|Shares Out. (in M):||51||P/E||0||0|
|Market Cap (in $M):||302||P/FCF||0||0|
|Net Debt (in $M):||-41||EBIT||0||0|
I believe Calix, Inc (CALX) represents a compelling long opportunity at current levels. The story here is relatively straight-forward. The stock is currently trading near historic low valuation levels in terms of EV/S due to extremely depressed bottom line results YTD in 2017 caused by several factors that should reverse moving forward, and more recently by a negative pre-announcement from their primary competitor. While the stock does not currently appear cheap on bottom line metrics (they’re generating losses), I believe they will return to profitability in 2H18 and their significant earnings power (relative to the current valuation) will become apparent over the next 12-18 months. Trading at just 0.5x EV/Sales, the valuation is compelling for a company that has grown its top line at a respectable 9% CAGR over the past 5 years (since 2012), was consistently profitable on a full year basis from 2010-2015, and has a target operating model of double digit operating margins. As they return to profitability and show progress towards their target operating model, I would expect the valuation to move closer to its nearest comp (ADTN) at about 1.2x Sales, representing a more than doubling in the stock from here.
What do they do?
CALX is a supplier of hardware/software to Communications Service Providers (CSPs). They are focused on the access (or last mile) piece of the telecom network. Their offerings enable CSPs to provision a wide range of service offerings to end customers through packet-based technologies over diverse types of physical networks (DSL, DOCSIS, GPON, etc). Basically CALX products allow their CSP customers to increase offerings to their end customers while reducing investment in physical networks and with lower operating costs. Their customer base is primarily telcos (as opposed to cable) in North America and they’ve historically served Tier 2/3 operators. While they have about 1300 customers, they do have some customer concentration, with CTL being their largest at 21% of sales in 2016 (and likely somewhat more than that YTD in 2017).
As one can see, the recent poor operating results are not at all consistent with their historical profitability levels.
Before getting into a discussion of CALX’s recent results and my forecasts, I’ll briefly discuss what is likely the company’s biggest top line growth driver moving forward, namely VZ’s NG-PON2 rollout. By way of background, both ADTN and a CALX/Ericsson partnership were selected in mid-2016 for initial lab trials. ADTN specifically press-released their participation in mid-2016, while CALX did not. However, ADTN has referred to being one of two vendors in the trial, and CALX on their Q217 earnings call talked about beginning field trials for NG-PON2 with a ‘large North American Tier 1’. This can only refer to VZ. CALX on the same call stated “this customer can and we believe will become a greater than 10% customer. There's no question in our minds about that.”
It is believed that VZ will end up using both ADTN and CALX/Ericsson in their NG-PON2 rollout. This article discusses VZ’s goal of using multiple vendors and interoperability amongst vendors:
…while this blog indicates a belief that CALX/Ericsson will be the “primary beneficiary” of VZ’s NG-PON2 (albeit they speculate at poor margins):
The timing of the ramp is certainly still an open question. ADTN stated recently that they don’t see a ramp from VZ before 2H18, though VZ (speaking at CALX’s annual user conference in October ‘17) said the following:
"If everything goes correctly... by the end of the year it should be in a state that's a deployable state from Verizon's perspective," said Verizon Director of Technology Vincent O'Byrne, speaking at the 2017 Calix Connexions Innovation and User Conference here. "[We will then] start deploying probably in the first quarter of next year."
In summary, I assume that CALX is involved here and that VZ likely becomes very material to revenues over time. As discussed more below, I assume some upward inflection in growth in 2H18 due to VZ.
While CALX’s recent top line growth has been strong at 14% YTD in 2017 (relative to its 5-year CAGR of 9% since 2012), this has been entirely driven by significant growth in its recently negative GM services business, which has been the primary factor driving bottom line losses recently. Focusing specifically on the services business, a couple factors have been responsible for significantly dragging down GMs here, namely their taking on (or perhaps being forced by large customers to take on) significant structurally low margin ‘development services’ business, poorly priced contracts (with poorly defined project scopes) signed in 2016 that largely have been recognized in 2017, and poor internal management/cost controls. 2017 YTD service GMs are -17% and were -27% in Q317. There are a number of reasons to believe this drag reverses moving forward:
The other significant factor driving losses recently has been a big ramp in R&D spending, as they’ve invested significantly in 1) their software-defined networking (SDN) platform called AXOS which they believe will be accretive to product GMs over time, and 2) investment in projects for new customers (I believe significantly related to VZ). Non-GAAP R&D expense increased nearly $10M from $21.7M in Q116 to $32.5M in Q117 (a 50% Y/Y increase), but has trended down slightly since then and has been guided to continue to trend down in $ terms moving forward as the incremental spend for investment in the AXOS platform is largely finished at this point.
Finally, I’d note that product revenues will likely grow sub-1% in 2017, substantially lower than in prior years. This also likely has been a drag on sentiment recently. I think this re-accelerates in 2018. While the company did not historically break out product revenue versus service revenue, the disclosures in 2017 included 2016 splits and indicate that product revenues were well over 90% of their business through Q316 (but had fallen to 83% of revenues in Q317 due to the 200%+ growth in services revenues). I think the 5 year revenue CAGR of 9% is generally representative of their product revenue growth rate over that period, given how immaterial services revenue had been before 2017. I believe the biggest reason for this slowdown in 2017 is a tough Y/Y comp (when revenues grew 13% in 2016), while management also attributes it somewhat to a shift in spending by their customers towards services. I find the latter explanation a bit questionable to be honest. Nevertheless, I believe that product revenue growth should move back towards the historical trend for a couple reasons:
In the model above, the key assumptions I’ve made for 2018 are:
Under these assumptions, their operating margins approach 5% in Q418 (and annualized EPS approaches $0.50), putting them well on their way towards their target 10%+ operating model ($1+ in EPS) with continued revenue growth.
In addition to the factors discussed above that have dinged profitability (and the stock) that I believe will reverse moving forward, most recently competitor ADTN pre-announced a big miss on revenues in Q417. On 12/28/17 after the close, they announced that revenue would come in at $125M versus prior guidance of ~$160M, a miss of over 20%. (on a side note, a nice gift to their institutional shareholders on the last trading day of the year!)
They blamed merger-integration related spending delays at a ‘domestic tier 1 customer’. This customer is CTL, who acquired LVLT during the quarter. In addition the being CALX’s largest customer, I believe CTL is also ADTN’s largest customer at 24% of 2016 revenues. ADTN’s stock has predictably sold off (~11%) since the announcement. CALX’s stock has also been hit – it’s currently down over 6% since ADTN’s pre-announcement (after selling off as much as 12%). This is despite CALX announcing their earnings date this past week without themselves pre-announcing. My discussions with the sell-side in the immediate aftermath of ADTN’s pre-announcement led me to believe that it was one particular program at CTL where ADTN was the sole supplier that was the culprit. That said, given the magnitude of the miss, I believe ADTN must have seen weakness elsewhere beyond CTL given the magnitude of the miss (unless CTL essentially went to zero for them, which seems unlikely). We’ll know more about ADTN when they report this coming Wednesday, Jan 17. But the fact that CALX did not pre-announce only strengthened my view that this was ADTN-specific. While I can’t rule out that some CTL-related weakness could show up for CALX, the stock has already been marked down, which I believe is likely presenting an opportunity here.
Given that CALX has recently been unprofitable and I expect it to stay so for a few more quarters, the most tangible valuation metric we currently have to look at is EV/Sales. CALX currently trades at ~0.5x Sales, which is very low relative to: