Long AFCI.. at 7 1/4, sounds right.. "September 23, 1998 DAILY SCREEN ARCHIVE, CAN AFC RUN THE LAST MILE?
IS IT TIME to resurrect Advanced Fibre Communications(AFCI)?
There couldn't be a more exciting, or treacherous, era to
be in the kind of business AFC is in, namely making communications
equipment for the so-called last mile of the telephone network. That's the critical piece that runs between home and business and the central switching office where phone companies connect telephone calls.
AFC has been sitting out much of the action these past few
months. Back in July its stock dropped in half, falling more
than 20 points after the company preannounced it would
drastically miss reduced analyst expectations of 17 cents in
earnings. On July 14 the company came in at 9 cents per
share instead, and the stock has been trending down ever
since. At today's price of a little over $8 per share, the
company is 80% off its high for the year of $44.
Seems both Wall Street and AFC's management got a bit
carried away: Revenues jumped more than 90% in the first
quarter of this year, from $44 million to $85 million, and
everyone figured the company would be averaging a 70%
revenue growth rate this year, instead of the 60% revenue
growth on average it now looks like the company may
actually deliver. The situation in July was pretty grim. It
seems the company missed its target thanks to having lost a
contract from GTE, and the company's CEO promptly
walked out to join Cable & Wireless PLC, the European
telephone company.
But we're not bolting for the door: AFC still has a 35%
secular growth rate, according to First Call, and its current
price gives it an extremely modest p/e of 22 based on this
year's expected 35 cents per share, which is why it turned
up on today's price-to-earnings-growth screen. The
company has experienced dramatic growth in the past,
selling industrial strength racks of modems that get placed in
neighborhoods to bundle up phone lines from individual
telephone and data service subscribers. We're convinced the
best opportunities for investing will come in the
communications space in the next 12 months, as the
semiconductor sector continues to try and figure itself out,
and as the computer hardware sector is overshadowed by
earnings uncertainty resulting from PC demand issues.
What's more, AFC's products, digital loop carriers, are
experiencing such strong demand because they are riding the
growth of the Internet. AFC, along with companies such as
Lucent Technologies (LU) and ADC Telecom (ADCT),
two other established equipment firms, is helping phone
companies transform last mile technology from a
voice-centric network to a combination of voice and data
traffic, as demand for Net access becomes the bread and
butter. AFC, in other words, is helping to build the Internet.
But let's face it: Value is the main driver in this pick. At eight
bucks, AFC is trading at about 3 times its book value of
$300 million and a discount to its expected growth rate in
the coming years. We don't think the company's business
will hiccup again substantially in the near future, but the
company does have issues. For one thing, it faces a raft of
competitors, from Japanese electronics giant Hitachi to
French communications conglomerate Alcatel's (ALA)
DSC unit. And there's a wave of technology coming down
the road that will take the digital loop carrier business in a
new direction. Startups such as privately-held Atmosphere
Networks are working on digital loop carrier devices, called
add-drop multiplexers, that use Asynchronous Transfer
Mode networking to create ultra high speed communications
networks in metropolitan areas that nonetheless allow for
customers to specify very fine grained amounts of bandwidth
-- something that's not possible with today's gear sold by
AFC and others. AFC has to address that challenge down
the road.
But that doesn't worry us too much. The market for
commodity semiconductors that can give AFC's gear those
ATM capabilities it will need is growing. Chip makers such
as LSI Logic (LSI), Applied MicroCircuits (AMCC),
PMC Sierra (PMCS), and startup Cimaron
Communications of Andover, Mass., have been developing
chips that can give traditional phone gear these ATM
capabilities, so chances are AFC will find the raw ingredients
it needs in fairly plentiful supply.
What's more, AFC's customers are rooted primarily in
providing plain-old voice services, unlike Atmosphere's
target audience, competitive local exchange carriers focused
more on data. That means AFC has some time before it
absolutely must adopt new ATM technologies.
No, what concerns us is AFC's reliance on a few big
customers and its exposure to Asia. Sprint (FON) was 15%
of sales in the first six months of this year, and international
sales are about a third of the company's business, with a
good chunk of that rooted in Asia.
But whatever happens in Asia and Latin America, most
analysts agree the great public works project known as the
Internet will continue in the U.S. And AFC has important
partners in 3Com (COMS), with whom it is building
capabilities for digital subscriber lines, and with startups in
that same area such as Efficient Networks of Dallas, Texas
and Redback Networks of Sunnyvale, Calif. Those deals
will give AFC some protection against the vagaries of
overseas demand.
So we offer a cautious recommendation, based on the fact
that the company's core business is not going away, and with
the assumption that the company's chastened management
will do what it has to do to keep on top of the very
important technology trends in its market.
-- By Tiernan Ray
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