Picking Up Zhone Technologies
by Bill Martin & Matt Ragas (11-FEB-05)
At 12:30 PM, Bill Martin and Matt Ragas purchased 3,500 shares of Zhone Technologies (NASDAQ: ZHNE ).
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** Why Buy Zhone Technologies!? **
Bill and Matt make no bones about the fact that they actively follow insider buying by the ``smart money.`` This typically means secretive and big swinging hedge funds and private investment partnerships with enviable investment track records, not the big mutual fund managers that share their typical run of the mill ideas with the talking heads on TV.
They also keep their eyes peeled for open market purchases by respected venture capital firms. VCs rarely make public market purchases, and when they make a public purchase in one of their existing portfolio companies, it’s only because they think the company’s shares offer them significant upside.
Thus, the disclosure that crossed the wire yesterday evening that $6 billion dollar venture capital firm New Enterprise Associates (``NEA``) has started loading up again on shares of networking equipment player Zhone Technologies has moved Bill and Matt off the fence on the name. After buying hundreds of thousands of ZHNE shares on the open market during the first half of last year, primarily at the $3 level and higher, NEA has purchased another 1.3 million shares of ZHNE in recent days at the $2.06 to $2.30 level. Legendary NEA VC Dick Kramlich, a thirty year veteran of the industry, is on ZHNE`s board.
For Q4, ZHNE posted revenue of $28.1 million, up 21%, and pro forma EBITDA of $500k, the first positive cash flow quarter in the company’s history. ZHNE does have $700-$800k per quarter in interest expense, plus CapEx, so the business isn’t yet free cash flow positive, but looking at its results in recent quarters, it is solidly moving in that direction. ZHNE ended last quarter with a modest net cash position of $24.5 million.
For the full year 2005, ZHNE is looking for continued EBITDA positive to breakeven results. In the current quarter, ZHNE expects revenue to be slightly down to flat sequentially, which is solid, given that Q1 is typically a seasonally down period.
While Bill and Matt are not particularly bullish on networking equipment plays as a whole, given their tendency for lumpy revenue recognition and visibility issues, they think there are still select interesting opportunities in this group. The key, as evidenced by our investment in Redback Networks (RBAK), is to focus on the smaller players in the space who are levered to segments of the networking realm where there is good secular growth taking place (Broadband, Triple Play, VoIP and FTTP related services), which can drive results. ZHNE does get a decent chunk of its revenue from legacy products, but it also has a stake in the ground in many of the growth areas above where providers are ramping CapEx.
At today`s price of $2.35, ZHNE checks in with a market cap of $225 million which values the name at less than 2x revenue. This certainly isn’t a dirt cheap stock, and ZHNE doesn’t have a track record of knocking the lights out execution wise, but Bill and Matt think their downside risk in the stock at this valuation is rather modest, while the upside potential over the next 12-18 months could be significant. The company looks to be close to hitting a profitability inflection point, which should lead to increased Wall Street interest in the name, particularly given that ZHNE has products in growth markets that investors are interested in, a veteran management team and strong insider buying conviction by NEA.
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