Description

When I recently got around to analyzing PWAV and its operating leverage situation for myself, I saw a company that had modest to decent top line prospects with an extraordinary earnings growth for the next 18 months. The company also has a very disciplined management team that demonstrated this degree of discipline by choosing to merger with the right partner. This merger made sense and (although still significant) it dilutes Nortel’s contribution to PWAV’s sales. The company’s balance sheet is strong with a $2 net cash position, and good cash flow. The upside for the stock is around +50% while the downside to the shares is in the neighborhood or 10% to 15%. Management has great influence on one of the potent catalysts.

DESCRIPTION:

Powerwave Technologies (PWAV) basically makes single and multi-carrier linearized power amplifiers for use in mobile network base stations. These linearized power amplifiers are extremely important components of wireless infrastructure because of what is known as an “SNR” –- signal-to-noise ratio. SNR is an integral part in the understanding of the wireless world because an acceptable SNR is required for clearer calls, greater signal range, and fewer dropped calls (understandably, all of these attributes rate very highly with consumers and wireless providers are keenly aware of these facts particularly in this new, number portability world where unsatisfied customers are more likely to switch carriers). PWAV’s customers are wireless infrastructure OEMs, like Ericsson, Nokia, Nortel and network operators such as Verizon, Cingular and AT&T Wireless. Nortel’s contribution to PWAV’s sales has been drastically reduced but is still a whopping 30% of revenues – more on this later.

The opportunity for PWAV seems to be in both the growth in base stations and maximizing its operating leverage. Since the mobile base station is at the center of wireless communication, let’s look a little closer at the base station. The typical base station costs about $250k. One can break this cost into three areas: connectivity (which costs about $90k), network operations ($100k) and what the industry calls radio frequency (RF) footprint which costs about $60k. The RF Footprint area is where capex is growing. Over 50% of the cost of the RF Footprint is in the cost of a single power amplifier. PWAV is a pure-play in this area but also competes with Andrew Corp., REMEC, among others. While the company has not seen pricing pick up, global capex spending in the RF Footprint is more likely to be non-discretionary than some may believe do customers increased propensity to switch carries with inferior service – providers do not have the luxury of, say, cable companies in making capex more discretionary. Industry watchers expect long-term growth of capex in the RF Footprint should range in the 15% to 20% range.

Regarding operating leverage, PWAV’s acquisition of a competitor last week made sense for a few reasons. First, with the acquisition of LGP Allgon, PWAV was able to significantly reduce it dependence on Nortel Networks which contributed to over 60% of sales based on the most recent filing. After the acquisition, Nortel’s contribution to the top line will be less that 30%. Headquartered in Sweden, LGP Allgon markets telecom products. The company is #1 supplier of tower mounted amplifiers in that region and is number 2 or 3 in other areas such as base station amplifiers. Second, the top-line synergies management discussed during the conference call are real as there appears to be very little overlap in customer/product concentration between the two companies. With this acquisition, PWAV’s market will be expanded by increasing the RF Footprint. The acquisition makes good strategic fit. PWAV’s sales mix in 20% carriers and 80% OEMs. By contrast, carriers account for 60% of sales and OEMs at 40% for LGP Allgon. Lastly, the deal will be accretive. When investor David Rocker (who is PWAV’s largest shareholder) quizzed management on this point, management answered enthusiastically, “Yes, we believe it’ll be accretive in the first full quarter after the transaction and accretive beyond those dates…”

Management can a bit euphoric at times; so let’s look a bit closer. The $15 million in annual savings that management discussed are small and doable given that the focus is outside the “four walls” of the company. The savings will be generated mostly by purchasing efficiencies and the reorganization of the supply chain. Getting plant efficiencies which is part of the synergy story are a bit tougher, but represent a smaller contribution in the $15 million number – about $3 to $5 million. PWAV will finance the ~$420 million deal (about 1.5x EV/Revs for ’03) by offering 1.1 shares for each of the nearly 50 million shares of LGP Allgon. In addition, PWAV will offer LGP Allgon shareholders the alternative to tender shares for cash (with a $125 million max). The deal represents a ~43% premium based on the announcement date. The acquisition is not scheduled to close until March of 2004 and requires a vote approval by 90% of LGP Allgon shareholders and has no collar.

For 2004, combined sales should reach around $600 million (up from $515 million) with positive cash flow (ex- consolidation expenses of about $7 to $9 million). The vast majority should come from power amplifiers:

45% -- power amplifiers
17% -- tower mounted amplifiers
11% -- antennas
10% -- repeaters/TMB
08% -- contract manufacturing
05% -- RF conditioning
04% -- microwave


PRICE & VALUE:

The share price has been basically in a trading range since the summer for a number of reasons: first, despite overall trends in cell phone sales, near-term visibility remains poor on capex spending in base stations. Second, the stock is still fresh from a series of downgrades while it was trading at $10 -- valuation was rich, gross margins continued to be depressed while ASPs and customer concentration were disproportionately affecting PWAV’s bottom-line given the company’s pure-play business model. Another reason causing the stock to languish is because, this new acquisition has yet to be fully absorbed by the market. The arbs may also be shorting PWAV to capture the spread, putting a temporary lid on the stock price.

Fundamentally however, the share price should be much higher given its valuation and outlook. The company looks reasonable on an EV/Sales bases but not on P/E. Combined EV/Rev valuation on ’04 numbers places the company at around 1.2x – 1.4x – somewhat inline with comparables. Regarding earnings, PWAV is expected to lose ($0.37) this year and is expected to swing to a profit and make $0.13 in 2004 and $0.35 in ‘05 (generating a 21x P/E, not to far from comps). The shares are worth at least $11.00 – implying an exit multiple of about 1.8x of EV/Rev on ’05 numbers of $660 million in sales (based on the low end of the 10% expected year-over-year top line growth assumptions discussed earlier). Earnings growth should triple off its low base from 2004 to 2005. Downside is around $6.50, given historical valuations, contributions for the recent acquisition and PWAV’s balance sheet strength. All of this assumes the deal gets done. The arbs seem to think that the deal will close, as well.

Catalyst

1) EPS growth in 2004 will be very high regardless of a potentially modest top line growth. For example, gross margins expected to increase from 16% to 22% in 2004 and to 24% in 2005. This is due the combination of PWAVs 18% and LGP Allgon’s 25% margins. Organic EBIT margins should double from ’04 to ’05. My guess us that investors will start to look at ’05 in about four to six months from now.
2) The introduction of 3G (or the fast uptake of 2.5G) services at existing operators will be a major catalyst as newly stringent demands is placed on the OEMs and carriers. This should keep top line (i.e., capex spending in this area) growing multiples of GDP.
3) The impact of local number portability to providers for upgrades and to maintain quality.
4) Capturing greater synergies from the LGP Allgon acquisition.