Description

Westell Technologies (WSTL)

Summary

Westell Technologies Inc. (WSTL) designs, distributes, markets, and services a range of broadband, digital transmission, remote monitoring, power distribution, and demarcation products used by telephone companies and other telecommunication providers.  WSTL has an Enterprise Value (EV) of $38m and trades less than 3x annualized 9 mos. EBITDA (approx $14m), less than 4x free cash flow, and less than 4x EBITDA less capital expenditures (approx $12m).  A new management team took over in Feb/Mar 2009 and has overseen a dramatic turnaround in Q1, Q2, and Q3 of fiscal 2010 (ended 3/31) due to higher gross profits, reduced operating expenses, and minimal capital expenditures.  CEO Rick Gilbert has focused on profits and cash generation in 2009 and for LTM net cash position has increased by $14m (See Quarterly Results below). We think WSTL can generate $10m to $15m of free cash flow per annum or 15 to 20 cents per share.  WSTL also has a cash-rich balance sheet with a net cash position of $58m or 87 cents per share (60% of market cap). Share price is $1.40, market cap is $96m, and EV is $38m.  Unleveraged FCF yield is over 30%.  We believe the asset-rich balance sheet provides good downside protection at these price levels, while continued cash generation and execution of the growth plan (described below) could eventually drive shares near $2.50 per share.  WSTL provides an attractive investment opportunity with asymmetrical risk-reward characteristics.

WSTL will release Q4 results after the close on 5/18 and we are hopeful to see continued progress on EPS and cash generation.

Business Description

WSTL has three segments:

Customer Networking Solutions (CNS) had LTM revenue of $77m and LTM gross profit of $13.8m.  CNS provides customer premises equipment and related software that enables high speed routing and networking of voice, data, and video services.  CNS customers are North American ILEC's and top 20 IOC's.  CNS customers include Verizon, AT&T, CenturyLink, Fairpoint Communications, Cincinnati Bell, Hawaiian Telecom, and Sasktel.  Targeted additional customers include Frontier Communications, Qwest, Windstream, and Telus.   CNS strategy includes a) making core business profitable and sustainable; b) expanding customer base to include most North American telcos; and c) transitioning the core business to a software-based, higher-margin model.  In the modem area, Motorola (MOT) is a competitor.  In the gateway area, 2Wire (private) and Actiontec (private) are competitors.  Management believes they have been increasing market share in CNS.  CNS gross margins have improved as customers are purchasing higher-end, higher-margin type products.  CNS is the company's most competitive and lowest margin segment.

Outside Plant Systems (OSP) had LTM revenue of $54m and LTM gross profit of $22.7m.  OSP products include outdoor cabinets, enclosures, power distribution, edge connectors, remote monitoring, and DS1 and DS3 transmission plugs.  OSP customers include wire-line and wireless service providers, multiple system operators (MSO's), utility providers, and OEM manufacturers.  OSP strategy is to harvest the legacy T1 transmission product lines while aggressively pursuing opportunities in wireless backhaul, smart grid, and associated integrated cabinet based systems.  OSP generally has a lot of smaller competitors without one 900 pound gorilla.  Also OSP relationships are strong as they are literally out in the field with major telcos providing customized solutions to their problems.  OSP primary focus has been on the wireless backhaul market, where a substantial portion of their business comes from, as well as smart grids.

Conference Plus (CP) had LTM revenue of $42m and LTM gross profit of $19.5m.  CP products include audio, web, and video conferencing services and online tools.  CP customers include more than 7,000 unique customers with almost 40,000 individual hosts.  CP strategy is to focus on higher-margin differentiated services and target specific vertical markets.  Competitors include Intercall (a subsidiary of West Corp), Premiere (PGI), and BT which are much larger.  Therefore, CP has sought to focus on customers that are less price-sensitive, including those vertical markets more concerned with types of service and quality of service than just price.

Strong Balance Sheet and Downside Protection

WSTL has an extremely strong balance sheet with a net cash position of $58 million as of 12/31/09 or about 60% of the market cap.  Its net cash position has been steadily building over the past four quarters under the new mgmt team and we expect this to continue.  Also, WSTL has a strong net working capital position of about $75 million or almost 80% of market cap.

Strong Cash Flow Generation

WSTL outsourced its manufacturing for telecomm products in fiscal 2008 and facilities in Aurora, IL are primarily used for distribution.  The Company's primary expenditures are for R&D and sales and markets as well as general and administrative expense.  Consequently, WSTL's three business segments are not capital intensive: we expect total capital expenditures to come in at $1 to $2 million for fiscal 2010 (ended 3/31).  Under the new management team, WSTL has generated very strong cash flow - cash from operations for 9 mos of fiscal 2010 is $14m and only $2m of this is from working capital changes.  We believe WSTL can sustain cash generation near these levels.

