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Manu Varma, Director of Employee Development at Sierra Wireless, seen here at the Sierra Wireless offices in Richmond, British Columbia, April 13, 2011. (Rafal Gerszak For The Globe and Mail)
Manu Varma, Director of Employee Development at Sierra Wireless, seen here at the Sierra Wireless offices in Richmond, British Columbia, April 13, 2011. (Rafal Gerszak For The Globe and Mail)

strategy lab

Why Sierra Wireless is tremendously undervalued Add to ...

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

In late January, one of the small cap stocks in my Strategy Lab model portfolio traded sharply higher. That company is British Columbia based Sierra Wireless Inc., which I also own personally. This week I’d like to discuss why the stock moved higher and why I believe it is still tremendously undervalued. Naturally, I’m not selling my shares.

In case you missed my initial column discussing Sierra Wireless, the company has two main lines of business. Most people know them for their AirCard wireless modems. They make high-speed USB modems that give people Internet access on the go. But the more exciting part of the business, at least to me, is based on selling products that most end customers don’t touch directly. Instead of USB modems that customers plug into their computer, Sierra’s “machine to machine” (M2M) segment is about putting wireless technology in automobiles, PCs, tablets, networking devices, payment terminals, billboards, or other vertical markets that benefit from wireless connectivity, where that functionality is built right into the product.

For many years I’ve been far more enthusiastic about the M2M market compared to the AirCard market. The AirCard brand is to USB modems as Kleenex is to tissue, or Coke is to cola. For many wireless geeks, the term “AirCard” is used to describe any USB modem even if it’s made by an aggressive competitor. Unfortunately, that’s all too often the case. Sierra makes the best USB modems in the business but it holds very little global market share. The products have become commoditized, and it’s hard for Sierra to convince new wireless operators to carry its gold-standard product when Chinese companies such as Huawei and ZTE crank out good-enough versions for peanuts.

So when Sierra Wireless announced a deal to sell the AirCard business to consumer electronics company NETGEAR, I cheered. Judging from the market reaction, so did investors. The stock moved from about $8 prior to the deal to more than $11 in a few trading days, after the market digested the news.

This deal consolidates management’s focus on the M2M market. It puts about $100-million of net cash in the bank giving the company plenty of powder to go after more acquisitions. As an investor I’m thrilled to see a divestiture of all the parts I wasn’t interested in, and an intense focus on the best parts of the business going forward.

Despite the big rise in stock price, I think this is just the beginning.

Once the NETGEAR transaction closes, Sierra Wireless will have more than $160-million in net cash with no debt. This puts the enterprise value of the business at about $175-million. The business that Sierra Wireless is keeping generated about $400-million in 2012 and is profitable.

ABI Research pegs the M2M wireless device market to grow 27 per cent annually from 2011 to 2016. Think about the strong growth of wireless connectivity built into all sorts of industrial and consumer products. I’m investing in the No. 1 player in this market for less than one half of last year’s revenue.

I don’t need a fancy spreadsheet with detailed income statement projections to realize the potential in this stock. I only need to ask myself a couple of important questions. First, is the market truly growing? Second, can Sierra Wireless earn good margins in this business. I think the answer to both questions is “yes.” When starting from such a low valuation, you don’t need to make highly accurate financial guesses to make money. Give this market some time (and some scale), and watch the profits roll in.

Let’s say Sierra takes its top line to $1-billion over five years. This would require about 15 per cent organic growth per year and a bit of acquired growth (part of their stated plan and one they have a solid track record in delivering). The improved scale should allow for 15 per cent operating margins, which should translate to $3.50 to $4 in earnings per share power. Even if the stock trades at a low 10 times earnings multiple, we’re looking at a possible triple from here. Maybe more. But it requires patience rather than a focus on quarterly earnings micro analysis.

When big changes happen in technology (or any market), the market has to discount two things: time and probability. Discounting time is obvious because you aren’t going to pay a dollar today for a dollar earned in the future.

But discounting the probability is much more interesting to me. When significant profitability seems several years away, not only will people discount the earnings, but they’ll doubly discount them by applying a lower price to earnings multiple against those possible earnings. So when the growth does materialize, the earnings become real and the P/E ratio climbs.

This is exactly what I think will happen with Sierra Wireless over a number of years. That is, unless a larger player comes along and acquires the company. In that case I’ll have to settle for an earlier end to the ride.

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