Description

Spirent Communications is a hardware and software testing company based in the UK with a long history in the field.  Its products traditionally helped test equipment such as routers and switches to assure their manufacturers that the products worked as advertised.  Its customer base in this area includes market leaders such as Cisco, Juniper, Arista Networks, Ericsson, etc.  Over the years the company has broadened its solution set and now provides service assurance products for telecom service providers such as AT&T and Verizon, as well as GPS testing equipment to the government and security test equipment to players such as Check Point, Palo Alto, and Fortinet.

To understand where Spirent is today and where we think it is going, you must understand a little bit of the recent history of the company.  Spirent used to be a growth company back when the Internet (and Ethernet) was new and everyone needed new routers and switches to connect.  As time went by, the business slowed as penetration amongst end users increased.  Spirent then began to slowly diversify its business by introducing new product lines to target existing and new customers.  In late 2006 an activist investor firm called Sherbourne Investors Management LP launched a proxy fight against Spirent and won 4 board seats out of 7.  With the board under its control, it proceeded to slash R&D spending with the result that Spirent generated peak operating income over a three year period and its stock price reached (post-Internet bubble) peak levels in 2012, when Sherbourne exited its investment. 

The relative paucity of R&D spending while Sherbourne controlled the board left the company in a weakened competitive position exiting that period.  In 2013 new CEO Eric Hutchinson laid out a plan to invest substantially in R&D  for three years to revitalize the company’s product line and reinvigorate its competitive standing.  The company is just emerging from this period now and is looking to grow with its new product set and some new external growth drivers in the market.

In terms of the competitive landscape, this market is a duopoly between Spirent and its US competitor, Ixia Communications.  While both companies are similarly sized, over the years there have been alternating share gains and losses between the two.  Ixia was purchased last year by Keysight Technologies (KEYS) and this has caused some disruptions within the organization, which Spirent is currently looking to capitalize on.  There are also other small players when you look at some of the adjacent markets Spirent has branched into. 

Traditionally the test market has been driven by technology cycles in the marketplace, forcing customers to upgrade or buy new equipment.  The new market driver at this point is 400G Ethernet, which is just starting out for the switch and router manufacturers and some of the telecom service providers.  This market was slow to get going last year which cause a dip in demand for Spirent, but is going to be a major driven in 2018.  Other newly ratified speeds such as 50G, 5G, and 2.5G will contribute to demand as well.        

Security test is a relatively new market for Spirent.  In this business, Spirent’s hardware generates realistic traffic that it passes along to the firewalls, intrusion prevention boxes, etc. being tested.  Within that traffic is embedded malware of various kinds that Spirent’s equipment tests to see if the devices under test can detect.  This product is called CyberFlood and has had a successful launch into the marketplace.  Spirent has small market share in this area but expects to increase over time.  Spirent groups its Ethernet testing business and its security business together for reporting purposes.  In aggregate, they generate about 60% of Spirent’s total business and we expect them to grow about 10% per year.

Another relatively new area for Spirent is the VisionWorks product line of lifecycle service assurance products that the company sells to telecom service providers like AT&T and Verizon.  These products detect underlying causes for outages in the network and speed repair times for the customers.  Spirent is unique in its active approach to assurance where its sends traffic into the network (similar to its security products) and can detect problems before  they affect the customer’s underlying user base.  This business is about 20% of Spirent’s overall revenue and we expect it to grow 10% going forward.   

Finally, Spirent has a wireless device testing business that has been in decline for the last three years.  This business is made up of two pieces; one is handset testing for conformance to standards such as 4G, and the other is testing devices for positioning such as GPS and GNSS.  The positioning part of the business has stayed relatively strong while the conformance test business has been very weak with the decline of the 4G cycle.  The overall business has now stabilized at about 18% of revenue.  We believe there is a good chance that this business begins to grow again as the 5G cycle starts to ramp up later this year but for now most investors are not focused on this.

Overall we view Spirent at this point in its lifecycle as an operating leverage story.  Management is tightening the screws on spending now after three years of heightened R&D investment.  The company is well positioned to grow given its new businesses such as security and lifecycle assurance, its 400G Ethernet test business, and its 5G wireless testing business.  The bar for revenue growth at Spirent is very low given that it hasn’t appreciably grown its top line in ten years.  If we are even partially right, Spirent will re-rate and its stock will move considerably higher.

In terms of numbers, we expect Spirent’s revenue to approach $500 million in 2018, representing about 9% growth from 2017.  We expect operating expenses to be about flat year over year leading to operating income of $73 million or about 15% of revenue.  At this level, operating margins would be at their highest level in seven years.  There is an opportunity for management to shrink operating expenses somewhat which would raise operating income even higher than our estimates.

In terms of a multiple, since we think Spirent can grow operating income at a 20% clip the next few years we think a 20x P/E multiple on 2018E estimates makes sense.  This would result in about 50% upside from current prices.

Catalyst

The catalyst will be as results get reported through 2018 showing the revenue growth and operating leverage of the model.  Spirent could also be acquired by a player like Keysight Technologies (KEYS) who is alrger and has been very acquisitive in the space.