One of the stocks in my Strategy Lab growth portfolio that prompts plenty of e-mail questions from readers is DragonWave Inc. This Ottawa-based technology company builds equipment that wireless service providers use to pipe bandwidth to the cellular towers that our mobile devices connect to. We’re constantly using our mobile devices for more data-intensive applications, which means the cellular towers need bigger and bigger data pipes connecting them to the Internet.
The old way of connecting cellular towers to the Internet was with copper wires similar to the classic phone network. In today’s world of 4G networks, operators either need to connect their cellular equipment with fibre optic cable or, where running fibre is too expensive, use specialty high-capacity wireless equipment to carry the data. This latter option is what DragonWave does so well.
In the long term, I think there is a huge market for what DragonWave is selling, known in the industry as “backhaul” wireless equipment. It’s much cheaper to setup a wireless link than to trench miles and miles of fibre to a cellular station outside of dense urban areas. I also believe DragonWave’s equipment is the best in the business, which is something I look for in an investment.
But it’s not always enough to have the best products in a market that faces enormous growth potential. The timing has to be right. With DragonWave, I might be right about the long-term opportunity and right about its product leadership; yet still be wrong about the stock if revenue doesn’t grow quickly enough.
Cash is king, and DragonWave is burning through its cash reserves quickly. If the cash runs out before enough growth materializes, this investment won’t work out in my favour. This is the reality of investing in higher-risk technology stocks.
When I added DragonWave to my model portfolio last July, I acknowledged the very high risk level. The company only had $24-million (U.S.) in cash, which it was burning through rapidly. Management estimated that the company was two quarters away from cash flow break-even because sales were looking strong, and activity was expected to translate into real orders in the short term.
Here we are, almost one year later, and DragonWave just reported fourth-quarter results for fiscal 2014. Rather than grow, the revenue line has dropped substantially over the past two quarters. Management’s estimate for reaching break-even has been pushed out by about one year.
The cash position has now declined to about $19-million, despite a recent equity financing. If the much-anticipated revenue growth is delayed for much longer and the company is unable to raise more cash, this is a stock that could drop to practically zero.
That said, we are finally seeing some light at the end of the tunnel. DragonWave’s order book for the current quarter is showing tremendous strength, and it’s looking like it will deliver 50 per cent sequential revenue growth in the first quarter.
The government in India just completed a wireless spectrum auction where operators such as Vodafone, Bharti and Idea Cellular spent more than $9-billion for rights to launch 4G networks. Japan’s Softbank has also acquired Sprint and is expected to invest billions in network expansion. Both of these major projects should benefit DragonWave. Meanwhile, there are other major projects DragonWave should benefit from in Pakistan, Indonesia and other parts of Asia.
It looks like DragonWave has finally hit the inflection point we’ve been waiting for. If enough growth materializes this year, the company should stop bleeding cash and finally reach profitability. With a market capitalization of about $70-million, I still believe shareholders are facing a fairly binary outcome. Either the business becomes a financial success and we’re rewarded with a multibagger (i.e. the stock price rises several-fold from here), or the business opportunity doesn’t bear fruit before DragonWave runs out of money, in which case investors could be looking at a something close to a total loss.
As volatile as the stock and the financial results have been over the last year, I don’t think much has changed with respect to the overall opportunity. I’m happy to hold a small position in this very risky stock, and I wouldn’t recommend it to anyone who didn’t truly understand the risks.
DragonWave is a good example of how it’s not enough to be the leader in an industry. The timing has to work out too. That doesn’t always happen.
Disclosure: The author also owns DragonWave in his personal portfolio.