Description

The Internet of Things (IoT) is a broadly used term that is appropriately used by many, but often abused by companies trying to attach themselves to one of the hot trends in the market. I would even dare to say it might be used more than the “_____ as a Service” tag. While my eyes typically start to glaze over when someone tells me they are an IoT play, it is undeniable that connected devices is a large and growing market that warrants some investigation and investment exposure. Some of the more mature IoT markets are short-range networking technologies that are used to cost effectively connect a wide variety of devices to local networks such as Wi-Fi, Bluetooth and ZigBee. A relatively young and emerging IoT connectivity market is what is known as Low Power Wide Area (LPWA). These technologies include SigFox, LoRa and new low-power low-cost LTE variants that seek to efficiently connect devices over miles rather than meters. The move to low cost, low power LTE is gaining significant momentum with carriers worldwide upgrading their networks to support the standard.  AT&T and Verizon will both have nationwide support this year. I like this trend due to the financial power of the carriers, their need for new growth avenues, and the low cost upgrade (software upgrade) of their existing networks to support the new LTE standards. LoRa and Sigfox require either new service providers, or existing providers to make some significant hardware additions to their networks. There are several ways to invest in this trend but I think one of the most promising is one of the few modem companies remaining and they happen to have a lead in the market. Sequans Communications (SQNS) was the first to market with these new LTE products and is a relatively unknown company with accelerating growth and scarcity value. 

Background

SQNS is a leading provider single mode LTE (Long Term Evolution) connectivity solutions. LTE, what is commonly referred to as 4G wireless, is a standard that was ratified in late 2008 with select deployments in 2009. We saw the first LTE service in the U.S. in 2011 with nearly 100% coverage of the U.S. by the end of 2013. It is clear now that majority of the world will eventually be covered by LTE networks, however, in 2008 this was not so obvious. At that time there was a competing 4G technology backed by Google and Intel named WiMax. WiMax gained momentum in 2008 when Sprint, Google, Intel, Comcast and Time Warner pooled spectrum and merged with Clearwire to market WiMax service. SQNS was originally a leading provider of WiMax chips. The company actually went public based on rapidly ramping sales of chips supporting WiMax on Sprint’s network. Sales ramped from $19M in all of 2009 to $31M in just the second quarter of 2011. SQNS went public in early 2011 at $10.00 per share and the stock reached nearly $17.00 before Sprint pivoted away from WiMax and basically pulled the rug out from under the company. 

After Sprint/Clearwire decided to move to LTE, this was clearly the beginning of the end for the WiMax technology. There would be several smaller countries that had fixed wireless providers using WiMax for the next several years, providing a small baseline business. Overnight CEO Georges Karam had to completely refocus the company on LTE, which was the beginning of a multi-year restart. SQNS refocused on becoming a single mode LTE company in a bet that as LTE coverage proliferated companies would opt for cheaper single mode chips vs multimode chips that also support earlier generations of wireless networks (2G, 3G and 4G). This makes sense for non-handset applications such as tablets, portable routers, laptops etc especially sub $200 tablets and portable routers that carriers give away for free with a two-year contract (think Verizon JetPack). This move has been fairly successful with the company growing revenue 65% in 2014 and 45% last year. While this line of business (replacing multimode with single mode) can likely grow to nearly $100M of revenue over the next two years, we believe the focus on low power/low speed LTE solutions holds much more potential. 

Internet of Things Products

In 2014 SQNS began to explore variants of LTE for the Internet of Things (IoT). Rather than focus on higher and higher data rates (commonly advertised by carriers) SQNS began to develop a solution with low power requirements, low speed and low cost. This would address the millions of devices that don’t require high data rates such as asset tracking, smart metering, remote sensors, alarm panels, etc. as well as devices where low power consumption is paramount such as wearable devices; think Apple Watch, Fitbit, Samsung Gear. The company revived the Category 1 (Cat-1) LTE revision that had never been utilized due to its low speed of 10 mpbs (most LTE is Cat-4 or above support 150 mbps). The lower data rate requirement allowed SQNS to develop a much smaller chip with less complexity that requires much lower power. This also allowed for a reduction in cost by over 50%. The interest in this solution has been robust and even lower speed and lower power standards have been introduced. After some debate it appears there will be two ultra-low power solutions: Cat-M and NB-IoT. For reference a Cat-M solution is expected to cost approximately $5 compared to roughly $40 for a Cat-4 or higher solution. Cat-M is also expected to enable low-power devices to last up to 10 years on a two AA batteries.  This point is crucial.  This longer battery life (without driving up the cost) is an enabling technology for many IoT applications where the “things” are geographically dispersed.  By definition, most enterprises looking to link their assets to the Internet wirelessly are doing so because a wired connection is not available on an economic basis.  Obviously, in many of these cases, constant battery replacement would make these applications impractical and uneconomical.  Lastly, we should note that the Cat-M and NB-IoT solutions are fairly similar and SQNS will actually address both standards with a single product. One significant difference is that Cat-M supports VoLTE. 

