MRVC--Bear, Stearns Update July 23, 98
Subject: Company Update
Industry: Data Networking Infrastructure
BEAR, STEARNS & CO. INC.
EQUITY RESEARCH
MRV Communications (MRVC - 23) - BUY
Taking A New Look At MRV;
Maintaining Estimates and Reiterating BUY Rating
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***We are reiterating our BUY rating of MRV stock after we
discussed with management at length on the company's long-term
strategy during our company visit last week. In our view,
despite the lack of understanding in the investment community of
the company's new strategy, MRV has been reinventing itself from
a small networking company with niches in 10/100 workgroup
switching and fiber optics components, to a full-service, end-to-
end networking vendor with revenues approaching $250 million run-
rate. The company's successful launch of the Gigabit Ethernet
backbone switches (now approx. 5% of revenues) has positioned the
company well in the high-speed LAN backbone environment. Its
acquisition of Xyplex has given the company good product
portfolio in WAN access and standards-based routing (supporting
both RIP and OSPF standards). Its expertise in fiber optics
should soon be appreciated by the investment community with the
upcoming shipment of WDM (wave division multiplexing) products.
The bottom line is - MRV is no longer "the low-end switching
company" that has been incorrectly labeled by most investors.
Instead, we think MRV should be viewed as an emerging full-
service networking company with strong product portfolio in
10/100 workgroup switching for wiring closet, Gigabit Ethernet
switching for high-speed LAN backbone, promising offerings in WAN
access and routing (such as the EdgeGuardian/ EdgeBlaster VPN
products from Xyplex), and emerging opportunities in optical
networking (use of fiber optics technologies such as WDM in
networking devices) thanks to its expertise in fiber optics
which, we believe, will increasingly differentiate MRV from other
networking vendors in the industry.
***MRV is scheduled to report Q2 results on Monday, July 27 after
the market close (Conference call dial-in number is 913-981-5507
at 4:45 p.m. ET on July 27). We are comfortable with our
estimates of $0.30 vs. $0.21 on $64 million revenues. We are
also expecting material improvement in DSO as the business in
North America (where credit terms are less generous than Europe)
is likely to have increased as a percentage of total revenues in
Q2 compared to Q1. We are also expecting to see some improvement
in inventory turns as well. In addition, we anticipate continued
strength in Europe and interestingly, solid results from Asia in
Q2.
***As an evidence that MRV is "moving up the chain", we believe
the company's average deal size has been increasing over the past
12 months. In fact, we think there were a number of deals in Q2
at about $1 million each, much higher than the typical deal size
of $50-200K. We find this encouraging as more blue-chip
customers are buying into MRV's good price-performance, reliable,
end-to-end networking solutions, including high-end Gigabit
Ethernet backbone switches, routing software (from Xyplex), and
fiber optics products, again not just low-end 10/100 switches.
***As for new product offerings, MRV has recently begun shipment
of its EdgeGuardian Virtual Private Network (VPN) products. In
addition, we anticipate the company to begin shipment of its new
WDM products within the next several weeks. The initial product
will be WDM4 (4 wavelengths per fiber) which will increase
available bandwidth on a single fiber by 400%. The follow-on
product will be WDM8 (8 wavelengths) which should be shipping in
3-4 months. MRV's WDM products are targeted at the metro access
networks for emerging carriers (CLECs), while WDM pioneer Ciena
is targeting at the WAN backbone for IXCs (Interexchange carriers
such as Sprint and WorldCom) with its high-end WDM products (16+
wavelengths). We view this as a good strategy for MRV as the
company will not be competing head-on with Ciena which has the
highest mind share in offering WDM solutions in the industry.
***Moreover, we believe MRV's Gigabit Ethernet switching
offerings, now accounting for about 5% of revenues, will continue
to gain momentum thanks to its unique product features -
supporting Gigabit speed at long distance (now at around 120 km
or 70 miles vs. competitors' 30-50 km) and it upcoming
incorporation of WDM capabilities inside the box, which will
eliminate the need for a separate WDM box.
***With its long-distance Gigabit speed capabilities, WDM
technology, in addition to WAN access and routing software from
Xyplex, MRV, in our view, has a potential to sell into the
emerging carriers (CLEC, national ISP) market should the company
establish the necessary channels through either partnerships or
acquisitions.
***We discussed with management the rationale behind the recent
private placement of the $100 million convertible notes
transaction. Some investors are puzzled by this move given that
the company has about $60 million in cash and no acquisitions are
imminent. Management explained that the Xyplex acquisition has
been going extremely well and the company is seeing a lot of
incremental opportunities that it would not have had without
Xyplex. As a result, it wanted to have the immediate financial
flexibility to make future acquisitions. In our view, the
convertible transaction should not be viewed as negative by
investors. First, the company has good track record of acquiring
companies with good technologies at very good price - Fibronics
in 1996 and Xyplex in January 1998 are prime examples. Second,
it is also true that the company now has better financial
flexibility to make acquisitions should a decision has to be made
in a short period of time - some of the technology M&A
transactions only take a few days to complete from the initiation
of discussion to the signing of agreement. Third, we think the
dilution effect is not significant on forward estimates. The
conversion price is $27.0475 with interest expense of 5% totally
paid by interest income on the proceeds. Should the convertible
notes be treated as debt (stock price substantially lower than
conversion price), there is no dilution impact on earnings.
Should the notes be treated as equity equivalents (stock price
substantially higher than conversion price), interest expense
should not be included in the EPS calculation and the dilution on
1999 EPS is only 0.10 (to $1.65 from $1.75). Immediately
however, we need to add $2.80 per share to cash - to a total cash
position of $4.80 per share. Consequently, from a financial
structuring standpoint, the convertible transaction was quite
attractive, in our view.
***As MRV moves up the chain, there will be inevitable concern
that the company is competing head-on with Cisco and 3Com. Our
take is - while the company is seeing larger deal size, it is
still not bidding the multi-million-dollar deals that Cisco and
3Com are going after. In addition, the company derives half of
its business from Europe, in which the markets are much more
fragmented than in the U.S. Moreover, the company has clear
product differentiations - fiber expertise/WDM, and as always,
better price performance.
***As MRV gradually communicates its "moving up the chain"
strategy to the Street, we expect to see material multiple
expansion on MRVC shares. The key reason why MRVC shares are
trading well below growth rate is that investors perceive the
company as a low-end, commodity-switching company and does not
deserve higher multiple. We believe should the company
successfully articulate its new strategy to the investment
community and should it continue to deliver solid financial
results, the stock will appreciate substantially from here. At
18.4 times our 1998 EPS estimate of $1.25 and 13.1 times our 1999
EPS estimate of $1.75, we consider the stock very undervalued
given its 40%-plus growth rate over the next two years.
**We are maintaining our estimates and are reiterating our BUY
rating on MRVC shares.
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MARKET CAPITALIZATION: $ 660 million
SHARE COUNT: 28.6 million shares
EARNINGS Q1 Q2 Q3 Q4
Mar Jun Sep Dec Year P/E
Current 1997 $0.19A $0.21A $0.23A $0.25A $0.88A 26.1x
Current 1998 $0.26A $0.30E $0.32E $0.37E $1.25E 18.4x
Current 1999 $1.75E 13.1x
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