What if you paid $1 for a lottery ticket, but if you didn’t win over the next two years, you could turn that ticket back in for $1.08?
As value investors, that seems like a no-brainer. At the time of this writing, Sycamore Networks (SCMR) trades for $13.30, yet has $15.31 in net assets with $15.17 of that in cash and liquid investments. With an expected annual cash burn rate of about 50 cents per share and shareholder-friendly management, we have a two-year period at these prices to see if Sycamore’s new product will hit the jackpot or not.
This is a company that many of us are probably at least somewhat familiar with. I’ve owned it off and on for at least the last three years. Previously it was only a cash or potential liquidation play. That changed about two years ago with the introduction of a new product, IQstream.
For investors who haven’t checked back into the company for awhile, keep reading to see how the focus of Sycamore has changed. IQstream is the lottery ticket. There is a small, unquantifiable chance that it will hit the jackpot. If it doesn’t, you still get your money back along with a bit of interest for your trouble. The risk-reward for owning Sycamore at these prices is very favorable. That’s probably why it’s one of the few equity holdings of Seth Klarman. It also should be noted that he got in at a much higher price, though the odds of IQstream being successful were probably greater at the time of his purchase as well.
Sycamore Networks’ Shareholder-Friendly History
Before getting into IQstream, it’s worthwhile to go through Sycamore’s history in order to demonstrate that management can be trusted to not do something dumb. That’s always a risk when there is a pile of cash. Here, though, more than a decade of prudent cash management decisions should give us solace.
Sycamore Networks was founded in February 1998. It went public in 1999 at the height of the internet bubble. If you adjust the share price based on its reverse split since then, shares reached a height of $1,711.25 per share on March 3, 2000. After reaching that high, they smartly did a secondary offering and, amazingly enough, after dropping to $510 in April 2000, the stock shot up once again to $1,672 in August of 2000. Ah, those were fun times to be an investor! While their initial products had great promise, they quickly become commoditized, and it was clear that additional capital was not going to help. Fortunately, the company kept most of that cash they raised.
Sycamore’s initial products focused on providing optical switching solutions to service providers. The idea is to improve network efficiency. Going all the way back to their 2000 annual report, we get this description:
“We develop and market software-based intelligent optical networking products that enable network service providers to quickly and cost-effectively provide bandwidth and create new high speed data services. We believe that the existing public network is unable to meet the demands of high speed data applications that are driving network growth. As data traffic on the public network continues to grow at rates that surpass available network capacity, we believe that service providers require new solutions to relieve network congestion and create new data services. Our intelligent optical networking products are designed to allow service providers to deploy, manage and optimize the performance of their fiber optic networks. Our products are based on a common software architecture that we believe will accelerate our release of new products and enable our customers to upgrade with minimal network impact and operator training. We have designed our products to protect service providers' existing investment in fiber optic and transmission equipment and provide a migration path to the next generation optical public network infrastructure.”In July 2000 the company had net assets, nearly all of which were cash and liquid investments, of about $1.6 billion. Today, they have about $444 million in net assets, again, nearly all in cash and liquid investments. In between that time, the company also had paid out two special dividends: $185.4 million December 2010 and $284.3 million December 2009. Other than those dividends, though, Sycamore’s operations have only burned through about $40 million in cash since 2008. They know the market for their old products was limited, and they’ve allocated their capital wisely. That includes the time period when they’ve tested and introduced their new product, IQstream.
The Lottery Ticket: IQStream
It should be noted first that if IQstream testing doesn’t turn into customer revenue, it’s likely that there will not be additional company investments into the technology. This is why I focus on cash burn of 50 cents per share each year over the next two years.
That being said, IQstream is the potential jackpot. Sycamore’s other current intelligent bandwidth products are in long term decline and generated revenue of only $48.7 million last fiscal year. Those products should not be relied upon by investors to create positive net income. However, the old products do have some value. The customer relationships from those products have allowed Sycamore to test and potentially market their new, more promising product, IQstream.
What is IQstream? Sycamore describes it as “a mobile broadband optimization solution designed to help operators reduce congestion in mobile access networks caused by rising demand for Internet video and other rich media subscriber content. IQstream is designed to lower the cost of delivering mobile data services by freeing up capacity in the cost-sensitive access network.”
Think about watching a YouTube clip on your smartphone or iPad. The way it currently works for non-4G devices is that each user has an individual stream. Data is resent for each user, causing a large amount of bandwidth to be used. Without getting too deep in the technical aspects, IQstream dramatically reduces the bandwidth used by directing the additional viewers in the area to the video without having to resend the data. Essentially, IQstream decodes, classifies and segregates data while preserving the quality of the content. The actual product hardware is installed at the radio network controller site and end-users are not aware or affected by it. Well, at least until they get their bill and realize they didn’t use nearly as much data as they used to.
The technical aspects are for engineers, but as investors, you can easily see the allure for both mobile user and, more importantly, mobile carriers. With data usage limits being implemented among many carriers there is clearly a demand for a more efficient way to route data, especially for video and streaming.
The negative here is that this primarily applies to 3G and 2G networks, so if the trials don’t take hold over the next few years, it won’t be worthwhile for Sycamore to pursue it any further.
