Description

I have been a bad boy and did not submit any ideas last year so my account has been frozen.  I must now work myself back into the good graces of VIC. 

 

The last idea I submitted was Redback Networks (RBAK) on August 2, 2005 at a price of $8.55.  I know this because as a member in bad standing I can only look at my own ideas.  ;)  RBAK was a provider of telecom equipment with a best of breed solution for service providers looking to roll out "triple play" (voice, video, data) services.  My recommendation garnered an astonishingly low rating of 2.5 which probably caused me some discouragement.  Fifteen months later, the company was acquired by Ericsson for $25 so please keep that in mind as you read this write-up. 

 

Today I would like to recommend Occam Networks (OCNW), another telecom equipment company specializing in access systems enabling service providers to roll out triple play services.  Occam has a somewhat convoluted corporate history, so it is probably worth giving you some background. 

 

• The company was started in 1999 by Mark Rumer, a well regarded industry veteran who played a key role in developing Cisco’s voice-over-IP technology. 

 

• The company went public through a reverse merger with Accelerated Networks in 2002.  At some point, Accelerated’s business  plan was abandoned and for many years the company has been all Occam.  Even though the company was nominally public, trading volume was limited and 85% of the shares were held by the original venture capitalists. 

 

• In March 2006, the company effected a 1-for-40 reverse split which brought the shares to their current trading range. 

 

• In November 2006, the company had a primary and secondary share offering which was essentially a going public transaction.  The lead underwriter was Weisel, accompanied by Jefferies, Merriman Curhan and Canaccord Adams. 

 

As of late 2003, the company had a promising product, but revenues were low and the operating loss and corresponding cash burn was significant.  At this time, the company was ostensibly a public company, but it was still 85% owned by the original venture capitalists.  The company was out of money at this point, but the VCs continued to fund the company at an enterprise value of roughly $60mm.  In March 2006, the company did a 1-40 reverse split and in November 2006 did a public offering that was sort of a re-IPO whereby the company became listed and gained a more institutional shareholder base. 

 

An investment in Occam requires accepting two important points that are beyond the scope of this report.  Some cursory research will reveal that these are not particularly controversial points. 

 

1. Delivering triple play services is an important priority for all manner and make of telephone company, from the RBOCs down to the small independents.  While these services can potentially double the average revenue per user, it is really more a matter of competitive necessity.  Those who do not upgrade will be lose considerable share.  (The most prominent example of this is probably Verizon’s FiOS service.) 

 

2. The explosion in data transport requirements is spurring a large generational change in network architectures.  Going forward IP/Ethernet will be the protocol of choice.  This change will not happen overnight so it will be important to continue to support legacy protocols as well, but the future is clearly and unequivocally going towards IP (Internet Protocol) and Ethernet. 

 

Occam sells a platform, the BLC6000, which is a differentiated and technically superior platform to enable delivery of triple play services.  This platform was built from the ground up using an IP/Ethernet architecture and is inherently better than competing platforms which are mostly still based on legacy technology.  The major company is Calix, a private company.  Calix has a legacy ATM based platform that is inferior to Occam's.  They are supposedly coming out with an IP based platform but it is proving very very late to market.  Other minor competitors include Zhone and Pannaway (private) which are losing share.  Adtran, with its Total Access 5000 solution,  is a potential competitor to watch although they are just starting to deliver. 

 

Occam has chosen to focus initially on the 1100 or so independent rural telephone carrier.  This is a good market as these customers tend to be both loyal and early adopters.  As the company has grown, it is now beginning to focus on larger carriers such as Embarq, the former wireline division of Sprint.  The paradigm for this type of company is Advanced Fibre Communications, which from 1994 to 1998 grew revenues from $18mm to $300mm selling their AccessMax platform largely into this market.  (AFC then chose to focus on the RBOC market and was acquired a few years ago by Tellabs.) 

 

Occam first introduced its BLC6000 in 2003, and revenues have grown rapidly since then.  The company has grown revenues from $3.2mm in Q1:03 to $20.1mm in Q4:06.  The balance sheet is clean with $60mm in cash.  2006 revenues were $69mm and consensus expectations are for growth to $95mm in 2007 and $125mm in 2008. 

