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STRATEGY LAB

Redknee Solutions: Why I’m shrugging off the stock’s recent setback Add to ...

Chris Umiastowski is the growth investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

One of the best performers in my Strategy Lab portfolio has been Redknee Solutions Inc., a small-cap Canadian stock that has soared from $1.18 a share when we launched Strategy Lab in September, 2012, to above $6 now.

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It’s gratifying when stocks I own take off like a rocket. (Disclosure: I also own Redknee in my personal portfolio.) But I don’t get emotional about these successes, because I want my portfolio to be determined by logic, not feelings. Get too tied up in short-term fluctuations and you lose track of the long term picture.

One definite benefit from my lack of emotional involvement is that I don’t panic when the market sours, as happened to Redknee after it reported fourth-quarter results last week. The market didn’t like the numbers, and the stock tumbled, losing almost 15 per cent.

The natural reaction was to think there must be some kind of devastating news. Not so fast.

Look deeper and you find the “problem” facing the stock in the short term is exactly why I’m bullish on the long-term story. In fact, I think the long-term opportunity looks even brighter than it did last year.

As a reminder, Redknee is a software company. It sells billing software to the wireless operators who sell us smartphone and tablet data plans. Historically these wireless companies have used software from other companies, but Redknee seems to offer a more compelling feature set. It focuses on selling software as a service (SaaS), so most of its revenue is recurring, which I like.

When I added Redknee to my portfolio, it was a small player in the billing software industry. But in December of last year it acquired a similar, but much larger software business from Nokia, which wanted to focus its effort on building and running broadband wireless networks.

For a modest price, Redknee quadrupled its revenue line and gained some very big global customers, including T-Mobile and Vodafone. This transformational deal turned Redknee into a big boy within its industry, and is largely responsible for the tremendous returns I’ve seen on the stock so far.

So why the big drop in price last week? In short, management is now competing for deals worth over $100-million in revenue. For a company with a market capitalization under $600-million, deals of this size loom very large. Seeing the obvious opportunity, management has ramped up R&D spending so that big customers can feel certain that Redknee will deliver the kind of support they expect. This increase in R&D was not anticipated by analysts, and resulted in an earnings miss that clobbered the stock.

Most sell-side analysts who cover the tech sector are hard-working and smart. But they’re often covering a dozen different stocks and it’s nearly impossible for them to anticipate the minor issues that the market reacts to. Yet the professional investment crowd is often compensated for short-term results. So when a high-flying stock shows any signs of short-term weakness, it takes a beating and it doesn’t matter that the reason for the short-term weakness (for example, increased R&D spending) is directly related to the long-term opportunity of winning the biggest deals in the company’s history.

With its sub-$600 market capitalization, Redknee is currently valued at about 2.5 times sales. For a software company facing incredible growth opportunities in a hot industry, I think that’s quite reasonable.

It may take a few years, but with good execution I look forward to seeing the company sport a valuation of more than $1-billion. Between now and then, there will continue to be bumps in the road. The market will get more excited and nervous than I will when it comes to short-term performance. I’ll watch the quarterly results only from the perspective of long-term objectives. In my mind this is the perfect combination of sleeping well at night and earning superior returns.

 

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