Value Equity Bucket -- DragonWave Inc

The thesis for DragonWave is pretty simple, they do one thing - high-bandwidth wireless links for IP networks.  The primary use of this is “backhaul” for 3G and 4G networks; backhaul is the connection from the cell-phone tower to the backbone of the Internet.

Demand-side: Why do we care?
The demand for this type of product to enhance and improve the connection of cell-phones to the Internet should be recognizable to us all.  I think it’s clear to anyone who’s had a cellphone (or mobile, as we Brits call them) over recent years, that the amount of Internet data we get using it has increased substantially.  After all, connecting to the web (and downloading all those iPhone/Android Apps) requires far more data (i.e. bandwidth) than making a phone-call, texting or sending an email.  Furthermore it’s also pretty noticeable, especially for those who live in Manhattan, that the wireless networks are struggling to deal with the amount of data that needs to be downloaded – after all who hasn’t been frustrated by the fact your iPhone (if you can get AT&T Service) or Blackberry are so slow to confirm the Mets’ latest demise!

Supply-side: OK, so we care…but what does that mean?
The supply-side is somewhat more complicated.  To help, let’s think of a wireless phone network in 3 parts; a) The backbone, b) The connection between the backbone and the cell-phone towers and c) The connection between the cell-phone towers and us, the end users.  DRWI is only involved in part b, and is agnostic about the other parts (i.e. it doesn’t matter to them how your network connects to the tower)

Some fun facts:
- There are c200,000 cell-phone towers in the US (800K in Europe)
- US Connection to Backbone: 75% use T1 lines, 20% use fiber-optic cables and 5% use TDM (a low-bandwidth microwave link)
- In Europe, however, 70% connect using TDM (due to the cost of using T1) and 15% by fiber-optic cables
- In Emerging Markets, almost 100% use microwave (predominantly TDM)
- Both T1 lines and TDM are low-bandwidth solutions (i.e. great for voice, not so much for data), whereas fiber-optic cables are a high-bandwidth solution.

Now, if growth in data continues to grow then the above suggests we’re going to need a lot more bandwidth.  Why?  Well, only 20% of the towers in the US (15% in Europe, even lower in Emerging markets) are connected using high-bandwidth solutions.  This is the potential opportunity for DRWI, though we should remember it isn’t going to happen overnight and will be a multi-year process.

Backhaul Technologies: We need lots of bandwidth, but why’s it good for DRWI?
There are 3-types of backhaul technologies:
1). Copper:  This is what’s used for L-1, xDSL, etc.  Copper’s problems are scalability and the fixed cost of getting the wire from the tower to the backbone is high, and that wireless carriers (unless they own that connection) have to pay a monthly charge to use it.
2). Fiber-Optic Cable: Fiber-optics are high-bandwidth, but the problem is again co  st (e.g. it costs $100/foot in cities; and while this falls in the suburbs/country-side, you also have to run the cables for larger distances!) and again there are recurring charges (if not owned by the wireless company)
3). Microwave Technology:  Unlike the other systems, there are no monthly recurring costs.
There are a few types of Microwave technologies:
- TDM: a low-bandwidth (i.e. not able to connect to IP) solution that will remain attractive for 2G expansion (especially in Emerging Markets).
- TDM-hybrid: where TDM (for voice) is used alongside a medium-bandwidth solution (for data), and so is attractive early in the upgrade cycle.
- Pure IP Microwave links:  DRWI is the leader in this final solution and adheres to specifications that make it similar to landline IP.  Furthermore, its Horizon systems are integrated (i.e. bandwidth increased easily and for low cost) and its Quantum solution delivers 4Gbs (the highest on the market).  While I don’t have definite numbers on DRWI’s cost advantage, based on a study by a US Wireless carrier, it appears to be 70%+ cheaper than using fiber and the roll-out is substantially quicker (<6mos vs. 2-years).

Risks
- Customers: A major risk is that while DRWI has over a hundred customers, Clearwire currently represents 80% of DRWI’s business.  Though this is not surprising, as Clearwire is the first-mover in 4G, DRWI will clearly have to expand its customer base beyond Clearwire.  To this end, the company’s announcement on 24th February  that they’ve signed an agreement with a major OEM, is a positive step.  However, it also is fair to assume that the stock will be volatile, until there’s definitive news as to whether the company will be getting any business from the US behemoths (Verizon or AT&T).

- Competition: DRWI is the leader in high-bandwidth microwave, but there are other companies involved in the space.  These include stand-alone companies Ceragon Networks, Aviat, Cielo, and Trango, as well as major multi-nationals such as Alcatel-Lucent, Ericcson and NEC.    Of these, only Ericsson seems to currently offer a product that has capability of 1Gbs+.

- Execution/Production:  The thesis implies that DRWI will see increased demand for their business, and a general risk in these cases is that management executes poorly and there are production issues.  While the former is certainly a risk (especially from a strategic perspective relating to AT&T and Verizon), I’m less concerned about the latter as DRWI outsources all of its manufacturing to Plexus (a $1.5bn EMS company).  In fact Plexus’ conference call comment on the strength of their wireless business gives me some comfort in taking the position before results.

So, it seems like an interesting company, but why does Our Man find it an attractive stock?
While the prospects for growth are certainly attractive to my mind, what makes DRWI an interesting stock is that the stock price does not reflect them (DRWI, on Nasdaq, closed yesterday, at $8.12.  The company’s primary listing, is DWI in Toronto, but all figures below are in USD)

Positives
- Balance Sheet: As of 11/09 DRWI had $3+/share of cash, and a NCAV of $3.50+/share
- The current price puts the stock at <10x fiscal 2010 (02/10) and fiscal 2011 (02/11) earnings.  This isn’t expensive, and reflects analysts concern about whether DRWI will get any Verizon/AT&T business.  While these risks are valid, the price reaction looks extreme given the Balance Sheet value of $3.50+ (predominantly in cash) and 2011 analyst estimates of $1.02/share.

Negatives
- The chart is ugly as uncertainty over whether DRWI will win business (ex-Clearwire).  Furthermore, as a small-cap, DRWI has and likely will continue to be volatile

Neither, just an observation
- In March & April, DRWI announced approval to buy back up to 10% of the stock at market.  With results on Thursday, I’ll be reading the transcript to get a sense of how business is going but also be looking at how much of their cash they spent defending the stock (or potentially buying it back very cheaply).

So, what does that mean for our position?
DRWI was added to the portfolio, this morning, at about a 1.5% position size.   Whilst this is a little undersized, it’s a decent size starter position (meaning I can live with never adding to it, should it run up, up and away) but that it does leave some room to add to the position (potentially to take it up to 2.5%) should the stock fall further.