|Shares Out. (in M):||96||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,287||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-152||EBIT||0||0|
Ruckus Wireless competes in the Wifi hardware space selling Wifi access points and controllers. The industry is marked by short product cycles and high levels of competition. Currently, Ruckus trades at a premium multiple due to growth opportunities in the service provider space. With the rollout of the 802.11ac standard in Q1 2014 diminishing Ruckus’s competitive advantage in beamforming as well as potential additional competitive intensity in the service provider segment as it grows, I think Ruckus’s revenue growth rate will decelerate and the stock has the potential to decline 50%+ over the next 2 years. Insiders seem to have caught on to this dynamic given the heavy insider selling by multiple members of management.
Ruckus Wireless’s business consists primarily of selling Wifi access points and controllers to enterprises and service providers. A Wifi access point essentially allows a device (e.g. cellular phone or tablet) to connect to the internet without the need for cables. Product cycles in the industry are short with the 802.11 standard for Wifi, which provides the basis for wireless network products using Wifi, having a new revision roughly every 3 years. In 2009, the 802.11n standard was created which serves as the dominant standard for Wifi products currently in operation. The new 802.11ac standard will be released widely in early 2014. The major improvements in 802.11ac vs. 802.11n is increased speed (802.11ac is around 2.5-3x faster), transmission primarily in the 5GHz spectrum as opposed to the 2.4GHz implying less interference and more range, and beamforming becoming a core part of the technology. Beamforming is discussed later in this write-up in greater depth.
Enterprise makes up roughly 2/3 of Ruckus’s sales. Ruckus has approximately 5% market share of this market and it is characterized by intense levels of competition. Competitors include Cisco,Aruba, HP, Motorola, Trapeze, Meru, Aerohive, and Ubiquity. To quote Selina Lo, CEO of Ruckus Wireless, on competitive dynamics: “On the enterprise side, we compete with everybody and his brother and mother. The enterprise Wi-Fi space is…very crowded. And that’s part of the reason why, even though we have a very healthy business there, our strategic target is the service provider Wi-Fi space.”
Ruckus focuses primarily on the mid-sized enterprise with end customers being in verticals such as hospitality, K-12 education, retail, and warehousing. According to Gartner as of 2011 the size of the enterprise market was $3.4bn and is expected to grow at a 15% CAGR to $6.9bn by 2016. Growth is driven by enterprise trends of bring your own device and increasing amounts of tablet usage which often only can connect to the internet through Wifi.
The main driver of competitive differentiation and advantage for Ruckus wireless is its BeamFlex technology (Ruckus’s version of beamforming technology). This technology allows for increased throughput and speed in environments with lots of interference from other Wifi access points or other sources. In a Wifi access point without beamforming technology, the signal that access point emits will be akin to a light bulb: it will emit a signal to all areas around the access point with equal intensity. In contrast, the BeamFlex technology has an antenna array which can be configured in many different patterns (it can make different parts of the array into either a glass or mirror creating different patterns of signals) and using the BeamFlex software it detects which antenna configuration creates maximum throughput for the device connecting to the Wifi access point. To use an analogy, this makes the access point emit the signal like a lighthouse instead of a light bulb. The access point concentrates the signal towards the device allowing you to view a web page or buffer a video faster on your device. There is a graphic in the appendix illustrating the difference between a Wifi access point with beamforming technology and one without it.
Service providers make up the other 1/3 of sales. Ruckus has approximately 18% market share in this business with Cisco leading in market share with 30% and Ericsson / Belair with market share slightly below that of Ruckus. End customers in this segment include traditional mobile operators rolling out Wifi as 3G / 4G offload, cable MSO’s, and wholesale Wifi operators such as Towerstream and Boingo. According to Infonetics Research, the market for Wifi solutions for carriers was $296mm in 2011 and is expected to grow to $2.8bn in 2016, implying a CAGR of 57%. This trend is driven by growth in mobile data usage. According to Signals Research Group, mobile data traffic in theUSis expected to grow between 53x – 153x from 2010 to 2020. However,UScellular capacity is only expected to grow 25x over this same time period. This gap in traffic volume and cellular capacity will in part be met by Wifi solutions. The basis for competitive differentiation on the service provider side is the BeamFlex technology discussed above.
BeamFlex Technology: A Source of Sustainable Competitive Advantage?