Sycamore is currently testing IQstream with five of their customers. They haven’t yet generated any revenue. On the last conference call, they said that the technical aspects are going well, but they are still explaining the value proposition. That’s not necessarily the most promising answer, but we should know for sure over the next year.
What are the chances IQstream will succeed? This is a difficult answer. I don’t think we should look at it other than a lottery ticket-type event. If it does succeed, though, estimates are that IQstream can contribute between $2 and $10 of EPS per year depending on the number of customers signed up.
Balance Sheet Strength
As I mentioned above, Sycamore’s balance sheet is what makes it worthwhile to own. Owning Sycamore for the chances that IQstream will be a success isn’t worthwhile unless the stock price is near the net asset value. At today’s stock price, though, you get paid 8% even if IQstream never gains a customer.
As of April 28, 2012, Sycamore has $440 million of cash and investments. They also have net assets of $444 million of net assets. With 29 million shares outstanding, that works out to $15.31 per share.
The cash burn rate is approximately $14 million per year. That cash burn goes to overhead, legacy product expenses and IQstream testing. Management has said that they won’t invest more money into IQstream unless they have customers signed up.
An additional element is Sycamore’s NOLs. As of July 31, 2011, Sycamore had federal net operating loss carryforwards of $804.5 million and state net operating loss carryforwards of $145.3 million. I haven’t taken these into account in the valuation because if IQstream isn’t successful, they won’t make much difference for the company. The NOLs go away in the event of an ownership change, so there wouldn’t be value if the company was bought out. However, if IQ stream was successful, these NOLs would have tremendous value. They also may have some value if they acquired a profitable company, depending on how the IRS would treat that transaction.
Management and Gurus
In most cases where a company has a large stockpile of cash and limited prospects, management ends up wasting the cash on what they perceive to be a transformational acquisition. Of course that acquisition typically then blows up in their face and the optimism before the transaction never translates into comparable net income after the transaction.
That won’t happen here. Sycamore’s management has demonstrated fiscal prudence since their founding. They have been careful to spend money even on IQstream. They are also under no delusions about their legacy products. They are only allocating the minimum amount necessary.
Sycamore was co-founded by Gururaj Deshpande, who still acts as the chairman. Deshpande is also the chairman at battery-maker A123 (AONE). He is the president of the private investment firm, Sparta Group, and is well-regarded in the technology field. In fact, in 2010 he was appointed by President Obama to be the co-chairman of the National Advisory Council on Innovation and Entrepreneurship.
Dan Smith has served as CEO and president since the company’s inception. He has previously been the CEO of Cascade Communications, another company that Deshpande had founded. Deshpande and Smith have been good capital allocators and are aware of the potential and limitations of Sycamore’s products.
As for insider ownership, Smith owns about 3.8 million shares. Deshpande owns about 4.6 million shares.
It’s always worthwhile to take a look at guru ownership as well. Six gurus own shares. If you combine Martin Whitman and Third Avenue Management, they own about 5.4 million shares. Klarman owns about 530,000. Jim Simons owns about 130,000. Donald Smith, Mario Gabelli, and Jeremy Grantham own less than 100,000 shares.
Valuation is relatively easy if you’re looking at liquidation value. Sycamore currently has net assets of $15.31. Given even a small potential that IQstream would be successful, shares should trade at least to this level. That would be a 15% gain at today’s stock price.
The chances of the success of IQstream are unknown, and if they are successful, the earnings are also unknown. There are a lot of variables about how many customers they could sign up and how much revenue would be generated from each. This write-up gives a guess of EPS between $1 and $10. He uses Vodafone’s European base only and can get to $300 million in revenue by applying $6,000 per base station to 50,000 bases. With 50% margins, that’s about $5 EPS for one customer on just 40% of their base stations in the continent. This is an example of how great the potential could be.
There’s not much more we can add to that other than speculation, but let me take a conservative stab. If IQstream fails, I assume management would pull the plug on it in two years and net assets are down to $14.31 per share. At today’s stock price, that gives an 8% return. If we conservatively apply a 5% chance that IQstream succeeds and makes $5 per share in earnings, the stock may trade at, say $60. Using those admittedly crude assumptions, shares should trade at about $17.55 today (5%x$60)+(95%x$15.31)=$17.55.
Worst case scenario we make 8% over the next two years. Best conservative case, we more than quadruple our money, though it would likely be more. These seem like good odds to me.
The risks here for the tremendous upside are that IQstream doesn’t succeed. That risk is already fully baked into the stock price and then some.
The next risk is that the cash burn rate increases. While possible, the history of management makes this unlikely.
There is also a risk that management makes a disadvantageous acquisition. Again, I find this unlikely. While they may use the cash hoard to make an acquisition, their conservative nature should protect us as shareholders.
The final risk is that IQstream succeeds, gains customers, much capex is spent by the company, and it is then eclipsed by newer technology. In the long run (10 to 12 years), this will happen as IQstream isn’t designed for 4G and LTE. If that were to happen sooner, we’d at least have a few years of lead time.
Sycamore Networks is a good bet certainly to their NAV level ($15.31), and up to $17.55 if you agree with my IQstream success assumptions.
Disclosure: Long SCMR