Description
Sycamore (SCMR) is a technology ex-darling of Wall Street. The Company, which IPO'd in 1999 briefly high an all time high - at over $200 per share in 2000 with a market capitalization over $20 billion. The company then began its long multi-year slide. At the peak, the company was long on sizzle but had a very unfavorable investment proposition. An investment anywhere near those levels was, to paraphrase Jim Grant, equivalent to "return-free risk" and subsequent events bore this out.
While revenues jumped between 1998 and 2000 due to some strong orders from several telecom companies during the boom years, revenue imploded as the telecommunications infrastructure building bubble came to a halt and industry wide, capital spending by telecom companies imploded. Today, Cap Ex in the aggregate is at unsustainably low levels. However, industry analysts are unable to peer through the fog ahead to predict when (or whether) the currently gloomy outlook will improve.
Today, the price per share is $3.60. With about 275 million shares outstanding, the equity market value is currently $990M. As of the end of last quarter, the cash and cash equivalents stood at $961M. Adjusting for cash burn estimated to be under $10 million per quarter, the underlying business is currently valued at about $80M (one year from now assuming they burn through another $40 million of cash in the next year or so).
Despite all the problems and uncertainties, SCMR at today's price represents an interesting free option on a variety of potential developments, any one of which could make this investment a double or triple from current levels within the next one to three years. On the flip side, there is very little downside from current levels because most of the negatives are more than priced into the stock and investors seem to be assuming that nothing will ever go right again for tech and telecom equipment companies. The current environment feels like a point of maximum pessimism and the risk reward is once again favorable with a good margin of safety provided by the company's ample cash reserves.
I am sure that it will interest many of you to know that Marty Whitman (of third avenue fame) is now one of the company's largest stake holders with over 9 M shares. One source seems to support the notion that they may still be buying - it never hurts to be in good company, though of course it is better to satisfy yourself that the facts and the reasoning are right.
The Business
Sycamore develops and markets optical networking products for telecommunications service providers and has a worldwide market. Target customers include a variety of domestic and international telecommunications service providers, Internet service providers, and newer start-up service providers, systems integrators, governments and enterprise organizations with private fiber networks. Though the market is broad, revenues have been imploding across the industry due to a tough spending environment, hangover from previous bubble spending, and some company specific size related challenges. The company has a very good optical networking product portfolio including fully integrated edge-to-core optical switching products, network management products and design and planning tools. The quality of this portfolio has been validated by some high profile wins against other leading equipment providers though these wins have not yet impacted revenues fully (e.g. Sprint win)
A bit of history (from their well written filings)
The world’s telecommunications infrastructure is largely supported by fiber optic networks primarily owned and operated by service providers. Following deregulation and privatization in the global telecommunications industry, there were many new entrants into the service provider market. Emerging service providers built networks and began competing with incumbent service providers in an effort to accommodate rapid traffic growth and projected growth on the public network. At the same time, readily available capital further fueled the growth in the number of service providers. Many equipment vendors offered substantial vendor financing to service providers as an inducement to build their networks. These events created significant demand for networking equipment.
In early 2001, access to capital decreased and in response service providers began curtailing their network build-outs. Within a short time period, service providers dramatically reduced their overall capital spending. Equipment vendors also ceased providing vendor financing, which further decreased available capital. As a result, there was a slowdown in service provider equipment purchases and a sharp decline in demand for networking equipment. During this time period, several service providers failed and a number of them sought bankruptcy protection. At the same time, however, some service providers looked to new optical products to help them more efficiently optimize and expand their networks to handle the increased traffic load while also managing their spending and expenses. In addition, following September 11, 2001, for defense and homeland security purposes, government agencies have increased investments in advanced, high-speed networking and communications technology.
What is Optical networking?
Despite the telecommunications industry’s economic difficulties, data traffic on the public telecommunications network continues to increase with the widespread use of the Internet and the World Wide Web. Consumers and businesses increasingly use the Internet for applications such as electronic mail, electronic commerce, and other voice, video and data services. This growth is increasing the demand for capacity, or bandwidth, at all levels of the public network.
Most service providers own and operate traditional optical networks designed primarily to support voice traffic. These traditional optical networks have a number of limitations on a service provider’s ability to offer services which provide a competitive advantage due to the following factors:
• Networks initially designed for voice traffic.
• Inefficient utilization of network capacity. In traditional optical networks, only one half of the available capacity is used for delivering services. The other half remains idle in the event of a network failure.
• Expensive to build and operate. Building traditional optical networks is a capital-intensive process, and requires the interconnection and management of multiple network devices. These separate devices require substantial space and power, and increase the cost and complexity of network operations.
• Time consuming, complex service delivery. In traditional optical networks, the delivery of high-speed services is a highly complex, labor-intensive process that requires a highly skilled workforce and can take months to complete.
• Difficult and expensive network expansion. Adding or changing high-speed services in traditional optical networks is difficult and expensive. As a result, service providers cannot quickly or cost-effectively respond to unplanned changes in their customers’ demand or accommodate rapid increases in data network traffic.
