Description

This has all the markings of a name that I like to short...fairly commoditized end product, large established competitors, minimal technology investment/advantage, inexperienced/evangelical CEO/poor mgt, small/saturating market, unsustainable margins/revenue growth, expensive stock and history of somewhat disreputable behavior.  I view this as an interesting short now as fundamentals and the stock have rebounded significantly off of a very difficult FY13 just ahead of what looks to be a saturating end market for their main product as evidenced by their most recent results.  I will skip over some of the extensive detail and instead either link to articles or answer questions.

Company Description:

UBNT is a provider of networking equipment.  Their main product is long-distance wifi equipment (airMax) used by fixed wireless internet service providers (WISPs) to provide wireless internet to underserved areas.  This equipment can shoot signals several miles over unlicensed spectrum in order to connect paying subscribers with internet access.  Their next largest business line is routers (UniFi), which are akin to a router that you would have in a home or business (think Linksys, Netgear, D-Link).  Other products include a wifi-enabled security camera (airVision), microwave backhaul devices (airFiber) and M2M communication devices (mFi).  The company was founded in 2005 by current CEO Robert Pera, received no VC funding and is headquartered in San Jose, CA. 

Overview:

UBNT has a very interesting/odd business model.  They sell networking equipment for lower prices than the competition (resulting in much lower GMs…40-45% vs. 60-70% for enterprise competitors), yet they are able to generate 30% operating margins by spending minimally on operating expenses.  Ironically, the company touts their strength in R&D, but they only spend ~5% of revs on R&D, which will amount to ~$35M in FY14 (vs. comps at 10-30% of revs and $60M-$1.5B).  Their only selling method is indirectly through distributors (no sales force) and their main product is also selling into a market that has largely been ignored by larger competition as it is very niche (WISPs, or Wireless Internet Service Providers). 

What this amounts to is a company that whose only competitive advantages are:

• The fact that they are able to sell commodity products for a lower price/margin into a market that everybody else is ignoring because it’s small (they’ve consequently become the market share leader)
• A very lean operating model that results in having basically no visibility into end demand for their product

The company has done a good job scaling this niche business, but it is my belief that they are beginning to run out of room in this market and that competition is picking up.  To compensate, the company has started moving away from their original business philosophies by introducing new products into areas that are much more competitive and saturated (network routers, microwave backhaul).  They are also beginning to abandon their “expense-light” business model by beginning to launch marketing campaigns to chase a “long-term vision” and establishing on-the-ground warehouses and other assets in order to better manage their supply chain.

It is my view that this business model is unsustainable in the long-term and margins will adjust significantly lower to be more similar to other producers of commodity networking equipment (~10-15% vs. 30% now).  To be simplistic, I believe that there are likely two steady-state business models in this market that are sustainable.  One is CSCO (high GM, significant innovation), the other is NTGR (low GM, low innovation).  If it is CSCO, the company will need to invest significantly more in R&D and sales, which will ultimately result in much lower operating margins.  If it is NTGR, they may be able to sustain their low level of S&M and R&D spending, but their gross margins will naturally come down over time as their products become increasingly commoditized (NTGR's GMs are ~30%).  This results from competition picking up within their existing markets and also entering more competitive markets.  Either way, operating margins should head lower.

The short is particularly compelling now as the stock is near all-time highs on the back of a significant sales rebound in FY14 after a very weak FY13 that will be covered later and I think that FY15 results could be disappointing.

Quickly...what is a WISP?  

A WISP provides wifi access in areas where fiber isn’t accessible or it doesn’t make sense for fiber to be run.  WISPs provide wifi to an estimated 1-2% of the US population (and 0.2% of the world population...1.6% of total WW broandband subscribers).  It is estimated that the WISP market in the US is ~2M subs and 10-15M subs worldwide.  This is corroborated from a few data points, including data out of Point Topic, a white paper on WISPs and a distributor blog, who appears to be fairly knowledgeable about the space (all referenced below).

Short Thesis:

1)   UBNT basically looks like a shell company (only 200 employees) with minimal technology, no sales force, no customer support and minimal hard assets that sells a commodity product with 30% operating margins that trades at 5-6x EV/sales, which seems unsustainable

• The company has spent <$125M cumulatively on R&D since launching in 2005 and spends only ~5% of revs per year relative to competitors who spend 10-30% of revs
• They basically take off-the-shelf chipsets and use open source software to make cheap networking equipment that lasts 3-5 years or considerably less according to some accounts
• The company has no direct sales force and relies almost 100% on 250+ distributors for sales
• This means the company has almost no visibility into the end demand for their product and minimal visibility into distributor inventories
• The company has no supply chain and instead relies on their EMS suppliers to procure a vast majority of inventory, build the products to spec, QA and ship directly to distributors
• Though some of this has been changing in recent quarters as they are starting to take on more finished good inventory and QA responsibilities in their own warehouses
• The company has no customer support staff and instead relies on "crowdsourced," "social" means, or a user/expert community that post questions and answers on their Ubiquiti community forum
• While I don't deny that this seems to have been an interesting way of approaching a very fragmented end market, it is unlikely that they'll be winning any consequential deals from real companies with this approach any time soon
• This also certainly helps fuel the bulls and their ability to use buzz words
• As a testament to UBNT’s lack of technological advantage and how the business model is likely unsustainable, the company was subject to a significant counterfeiting scheme that actually impacted sales
• In FY11/12 one of UBNT’s distributors (Kozumi) began counterfeiting their products and placing them into the supply chain…this disrupted sales for several quarters and customers couldn’t tell the difference and didn’t know if they were getting the right product
• http://dl.ubnt.com/newsletters/0148.html

2)   The niche market that UBNT mainly addresses is small and appears to be running out of room

• UBNT sells wifi hubs and access points to WISPs, which according to the numbers below, looks like a fairly small market with only ~10-15M subs worldwide (latest data available before paywall shows ~11M subs in the beginning of 2013)

• The WISP market also doesn’t appear to be growing like crazy (as per latest data available)
• In fact, FTTx/FTTH are where most of the incremental growth is occurring 

• I think that the niche opportunity UBNT was able to exploit may be running out of steam now for a few reasons:
• Market sizing (US) – there are an estimated 2M subs in the US that receive internet from WISPs (see p. 3:  http://www.wirelesscowboys.com/wp-content/uploads/2011/10/americas-broadband-heroes-fixed-wireless-2011.pdf)
• 2M subs x $50-75/access point = $100M-$150M in TAM                                                 
• Access points appear to be ~80-90% of sales, so maybe total TAM of $110-$190M including hubs
• Cumulatively over the last four years (3-5 yr replacement cycle), UBNT has recorded an estimated ~$150M in revs in NA, implying ~100% mkt share
• At the very least, it appears that the NA market might be not a significant growth market going forward
• Market sizing (WW)
• A lot of triangulation here, but UBNT only generates 20-25% of their revenues from the US and the above graphic suggests that the US is likely ~20% of the WW Fixed wireless subscriber base, which suggests that UBNT may have reached their steady-state revenue split geographically, which implies that the RoW market might not be a significant growth driver going forward
• Since TAM sizing is often voodoo, I think looking at UBNT’s revenues might be more instructive – FY14 revenue growth in their Airmax product has been very strong (~+50%) off of a very weak FY13 due to counterfeiting issues
• Adjusting for counterfeiting, revenues might look more like this: 

• It appears while this year looks very strong, it’s probably due to latent demand built up in FY13 and easy comps…the underlying growth appears less strong
• If one assumes that FY14 experienced increased demand from delayed shipments as well as normal demand, it creates very difficult comps going into FY15
• Also, look at the sequential growth of UBNT's NA revenues recently:

• Finally, inventory - hard to know exactly what to make of it, but inventory days have been increasing significantly despite what management had been guiding, indicating possible channel issues

4)   UBNT’s next leg of growth is predicated on wireless routers, which is a very competitive market that isn’t growing very fast

• Unit Growth (ASPs tend to decline each year such that revs are more flattish):

• UBNT’s positioning is pretty weak from IDC’s perspective: 

• Unit volume for UBNT has picked up this year (nearly three years after launch) and management has discussed aggressive growth plans going forward (doubling again next year), but it wouldn’t surprise me at all if much of the inventory that is building is related to this segment 
• Simplistic again, but "Enterprise Technology" (router) sales peaked in Q114 and have trended down since then...two quarters don't make a trend, but it suggests some air coming out of the balloon

• I expect growth in WLAN (<20% of revs) might also to disappoint in FY15 relative to management's stated expectations

5)   Management’s signals and actions suggest that they are beginning to abandon their original strategy of an asset/expense-light business model in an effort to maintain growth

• The CEO’s words from the last call:  “To repeat what I said last call, when we first entered the public market I was very proud of our financial margin profile. I have shifted my focus on accelerating a vision at the sacrifice of that financial profile.”
• They introduced “Ubiquiti World Network” which is effectively a marketing program for themselves and WISPs that they’re dropping several $M into
• The company is now stockpiling inventory in a warehouse in China and is contracting with a 3^rd party logistics company where previously the company relied on their EMS contractors to ship directly to their distributors
• I expect margins to contract as the company continues to ramp their R&D and capital spending in an attempt to stay relevant and effectively manage their business

6)   UBNT’s valuation is more similar to that of a software company than a hardware company, which is driven by their unsustainably high margins

7)   Other

• Management is inexperienced, hyper-promotional and not necessarily wholly focused on the company
• The CEO is 36 and used his newfound wealth to acquire 26% of the Memphis Grizzlies and spends at least some portion of his time challenging ex-NBA players and owners to 1x1 games
• His Twitter account is fairly interesting
• 3rd hand accounts suggest he’s difficult to work for
• For what it’s worth, LinkedIn has tracked ~50 employees that formerly worked at UBNT…may not seem like a ton of turnover but that definitely doesn’t capture everybody and the company only has ~200 employees
• The former CFO and CMO were both fired and the banker that helped take UBNT public from UBS is now the CFO
• Management was caught shipping product into two distributors that then shipped product to Iran, which is obviously against the law
• The company continued shipping to one of the distributors even after the government caught them
• For whatever it's worth, IR wouldn't even grant me a call when they found out I was a long/short investor
• One of their top distributors (Flytec) seems to be very shady…more details:
• http://www.shortzilla.com/new-short-position-ubiquiti-networks-ubnt/
• 90% of their cash is offshore, which doesn’t leave them a ton of flexibility for capital return
• Read-through on TPLink (biggest Chinese competitor) from POWI this past Q was fairly negative

Risks: 

• Channel fill/stuff
• UBNT just signed up SCSC and IM as channel partners, which will likely lead to some initial channel fill
• The company has 250+ distis all over the world, so lots of pockets to hide sales
• The end market is bigger/grows faster than we believe
• New "killer" product introduction 

Valuation:

• This should trade at 0.5-2x EV/sales, which yields a stock price in the single-digits to teens for 60%+ downside

Catalyst

• Revenue growth disappoints
• Margins start to decline