Improved Profitability

As discussed, new management has driven sharp improvements in profitability for 9 mos of fiscal 2010.  Quarterly results below show the consistent improvement in operating results.  Cash operating expenses have declined 36% from $18m in Sept 2008 Q to $11.5m in Dec 2009 Q.  Furthermore, on a consolidated basis, gross profit dollars and gross profit margins have improved year-over-year for three consecutive quarters.  For 9 mos of fiscal 2010 the company has generated EBIT of $8m and EPS of 11 cents.  We believe WSTL can achieve EBIT of $10m to $12m for fiscal 2010 and EPS of 13 cents to 15 cents (EPS is not fully taxed).

Shift from Hardware Products to Higher Margin Software Products

CNS generates the most revenue but it has the lowest gross margins and was generating large operating losses before new management entered.  CEO Gilbert sharply reduced operating costs and improved gross margins by focusing on profitable revenue growth.  The focus is on transitioning CNS core business to a higher-margin, more software-based model.  They are seeking to move away from lower end products to higher end residential gateways with better margins.  CNS recently announced the extension of its contract to provide its Ultra Line Series3 product to Verizon for its FIOS system into residential customers.

Management is focused on transitioning its gateway type product at CNS to be more software oriented in order to achieve higher margins.  There is the ability to load software applications in these gateway products.  The result could be very sophisticated home gateway products that have the ability to significantly expand functionality via software.  CNS is focused on developing its Home Cloud software strategy.  Home Cloud is WSTL's undertaking to build software-based broadband products and services intended for residential users.  Home Cloud would control from one point home-based activities such as network security, file mgmt, media sharing, energy mgmt, home security, and various applications.

Strategic Plan

In fiscal 2010 (ended 3/31) WSTL's strategy has been to return to profitability (Q1, Q2, and Q3 all profitable) and generate cash flow ($14m+ generated in LTM).  Management has concentrated on building profitable customer relationships and gross margins have improved as a result.  Although consolidated sales were down for Dec 2009 Q gross profit dollars were actually up due to improved gross margins, primarily at CNS.  We expect management to continue focusing on profitable growth and higher margin business rather than just trying to grow sales.  New management has done a good job executing on its plan for fiscal 2010 so far.

In fiscal 2011, WSTL strategy will shift to focus more on growth opportunities.  Management has repeatedly stressed that these are very targeted and focused growth initiatives with significant planning behind them.  These growth initiatives include a) CNS next generation products; b) CNS Home Cloud software and device development; c) OSP Ethernet wireless backhaul; d) additional new products for OSP; and d) CP differentiation and managed bridges for clients.  We believe there will be some investment in growth in fiscal 2011 but we do not expect it to be a large number.

Conclusion and Target Price

While WSTL's three segments are not wide-moat businesses, we do think they have viable business niches and, at current prices, you are not paying much for the optionality of continued strong free cash flow generation and/or successful execution of the strategic plan.  These businesses are not capital-intensive and have attractive ROIC numbers.  CNS is certainly a tough business but we think OSP and CP are better businesses than one might think at first glance.

Based on 5x our conservative target EBITDA of $18m for fiscal 2011 and a $65m net cash position by year end fiscal 2011, WSTL could trade for $2.30 or more per share vs. $1.40 per share today (+65%).  Alternatively 8.5x our midpoint FCF of $12.5m plus $65m of net cash divided by 67m shares results in $2.50 per share (+80%).   If the strategic plan works well and/or cash generation exceeds our estimates, we think there could be significant upside to our target price.

Summary Financial Information

Catalysts

• 1. Strong free cash flow generation; net cash position should continue to over time; large $67m NOL to shelter cash taxes.
• 2. Management focus on improved profitability and higher margin sales opportunities.
• 3. Management shift to a more software-focused business should be positive.
• 4. Consistent generation of profits on quarterly basis.
• 5. Low valuation of less than 3x our fiscal 2010 EBITDA and unleveraged free cash flow yield of 30%.
• 6. Low risk balance sheet with net cash position of $58m as of 12/31/09 (60%+ of market cap)

Risks

• 1. Telecomm sales results can be volatile quarter to quarter due to inventory stocking, etc.
• 2. Customer concentration with sales to two largest telcos representing almost 50% of sales in fiscal 2009.
• 3. Telecom business is severely impacted by the recession.
• 4. Dependence on new product introduction.

Disclaimer

Disclaimer:  We own shares of WSTL.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst