Light at the end of EXFO’s fibre-optic tunnel

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Some investors like companies with easy-to-understand products, consistently rising sales and inexpensive valuations.

EXFO Inc. is not for them.

Instead, the Quebec City maker of testing equipment for telecom companies may appeal to investors who like industry leaders that have fallen into a cyclical funk — and should return, eventually, to their high-growth, profitable ways.

It takes that kind of longer-term thinking to get excited about EXFO these days. The company has spent much of 2012 disappointing investors. Second-quarter revenue, announced in March, was below expectations; the company pre-announced a third-quarter miss and net loss; and fourth-quarter guidance, issued in late June, was under the consensus expectations of analysts. A multimillion-dollar restructuring charge suggested a turnabout is not imminent.

The result is a year-to-date loss of 20 per cent and current price levels near 52-week lows, almost half the 52-week high. (Shares closed Friday at $4.70.)

Yet the company still has a forward price-to-earnings ratio that's pushing 30. What gives?

The answer is that the mishaps of 2012 suggest that better days for EXFO are more likely to come in 2013. And if they're anything like EXFO's past, they could be quite nice.

"This is a good company with exceptional management and products [that has] poor order momentum driven by carrier spending weakness," says analyst Robert Young of Canaccord Genuity.

The "carriers" are the wired and wireless companies that use EXFO's product to test whether their networks are working. As analyst Thanos Moschopoulos of BMO Nesbitt Burns notes, EXFO started out with products used primarily when a network was built and activated, limiting its ability for recurring revenue. Also, EXFO's equipment was limited to more basic tests, rather than more complex issues of voice and video quality.

That has changed over time. EXFO now has what Mr. Moschopoulos calls "a better mix" of products for many kinds of tests across optical, copper and wireless networks over the course of their lives.

That product mix contributed to revenue gains of 33 per cent each in 2010 and 2011.

The problem right now is weak capital spending by EXFO's core customers, who also seem to spending less at other telecom vendors like EXFO competitor JDS Uniphase Corp.

EXFO's problems read like a road map to the current global concerns: Europe, where it gets nearly a third of its sales, is troubled, China is slower than expected, and the U.S. isn't picking up as quickly as hoped.

That's prompted a number of analysts to get nervous about what they term the lack of visibility into the company's short-term earnings, with seven of nine placing "hold" ratings on the shares. Mr. Young, of Canaccord, has a "hold" rating and $5 target price despite his complimentary comments about the company.

Kris Thompson of National Bank Financial, who also has a "hold" rating and $5 target price, said that while the company's stock "could see torque once the [capital expenditure] spending cycle improves, we'd sit on the sidelines and buy this stock later on the way up, and not try to catch the bottom." (His comment came in June when the shares were about 10 per cent higher.)

BMO's Mr. Moschopoulos, who had the misfortune to initiate coverage in April with an "outperform" and $9.50 target price, is one of two who maintain a "buy" call, though his target is now $6.

"We were clearly too early with our call on the stock; however, we continue to believe that EXFO's challenges are a function of the telecom spending environment rather than indicative of any company-specific issues," he said.

"If history is any guide, we see the potential for significant upside to the stock once the cycle ultimately turns, and we continue to see the risk/reward to the stock as attractive."

EXFO is debt-free and has cash that is now nearly a quarter of its market value. And the company's enterprise value – market capitalization plus net debt – is now less than one times revenue. "While we generally focus on earnings-based metrics," Mr. Moschopoulos said, "in our view it's not common for healthy companies in the telecom equipment space to trade below [one times] EV/sales for sustained periods of time."

The stock may kick around for another quarter or two at those levels, while the poor visibility continues. And another disappointment may produce some more price erosion. But investors intrigued by the EXFO opportunity may find that once the market shows some signs of life, the shares will zip ahead like light on a fibre-optic cable. It would be best to get in when sentiment is still dark.