Ottawa tech company DragonWave, faced with an ailing customer that once accounted for 80 per cent of its sales, needed to do something drastic.
So it struck a deal to buy a piece of a Nokia-Siemens joint venture that could boost its sales eightfold. It is, as many have said, a “transformational” acquisition for the maker of microwave radio equipment for wireless Ethernet networks.
The problem, however, is that DragonWave’s share price has also been transformed, gaining nearly 70 per cent from its 52-week lows. Investors seem to be expecting a smooth integration and a rapid ascension of sales and earnings – and rejecting the advice of several analysts who say DragonWave’s path to profitability may be a rocky one. They’d be wise to listen to the skeptics and exercise some caution.
In at least one respect, shares of DragonWave are immediately appealing: As of its third fiscal quarter, ended in November, the company had no debt and $60-million (U.S.) in cash, or nearly $1.70 per share. That means, at DragonWave’s lows in 2011, you could have had the operating business for little more than $1 per share.
A glance at DragonWave’s income statement shows why: Sales dwindled from $158-million in fiscal 2010, to $118-million in 2011, to an estimated $52-million in the fiscal year that closes this week. The company’s profits disappeared; it’s expected to post negative EBITDA, or earnings before interest, taxes, depreciation and amortization, of nearly $30-million.
The problem is Clearwire Corp. , a wireless network provider that was once DragonWave’s major customer. Clearwire’s WiMAX network technology increasingly looks passé, as North American carriers embrace LTE (or “long-term evolution”) networks instead. Clearwire plans an LTE rollout in 2013, but the money-hemorrhaging company will likely need hundreds of millions more in financing to pull it off. (Clearwire represented just 5 per cent of DragonWave’s third-quarter sales, illustrating how much it has had to scale back.)
Hence DragonWave’s move to buy the microwave equipment business of Nokia Siemens Networks, a joint venture of the two international tech giants. In essence, Nokia Siemens is outsourcing the business of making the products; DragonWave becomes the “preferred, strategic supplier” to Nokia Siemens, which will continue selling the microwave-transport technology to its customers.
DragonWave management sees, at full ramp-up of the new business in 2013, annual sales of $400-million (up from about $300-million today), with gross margins of 30 per cent (up from about 26 per cent) and operating margins of 10 per cent.
Let’s set aside the issue of the risk of replacing one large customer with another, and focus on the estimates. What we find is that a number of analysts who follow the company are deeply skeptical of DragonWave’s goals.
“We believe the transition will be rocky and investors should wait for tangible progress,” says CIBC World Markets’ Todd Coupland. National Bank Financial analyst Kris Thompson says, bluntly, “We do not expect DragonWave to achieve these targets.”
Mr. Thompson, who has downgraded the company’s shares to an “underperform” and a $3 (U.S.) target price, believes DragonWave’s stated goals would translate to about 75 cents per share in earnings “if everything goes as planned,” but the “near-term results will look ugly,” with another loss for the year ending February, 2013.
Mr. Coupland, also with a “sector underperformer” and target price of $3, notes DragonWave’s money-losing ways could eat into its cash balance, and the costs of the new acquisition could quickly exhaust the entire $50-million debt facility company management has said it will use in buying and integrating the business. “Our bottom line is the balance sheet has greater risk given all these moving parts and the real chance that targeted revenue could be volatile and lumpy … leading to greater-than-expected cash burn rates.”
This degree of uncertainty creates both outsized risk and opportunity. If DragonWave management is right, earnings per share could top $1, and recent share prices of around $4.75 seem cheap. (Bullish analyst Peter Misek of Jefferies & Co. places a 10 multiple on his $1 earnings per share forecast for the year ending February, 2014, and sets a $10 target price.)
What seems at least as likely, however, is that investors have been too quick to embrace the estimates of a company that’s dancing on the edge. Buying at current levels could be a transformational event of exactly the wrong kind.