Some sellside analysts have written about the BeamFlex Adaptive Antenna technology as a source of sustainable competitive advantage. I think this is a highly dubious argument at best as even the founder of Ruckus Wireless has admitted that it’s not a question of if their technology will be copied, it’s a question of when. Victor Shtrom, Co-Founder and Chief Wireless Architect of Ruckus, gave an excellent overview of Ruckus Wireless at the Wireless Field Day 2 inSan Jose,CA on January 27, 2012. The video is available on Youtube and has been viewed 4,601 times and is very technical in nature. Given the number of views and the intended engineering audience, I’m assuming not many sellside analysts have viewed the video. Here are some key quotes from Victor from that video:
Speaking about their beamforming technology, Victor says: “It’s all proprietary…we’re pretty far along in this technology. I think other people are probably capable of figuring it out.”
“The beauty and defendability of Ruckus is that we’re at the intersection of two places where there’s a bunch of people that can figure out the antennas and probably a bunch of people that can figure out the algorithms, but they’re not in the same building. They’re hardly ever in the same building. And can I pick on Cisco for a minute. Their hardware team is inOhioand their software team is here [inSan Jose], and there’s just no way you can do this being inOhio.”
“We don’t want too many people knowing about this because it’s kind of…both Bill and I came from different backgrounds and again it’s this intersection of things and once people kind of figure it out, they’ll be on our tail, but hopefully we’re far along now. That’s why I’m talking to you, initially I would not be.”
Since speaking in January 2012, it seems that Victor’s prediction of competitors copying the BeamFlex technology is coming true. In the latest 802.11ac standard, beamforming is being incorporated into many of the Wifi access points coming onto the market. The beamforming implemented in 802.11ac differs from the BeamFlex technology in that it is an implementation at the chipset level rather than having a hardware antenna array that can configure different patterns. According to Ruckus, this allows them to have a more focused signal than a mere chipset implementation. From speaking to competitors atArubaand Meru, it sounds like Ruckus may still have better Beamforming technology but the gap has narrowed with the rollout of beamforming as a standard on 802.11ac. Even though Ruckus theoretically has better technology, the standard implemented on 802.11ac may potentially be good enough for many of Ruckus’s existing and potential clients. One data point that supports this is many Ruckus clients opt to buy a more compact, less robust beamforming device from Ruckus rather than getting a bulkier device that is more expensive and has better beamforming capabilities. The move to creating a standard around beamforming for all device manufacturers on the 802.11ac technology seems to move beamforming to becoming a more commoditized technology.
When the company was asked about the ramifications of beamforming coming onto the 802.11ac standard, Selina Lo, the CEO, had the following response on the 3Q 2013 earnings call:
Our current BeamFlex technology is an edited technology beam forming. Today, in most of, even in the days of 11n and certainly with 11ac, the chip sets already support beam forming but it is beam forming at the chip level. Basically in a simple way to explain that, at the chip level beam forming has to do with being able to add signals on two different streams add them together to make the signal stronger. Or to face the signal to make the noise weaker. And that is a chip level beam forming that most recent products, products over the last year support including Ruckus.
What we do with BeamFlex is a whole different level of optimization. Basically, all of our antennas have hundreds to thousands of antenna configurations, each antenna configuration forms a unique antenna pattern that can push a signal a particular way, a particular direction. And the way we select the antenna combination is actually based on constant learning when packets come into the access point, the access point, every package, the access point will evaluate the throughput of that packet relative to the antenna configuration that was used to receive it and the sender.
As Selina Lo depicted it, you would think that Ruckus was facing beamforming technology in 802.11n and there is no substantial paradigm shift with 802.11ac. What she left out is that although beamforming was an optional technology in 802.11n, there was very little adoption of it. With 802.11n, the IEEE (the international body that establishes the 802.11 standard) didn’t spell out exactly how beamforming was to be implemented. The wireless access point you bought might have used one technique, but if the Wi-Fi adapter in your laptop used a different implementation, beamforming would have never worked. Therefore, beamforming didn’t have quite an impact with 802.11n. The IEEE didn’t want to make the same mistake with 802.11ac, so they prescribed a particular fashion of implementing beamforming in this standard. This ensures that every company’s products will work together. This has resulted in beamforming becoming a common feature in Wi-Fi access points utilizing the 802.11ac standard.
Other Red Flags to Ruckus Wireless
There are other red flags to the Ruckus Wireless story. One is the increase of day sales outstanding. If you examine it on a quarterly basis, it increased from 40 days in Q1 2012 to 75 days in Q2 2013 although it has dropped back down to 55 days in Q3. When management was asked about this trend they didn’t cite any specific things driving the trend but rather stated that it was a confluence of factors that drove it. Ruckus sells its enterprise equipment through a 2-tier distribution system with over 6,000 value added resellers who eventually sell the equipment to end customers. There could potentially be channel stuffing to keep revenue growth rates high to meet guidance numbers.
