Weisel on SONS
Sonus Networks, Inc. (SONS): Secular Growth Play Leveraged to VoIP
Upgrades; 2H07 Recovery Creates Upside Opportunity; Resuming Coverage
with Overweight
Executive Summary
Resuming coverage with an Overweight rating and price target of $8:We
had suspended our rating and estimates on SONS due to lack of full
financial disclosure (aka filings) related initially to revenue
recognition issues and subsequently to an investigation regarding
stock option grants. Recently, SONS has become current with its
financial filings and appointed a new CFO. It is time to resume
coverage on the name; we do so with an Overweight rating with respect
to our telecom equipment coverage sector and a 12-month price target
of $8.
Long-term growth profile: leveraged to the VOIP upgrade cycle, SONS
can generate 25% y/y revenue growth through 2009. Our analysis
suggests that the carrier-grade Voice over Internet Protocol (VOIP)
equipment segment can deliver a 20% CAGR during 2007-2009,
outperforming the overall network equipment sector with a high-single
digit growth profile over the same time period. As a pure play,
deriving most of its revenues from sales of VOIP platforms to
carriers, SONS is strongly leveraged to this secular up cycle. We are
modeling at least 25% y/y revenue growth for SONS in each of 2008 and
2009.
Near-term growth prospects: we expect significant revenue
acceleration in 2H07 as Tier-1 customer resumes spending after a 1H07
pause. Our industry checks indicate that one of SONS' largest
customers, AT&T has resumed spending on its VoIP upgrades after a
1H07 pause and that SONS is experiencing increased order activity in
2H07. Taking into account revenue recognition, we expect a
sequentially up 3Q07 followed by a very strong 4Q07; net-net, we
expect 2H07revenues to be up 19.4% versus 1H07. This should boost
investor confidence that SONS' 1H07 slowdown is transient and the
company's overall fundamentals and execution remains strong.
We expect profitability expansion as gross margins improve from 2Q07
levels and opex growth moderates. A combination of gross margin
declines and operating expense ramp has been pressuring SONS margins
of late; we expect the trend will reverse going forward. (1) Gross
margins: after enjoying robust gross margins, in the 62-65% range,
SONS experienced a significant decline in 2Q07, when gross margins
fell to 57.8%, down 710bp q/q and 660bp y/y. However, we have not
found evidence of any unusual pricing trends in the VoIP equipment
sector. In our view, SONS' 2Q07 gross margin dip is transient,
related to product and customer mix rather than structural in nature,
and should recover going forward. We are modeling gross margins in
the 61-62% range in 2H07 and 60-61% range longer term. (2) Opex: Our
conversations with management indicate that SONS' opex growth is
likely to moderate going forward as headcount additions plateau and
costs associated with the accounting investigations ratchet down. (3)
Operating margins: Our analysis suggests that the gross margin
recovery and moderating opex trajectory, when coupled with strong
revenue ramp, could propel operating margins up from low single
digits to high teens by YE07.
Tier-1 customer announcement could act as a positive catalyst. Our
industry checks suggest SONS is actively engaged in trials with a
number of Tier-1 operators, including T-Mobile, British Telecom and
AT&T's international network. The probability of one or more of these
trials translating to contract win remains high; such an announcement
would act as a positive catalyst for the stock.
SONS valuation: In our view, based on a number of valuation metrics,
SONS is currently trading at a discount versus its growth
opportunity. (1) On a P/S basis: the stock is trading at about 3.8x
on CY08 estimates, toward the lower end of its three-year historical
range of 3x to 6x. If our investment thesis materializes, the stock
should support a P/S multiple in the 5-6x range, toward the higher
end of its historical range, yielding a fair value between $8-9. (2)
On a P/E basis: Given our view that SONS can grow its earnings at a
30% normalized rate over the next three years, we believe the stock
can support a P/E multiple of 25-30x FTM earnings; based on our 2009
estimates, this methodology yields a price range of $7.50 to $9.00.
(3) On a DCF basis: Our five-year discounted cash flow model, with
reasonable parameters, yields a fair value in the $7.50-9.60 range.
Taking a "middle of the road" approach, we establish a 12-month
target price of $8 for SONS. In addition to general market and
macroeconomic risks, the risks to our price target include: (1)
delays in key customer deployments pushing out the revenue growth
trajectory; (2) competitive share loss to larger, more established
equipment vendors and/or to a crop of next-generation players
attempting to enter the VOIP segment; (3) gross margin volatility;
and (4) management inability or unwillingness to contain opex. |
