Why Sycamore Networks?

Sycamore Networks (SCMR)

Price: 19.39 (11/20/11)

I want to apologize for the slowdown in posts, I've been working on finishing (remodeling) our basement which has sucked up pretty much all of my free time.  I'm just about done framing, so I only have a bit of electrical and drywall left, hopefully I'll hit my goal of completing by Christmas.  Until then I'm hoping to get a post out once a week or so.  

Onto Sycamore Networks..

This is a stock I first saw discussed in a Marty Whitman shareholder letter (my wife has the Third Avenue Value fund in an IRA) as a net-net the fund had purchased.  I took a look but the stock wasn't selling below NCAV, and I didn't see any other attraction at that time.  This weekend I saw an article in Barrons that mentioned Seth Klarman's hedge fund had started to purchase shares in Sycamore Networks and I decided to take a look again.

After digging into the 10-K I can't figure out why Marty Whitman or Seth Klarman have invested, the thesis is somehow beyond me.  These are two very smart investors, so I'm presuming that I have somehow overlooked something hidden that's really big and important, if you know what that is please email me or leave a comment at the end of the post.

The business

Sycamore Networks builds specialized switching equipment that helps reduce network congestion.  The company sells products for the fixed line market, mobile, and broadband networks.  There are a few problems Sycamore is trying to solve, the first is general network congestion, this is where the traffic amount is larger than the bandwidth available.  The second is peak demand, a network might be able to handle traffic for most of the day but if there is a spike due to some external event network traffic might grind to a halt, as an example I remember trying to get to CNN.com on 9/11, no matter how many times I hit refresh nothing would load in any reasonable speed.  

The sweet spot for Sycamore is a customer who wants to stretch their existing network a little bit more without having to upgrade the infrastructure completely.  In a computer network there are a few important pieces, the wires, the routers, repeaters and switches.  The wire in the ground might be able to support 600Mbps or even 1Gbps the limiting factor with regards to maximum speed are the endpoint switches and repeaters.  To upgrade a network segment all of the switches and repeaters need to be upgraded to the higher standard.  This can be costly considering in some situations repeaters are buried underground, or in hard to access locations.  Secondly if a provider upgrades the network there is no guarantee clients will be willing to pay for increased speeds in an amount that will cover the upgrade cost.

Sycamore helps this by working to streamline traffic on a congested segment.  The company website has all sorts of great marketing spin videos explaining their secret sauce but it boils down to a simple technology, QoS or Quality of Service.  Each packet sent from a computer over a network has a priority code, normally each packet is treated equally. A packet containing banking information is given no higher priority than a packet destined for YouTube.   Video and gaming are very high demand applications, but often low priority.  A video can drop a frame or two and it will be almost indiscernible to the user, whereas a dropped packet from a website might mean the site won't load at all.

QoS isn't anything extraordinary, the Linksys router I have in our basement has a very rudimentary version of it allowing me to statically state that web traffic is more important than Kazaa, or video game traffic.  The shortfall is there isn't much configuration available, and the routing is based on the port, not the content of the packet.

What makes Sycamore devices valuable is the software installed can intelligently determine what is inside of a packet and prioritize dynamically.  This means if a network segment starts to become highly congested packets destined for YouTube can be de-prioritized and web traffic prioritized.  Or on a telephone network calls can be routed differently to avoid busy signals.

I'll be the first to admit the technology is cool and very innovative.  I'm sure Sycamore has a building full of very bright people up in Massachusetts figuring out these problems, and it seems like there's demand for a product like this with broadband usage exploding and mobile data usage growing quickly.

The history

The company IPO'ed back in 1999 during the height of the dot-com boom, they did a follow on offering in 2000.  It seems that they've been working down the IPO cash ever since.  This is where the mystery of the attraction starts to begin for me.

Since the IPO the company has never recorded an operating profit, only once they recorded a profit which was due to other income.  The company was cash flow positive 2006, 2007 and 2008, and had a meager amount of free cash flow in each of those years.

The one bright light I can see in this stock is that gross margins have been increasing which is good, the problem is R&D expenses track pretty well with gross profit.  That means that by the time SG&A comes along the company is already in the red.  

Valuation details

I don't really have much to add here, the numbers speak for themselves, so I'm just going to dump out some stats.

-P/S 11.3

-EV/Sales 3.3

-Gross Margin: 52.8 TTM

-Book Value 15.71

-Revenue Growth: 3yr -25%, 5yr -11%, 10yr -18%

-NCAV of $15.34, Net Cash of $14.63/sh

None of these numbers jump out at me as a screaming buy outside of the high cash value per share.  The problem is the company is constantly eating into the cash balance each quarter as sales fail to cover expenses.

Summary

I can understand the appeal of Sycamore Networks as a story stock, broadband and mobile data are growing rapidly and the company has a solution that can save carriers a lot of money.  The problem to me is that broadband has been growing since 1999 at a fairly rapid clip, and the company has never been able to turn an operating profit, and they've only been cash flow positive in three of the last ten years.  And the last ten years have been prime years for data growth  If Sycamore hasn't been able to capitalize in the past when conditions were ripe what will be different going forward?

The one thing I do get is the high cash balance, but there are other router and networking companies with high cash balances selling at cheap valuations.  

I guess my confusion lies with the fact that two renowned value managers have positions in this stock.  I recognize they're far more intelligent than I am, so I'm presuming I'm missing something.  If you have any ideas on what I'm missing please send me an email or leave a comment.  

Talk to Nate about Sycamore Networks

Disclosure: Long Third Avenue Value fund, and by proxy long Sycamore Networks.