Another major red flag is the consistent selling of stock by a variety of insiders. There hasn’t been one insider purchase but there has been plenty of insider selling from Selina Lo (CEO), Seamus Hennessy (CFO), William Kish (Founder & CTO), Steven Martin (Sr. VP, Engineering), Bart Burstein (Sr. VP, Field Ops and Business Development), Denis Maynard (VP, Sales and Field Ops), and Scott Maples (VP, Legal & General Counsel). These insiders have consistently sold the stock over time. In total, insiders have dumped almost $45mm worth of stock around $14 / share. I’ve included a chart in the appendix highlighting insider selling transactions. In addition, Sequoia Capital has also virtually sold its entire stake.
Another negative is that potential cable MSO consolidation may lead to increasing customer consolidation.
Bull Case on Ruckus Wireless
The bull case centers on Ruckus’s position in the service provider market. As I described earlier, the service provider market is expected to grow substantially driven by increasing use of mobile data and lack of cellular capacity build out to meet that need. Currently, Ruckus Wireless is the number 2 player in the ~$300mm service provider wifi market and has a differentiating technology with BeamFlex. According to bulls, this positioning should allow Ruckus to have a long runway for growth and margins should scale as that growth is realized (RKUS has provided long term operating margin targets of 17% - 20%).
Although there is a long runway for growth in the service provider market, I think the bull case fails with respect to thinking dynamically about potential increased competition in the future around the service provider market as well as Beamflex as a source of sustainable differentiation. I’ve talked about Beamflex earlier so I’ll focus on increased competition. Currently, the service provider market is a $300mm market with a much more benign competitive structure than the $3.5bn enterprise market. From conversations withArubaand Meru, it seems there are few gating factors that prevent enterprise Wifi players from getting into the service provider segment. In addition, Ruckus could be at a disadvantage due to bundling by bigger wireless infrastructure players such as Cisco, Nokia, Ericsson, and Alcatel Lucent which could sell a complete solution of small cell and Wifi to mobile operators. Therefore, it seems that the low level of competitive intensity may not persist in the service provider market, especially as the market grows and it becomes a bigger source of potential profits to larger players.
In terms of valuation, I think of a bull / base / bear case for the financials for the company. In the bull case, I assume enterprise revenues grow at 15% from 2014 – 2016 and service revenues grow at 40% a year (in line with Dell’Oro estimates of market growth). Assuming they hit their longer term margin target of 17.5%, this gets me to an EPS number of 0.57. Off the current share price of $13.50, this is approximately 24x 2016 earnings net of cash. I use earnings because this approximates free cash flow.
In terms of a base case financial projection, I have enterprise growing at 15% and service revenues growing at 40% in 2014 and then 25% thereafter as competitors enter and Ruckus’s technological competitive advantage diminishes. I assume operating margins get to 11% as gross margins decline by a point a year and Ruckus has trouble hitting their R&D, sales & marketing, and G&A targets as a percent of sales as the business is more subscale then they projected. This implies 2016 EPS of 0.33 which if it trades at a 20x multiple implies a $6.60 stock, or down ~50% from current levels.
In terms of a bear case financial projection, if enterprise grows at 10%, and service provider grows at 25% in 2014 and then 10% thereafter, and you assume margins don’t hit their targets due to increased competition and they get to a 7% operating margin, then you get 0.17 of EPS in 2016 which if it trades at a 12x multiple could imply a $2 stock, down 85% from current levels. This EPS number (as well as EPS numbers above) is pre-stock based comp. If the market starts deducting stock based comp and valuing on that basis, the result could be even worse.
Given the valuation, I think this presents an asymmetric short opportunity. Even in the bull case if they hit their margin targets and grow at a healthy pace with a premium multiple, you don’t lose much money at the current price. A bigger risk to losing money on this short is if Ruckus gets acquired by another company. However, a mitigant to that risk is in the form of a near term catalyst with 802.11ac increasing competition levels with Ruckus’s proprietary beamforming technology.
Risks to Shorting the Stock
Take-out: Ruckus could potentially be acquired by a service provider infrastructure player looking for an internal Wifi capability. This would be similar to the Ericsson acquisition of Belair. Potential acquirers might include Alcatel Lucent or Nokia. Financial terms for the acquisition of Belair was not disclosed but Cisco paying 13x run rate bookings for Meraki might suggest that there could be a takeout premium (Ruckus trades at ~3x forward sales).
New Innovations by Ruckus: Bill Kish and Victor Shtrom are widely respected as being very smart and innovative. Even during a conversation with Meru, the Meru employee conceded that Bill and Victor had been very innovative. Bill and Victor may potentially have other innovations that could continue to give Ruckus Wireless an edge over competitors.