for Q2 and above 15% in the back half of 2014. Last time I spoke to the company (last week at the annual meeting), they reiterated their comfort with their Q2 guidance. I think that M&A is not necessary to happen for this idea to work. If the company can just do what they have guided and show that they can grow at 15%, I would expect the multiple to expand and be closer to its peers.

There is a lot of lumpiness in these revenue numbers. It is worth noting that 18 months ago, it was Sandvine that was in the penalty box after missing a couple of quarters and showing no growth. SVC was then trading at around 1x revenue. And Procera and Allot were trading at very high multiples. And now it’s Procera’s turn.

From a technology point of view, the feedback I received from discussion with industry participants is that the technology is on par with, if not superior to, the other offerings. This is evidenced by the fact that Procera came last to market and has been able to gain market share over the last few years. Sandvine created the space. Allot came in second and Procera came last to market and has built its business by taking customers from Allot and Sandvine because of the technological quality of its solutions.

PS Price is as of yesterday's close.