 

The company has been profitable for the past few quarters, but the income statement is only just starting to normalize.  The business model calls for 42% gross margins and 13-14% operating margins, both of which are reasonable for a company in this industry, although AFC achieved 18-19% operating margins at its peak. 

 

At just 1.0x 2007 revenues with at 30-40% growth rate, the shares are exceptionally cheap.  The stock price is down to $8.50 from a high of over $20 even as business continues strong.  More tellingly, the enterprise value is just $100mm.  In late 2003, when quarterly revenues were just $3.7mm and the company was running a large operating loss,  the venture capitalists were financing this company at a $60mm enterprise value.  My feeling is a more appropriate valuation is closer to 2.5-3.0x revenues and this is consistent with other similar, rapidly growing comparables such as Big Band Networks.  Notably, Redback Networks was acquired for almost 6x 2007 revenues.  I believe that analyst estimates for revenues and earnings are likely to be prove extremely low. 

 

Current revenue estimates only include the effect of continued growth and penetration of the independent telephone market.  Importantly, Occam has a number of very large opportunities, any one of which could be transformative for the company. 

 

1. Continued progress in penetrating the smaller independent telephone companies.  Occam has a terrific reputation here and continues to make impressive strides in picking up new customers.  Companies typically upgrade their networks over a period of several quarter to several years.  Management suggests that the number of new customer additions is a good metric by which to judge the company.  For Q1:07 management announced that they had added 24 new customers, about double the recent run rate. 

 

2. The company’s typical customer is a small rural telephone company with perhaps just 25-50,000 lines.  This leads to a relative diversified base of business.  One of the company’s larger customers (6-7% of business) is Fairpoint which has about 250,000 lines.  Recently, Fairpoint announced that it will be purchasing about 1.5mm rural lines from Verizon.  This is a win-win-win situation as Verizon had pretty much ignored these lines.  Fairpoint has announced that it will invest significantly to roll out broadband and IPTV services rapidly.  This represents a huge opportunity for Occam as the increase in lines at Fairpoint is 30-50x the size of their average customer.  Once this deal closes, I would expect a significant increment in business to Occam.

 

3. Tellabs has chosen Occam as their next generation upgrade path for the existing AccessMax installed base.  As discussed earlier, AFC was the dominant supplier to the independent telco market in the mid-‘90s.  This joint venture can get Occam into much bigger doors.  It is 2007 and there is a major upgrade cycle in the offing.  Occam equipment can be retrofitted into existing AccessMax cabinets allowing the installed base to upgrade while preserving some of the value of their investment.  Currently, Occam is in a FOA (First Office Application) with Embarq for the AccessMax retrofit/upgrade market.  Embarq is the 7mm line former wireline division of Sprint.  The BLC6000 has already passed lab testing and the FOA is the final step before a commercial deployment.  Potential revenues could be quite significant for Occam. 

 

4. The company has stated it is in advanced trials with one other large firm.  This is likely another sub-RBOC company like Windstar (spun out of Alltel.)

 

5. Cisco has written a white paper (google Cisco Occam Serviceflex) which discusses how Occam’s products interoperate with their products.  It is pretty unusual for a company the size of Cisco to write a white paper with a company the size of Occam.  Interoperability is a major concern and this is a real endorsement and should drive significant customer flow. 

 

 

So, why are the shares so cheap?  One answer is obvious.  The company is late on filing its 10K.  On April 2, the company filed with the SEC indicating it would be unable to file its 10K in a timely manner.  At the time the official explanation was as follows:

 

Occam Networks, Inc. (the “Registrant” or the “Company”) was unable to file its Form 10-K for the fiscal year ended December 31, 2006 without unreasonable effort or expense because the Registrant’s Audit Committee is currently conducting a review of the Company’s commitments to provide customers with software, hardware and software maintenance, hardware and software upgrades, training, and other services in connection with the customer’s purchase of the Company’s network equipment. The Audit Committee is also considering whether these commitments impact revenue recognition and the adequacy of the Company’s internal controls relating to the documentation of customer commitments as part of the terms and conditions of sale.