• Limited ability to offer new services. Traditional optical network services are optimized for voice, not data. The inefficient nature of traditional optical networks limits the types of high-speed services that can be offered to customers. In addition, the high cost of creating and managing high-speed services in traditional optical networks impacts a service provider’s market competitiveness.
Sycamore’s optical switching solutions enable service providers to transition from inefficient, voice-centric networks to more efficient, data-optimized networks. Sycamore has integrated, edge-to-core optical switching products that can significantly reduce service providers’ capital and operating costs, simplify network operations, and provide the foundation for a new generation of optical network services. Uptake has been slow due to the aforementioned cap ex headwinds and competition. However, the company has a good portfolio of products and R&D technology that should have value in a number of different circumstances that are detailed below.
Management
The company is run by a proved duo, Gururaj "Desh" Deshpande (Chairman) and Daniel Smith (CEO) were the same team that founded and sold Cascade to Ascend and then (I believe) to Nortel. Both are independently wealthy (probably in the $100M+ range) and have significant stakes in Sycamore. Despite the ups and downs, they have continued to execute while taking the tough actions necessary to conserve cash. Through three significant restructurings over the last 3 or so years, the company has managed to get cash burn down to about $10 million per quarter with about 350 employees. They have done this while continuing to invest in R&D and continuing to put out great products that have established them as one of the technology leaders in the optical networking space. They manage for the long term, care about shareholder value and manage the business for the benefit of shareholders. I met Desh a number of years ago. He is ethical, focused, and visionary and my experience is that cream eventually rises above challenges. That fact that this company is still around after so much adversity is a testament to this management team.
Catalysts
As mentioned above, almost everything that could gone wrong has done so and almost every conceivable negative is priced into the current value of the company. However, after three or four bad years, some of the underlying secular trends should begin to swing the pendulum in the other direction. There are a number of potential developments, any one of which could make this option valuable over the next one to three years including any of the following:
1.) Strategic Review bears fruit - the Company hired Morgan Stanley earlier this year to explore strategic alternatives. The company’s product portfolio and R&D strength in a vary important area could begin to unlock significant value for shareholders thought the outcome is currently uncertain. Sycamore should probably fit nicely and be additive to a number of companies in this industry including companies like Nortel, Lucent, Cisco (longer shot), Tellabs, etc. However, biggest obstacle would be that everyone of the potential buyers is down and out right now, and an acquisition to build long-term value may not be that popular with wall street and not of these already unpopular companies can probably afford to take even a perceived risk at this time. If the business is sold for significantly above the embedded value of $40 to $80M in the next 6 to 12 months, SCMR could be a quick 30% to 50% from here. A deal could be followed by a large dividend though the company will try to do it in a tax efficient manner. In addition to the cash, the company has NOLs of about $345M which is assumes are worth nothing (on the balance sheet due to a valuation allowance). However, a strategic buyer might put a higher number of these NOLs in a properly structured transaction
2.) Resource conversion - the company may use its cash to increase dividends, special onetime dividend, or buy back significant amounts of stock which could increase the price.
3.) Cap Ex environment for telco improves and the pursue strings begin to loosen (even temporarily) leading to a re-acceleration in the top-line revenue growth.
4.) Recently announced customer wins (e.g. Sprint and the Federal Government GIG-BE - considered to be a 9 figure order in the early stages of procurement) ramp up into revenue over the next 2 to 4 quarters and multiple expands.
Risks
As mentioned, the risk reward here is quite favorable with limited downside and asymetrical upside. Not a lot has to go right for this to end up a good investment.
In terms of risks, for completeness, I mention that these is some chance that:
1.) the result of the strategic review is that the company engages in a stupid acquisition. Due to the quality of the management team, I would think this is unlikely.
2.) Product cycle never improves and never gets an more traction (unlikely due to the underlying trends of bandwidth growth and the shift to optical coupled with their good product portfolio and capabilites)
3.) Scale disadvantage - they are much small and have a far more focused product portfolio than many of the big competitors and this is a disadvantage. However, this makes them a potentially interesting acquisition for other players. Also because they focused, they have developed very good products in their niche and due to these efforts, they have beat out some of the biggest players in the optical network space (a space which will expand in the years ahead)
Summary
Although SCMR is a technology company, it features good management and a compelling valuation with essentially a free option on the possibility that either a.) telecom spending improves b.) their strategic process bears fruit b.) customer wins slowly start to make an impact on the top line with a lot of potential operating leverage. Meanwhile, the downside risk is very limited by the cash in the balance sheet, the hidden NOL assets, quality management and management ownership, and very low annual burn rate.
Catalyst
Although SCMR is a technology company, it features good management and a compelling valuation with essentially a free option on the possibility that either a.) telecom spending improves b.) their strategic process bears fruit b.) customer wins slowly start to make an impact on the top line with a lot of potential operating leverage. Meanwhile, the downside risk is very limited by the cash in the balance sheet, the hidden NOL assets, quality management and management ownership, and very low annual burn rate.