I believe SQNS is now the clear leader in the low power LTE market.  The company introduced its Cat-1 product in 2015 and is now certified on Verizon, AT&T, T-Mobile and NTT Docomo in Japan. Sales of Cat-1 have just started and we expect will ramp throughout 2017 and 2018. They introduced their CAT-M/NB-IOT product in early 2016 and last month they introduced and updated version that includes an ARM processor. The company has announced partnerships with Verizon, Gemalto, ST Micro, Foxconn and Huawei to name a few, and their ecosystem continues to expand rapidly. We expect Cat-M revenue to begin to ramp in late 2017, which will layer on top of growing Cat-4/Cat-6  and Cat-1 revenue. We expect SQNS to grow revenue at approximately 45% this year mostly driven by Cat-4/Cat-6 and Cat-1. We expect the company to exit the year at a nearly $100M annual run rate with CAT-M accelerating growth in 2018. 

The competitive landscape in this market is quickly evolving. SQNS is the only remaining independent single mode LTE Company after Sony purchased Altair Semiconductor a year ago. I expect Altair (under Sony) to continue to aggressively pursue the low power market, but Sony may cede the Cat-4/Cat-6 high speed market to SQNS. I believe SQNS has at least a nine-month lead on Altair in the low power market. Qualcomm is the dominant LTE modem company and has announced products for the low power market, but they remain multimode products, which largely defeats the purpose of providing ultra-low power/cost. Intel has also announced products, but they are following a similar path as Qualcomm. We believe SQNS also has at least a 9 month lead on both of these companies and we expect these companies to keep their primary focus on the much larger handset market. Huawei has been one of the largest proponents of the NB-IOT standard and I expect them to be a competitor with their Hisilicon unit. However, last week I was surprised to see Huawei will use SQNS’s modem for CAT-M and possibly NB-IOT which speaks to the company’s leadership. 

Valuation/Potential Return

Looking at valuation SQNS is not cheap on traditional cash flow metrics as they are currently losing money. The company has guided to being breakeven later this year with quarterly revenue north of $20M. They raised money last year and had over $20M of cash on the balance sheet at the end of the year, which should provide enough cushion to reach profitability (the company has been serial capital raisers during their turn around so I would never say never, but I think they are done selling stock). I’ve used two different valuation methodologies for SQNS: buyout and earnings potential. 

In an acquisition scenario I look at the revenue multiple paid for Altair. While they were a private company I estimate they were doing $30M-40M in revenue, which would equate to a revenue multiple of 5.25-7x. Using that multiple on 2017 revenue equates to a range of $4.10-$5.40 per share.  Using the low end of that multiple on 2018 estimates yields a share price of $6.50. 

I don’t want to rely completely on a buyout (although I think it is likely) for my valuation and look to a rough model of the company’s earnings power. The company had gross margins of 44% last year and operating expenses of $40M. I expect margins to remain similar or compress slightly this year as some CAT-1 and CAT-M shipments are modules rather than just chips. Modules are mid 20% margins versus chips at 50% or better. As volumes ramp nearly all revenue will be chips and margins should trend to 50% or better. Operating expense should stay mostly flat as SQNS has been spending heavily on new products. I would expect some additional sales expense on higher revenue and for other expenses to drift slightly higher as they seem to always do with higher revenue. Using revenue levels of $150M, $200M and $250M, gross margins of 50% and operating expenses of $45M, $55M and $65M yields pretax earnings per share of $0.33, $0.50 and $0.66. I believe this level of revenue and earnings is achievable in 2019 as CAT-M continues to ramp. This level of earnings would justify a $5.00+ share price. 

Conclusion

SQNS is a unique asset with increasing appeal to potential buyers. I expect as revenue continues to ramp and the market potential for LTE-M/NB-IOT becomes apparent to a larger audience the stock will react accordingly. While the price performance in the last 3 months has been impressive the stock is essentially flat Y-o-Y despite continued revenue growth and a rapidly expanding customer base. I think it offers an attractive under-the-radar growth stock investment. 

Risks

• Competition from Qualcomm, HiSilicon, Sony etc.
• Slower than expected ramp of IoT products and market
• Execution missteps

Disclosure: The fund I work for is long shares of SQNS and may buy or sell shares at any time without notice.

Catalyst

• Ramping IoT revenue
• Potential buyout