 

In my mind, the most likely thing that happened is that there was at least one instance where a salesman promised maintenance software upgrades to a customer without prior approval.  Software is usually a fairly integral part of the platform, and this software is typically upgraded every so often.  If a new software release were scheduled, it would not be particularly unusual or concerning if a salesman promised a free upgrade as that release becomes available. 

 

FAS 97-2 is the relevant accounting statute and deals with the issue of a contract sale with multiple deliverable elements.  In the example cited, the company cannot recognize revenue on the value attributable to the maintenance software upgrade until that software is delivered.  To the extent such recognition occurred, the company would have to restate prior periods and defer the revenue associated with the software upgrade.  In some cases, this can create real revenue recognition issues, particularly for platforms where software enables significant functionality and is a very significant portion of the value of the platform. 

 

The range of outcomes is fairly wide, and are represented by the four potential outcomes below:

 

1. A review by the audit committee that exposes internal control deficiencies, but no need for restatement.

 

2. A review by the audit committee that requires a modest restatement of revenue reaching back for just a few quarters. 

 

3. The uncovering of systematic and longstanding issues that require a multiyear restatement of revenues, but which would not require a significant restatement of total revenues.

 

4. The uncovering of systematic and longstanding issues that require a significant decrease in revenues previously recognized. 

 

Option (1.) is obviously the best case scenario, but I think it would be naïve to assume this. 

 

Option (2.) is the one that I am prepared for.  Maintenance revenue as a whole is not an important part of this business, and any restatement could be in the 5% range. 

 

Option (3.) and (4.) are less likely in my mind.  The company is still small, and in a sense, has only been truly public since November.  I just don’t think there has been the incentive to engage in systematically deceptive sales practices.  Importantly, the company essentially went public in November and should have been the subject of fairly rigorous due diligence efforts by its bankers. 

 

Significant revenue recognition issues often manifest themselves as a extending of days accounts receivable.  As can be seen below, there is no such issue here.  Not only are days sales outstanding in the quite good level of 50 days, but the trend has been clearly improving over the past five quarters. 

 

 

OCCAM NETWORKS	Q4:05	Q1:06	Q2:06	Q3:06	Q4:06
Days A/R	66	57	55	59	50

 

 

My conclusions are as follows:

 

1. I do not believe there was any willful malfeasance on the part of management.  Prior to coming fully public in November, the company was essentially a quasi-private entity.  Conference calls were brief, and no forward guidance was given.  It is hard to imagine the company would have been systematically trying to inflate revenues because there was simply no incentive.  Further, prior to coming public, the company was somewhat cash constrained, and certainly not trying to push the limits of possible growth. 

 

2. Any restatement is unlikely to be particularly large and should not affect fundamental perceptions of the company.  According to Joanna Makris at Canaccord, who has been following this company for some time, maintenance revenues make up about 10% of the company’s aggregate revenues.  During a recent discussion, the company implicitly suggested this number was in the ballpark.  The promise of a free maintenance upgrade, given to a small number of companies, might result in a revenue restatement of just a few percent of revenue. 

 

3. Any restatement is not likely to be overly difficult.  With the enactment of Sarbanes Oxley, greater and greater scrutiny has been paid to adherence to proper accounting standards.  As a result, quite a few companies in the technology world have had revenue recognition issues resulting in restatements.  Some of these have led to very lengthy inquiries that have resulted in significant restatements, and obviously this is the fear that is baked into the share price.  Occam is a small company, with a limited number of products and a limited number of customers.  Revenue growth has been rapid, but if you look back just two years, the company had just $6.5mm in quarterly revenue.  I find it hard to believe that even a thorough review would take all that long.  Further, the company went public in November, which necessitated a full due diligence process that should have uncovered widespread issues. 

 

Catalyst

The company will file its 10K and attention will revert to the company's strong fundamentals.

The company is facing a number of promising opportunities such as Fairpoint or Embarq.

Tellabs would make a very logical acquiror. Tellabs has staked out the access market as being a strategically important area. They acquired Advanced Fibre. Occam's solution is a logical upgrade to the Advanced Fibre installed base. There is already a multi-tiered joint venture in place where Tellabs has licensed certain Occam backhaul technology, and also resells Occam product.