Well the summary part of the Van Kasper writeup is now posted on their site, so I don't have to synopsize that part. Here is the link:
vkco.com
This report is NOT copyrighted, nor is there any language restricting the use of this information. Indeed, their disclaimer says they may have an active trading position in this stock and buy or sell at any time. So rather than partially restating this report in my own words like I normally might do, I see no harm in reproducing much of the text in a straight re-keying. I have broken up some paragraphs for easier reading.
In doing this synopsis, there are some items that I believe is not generally known to the thread. [* These items will be enclosed in brackets, with an "asterisk blank" to stand out - like this sentence *]. Items of particular importance will be bolded. In a few spots typos or incorrect data is presented. I show the original text and my version using brackets and "sic" [sic].
First, their disclaimer copied verbatim:
"The study on these pages is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed herein reflect the judgement of the author at this date and are subject to change without notice. Facts have been obtained from sources considered reliable, but are not guaranteed. First Security Van Kasper it's directors and employees and their families may have a position in the securities of the companies described herein, and may make purchases or sales while this report is in circulation"
MRV COMMUNICATIONS, INC.
(MRVC - $15 1/16)
Initiating Coverage; Strong Buy
EPS REVENUES (MM)
Fiscal Year: 99/98 00/99 00/99
December 1998A 1999E Change 2000E Change 1999E 2000E Change
Q1 $0.25 $(0.03)A NM --- --- Q1 $70.1A --- ---
Q2 $0.30 $0.02A NM --- --- Q2 $73.3A --- ---
Q3 $0.05 $0.01 NM --- --- Q3 $71.7 --- ---
Q4 $(0.09) $0.02 NM --- --- Q4 $75.4 --- ---
Year $0.53 $0.02 NM 0.22 NM Year $290.5 350.5 21%
P/E 28x NM 68x Mkt Cap/Revs 1.4 1.1
52-Week Range: $22 3/8 - 5 1/16 Rating: Strong Buy
Market Cap. (MM): 402.5 Price Target $40
Shares Out. (MM): 26.73 Book Value/Share: $6.48
Estimated Float (MM): 21.85 Current Year ROE: (1%)
Est. Insider Holdings: 18% Debt to Total Cap. (6/99): 34%
Est. Institutional Holdings: 22% Gross Margin (FY98): 39%
10-Day Average Volume: 437,480 Next EPS Report: Oct. 1999
Investment Conclusion: We are initiating coverage of MRV Communications, Inc. (MRVC) with a Strong Buy recommendation. We believe MRVC's unique position as a vertically integrated fiber optics networking firm, and the Company's track record of delivering innovative leading edge products positions them to take advantage of the rapidly expanding area of optical networking. Our 12- to 18-month price target of $40 (+166%), is based on 3x FY 2000 sales, which is half the industry multiple.
- Outstanding Growth: Driven by the ever increasing demand for bandwidth, we expect MRVC to achieve a 20%+ revenue and 30%+ earnings growth over the next three to five years.
- Expanding Gross Margins: Gross margins rebounded from 29% in Q4 1998 and are expected to expand as the Company transitions into higher-end products for the WAN and remote access markets.
- Unique Strategic Position: MRVC's networking and fiber optic transmission expertise uniquely positions them to take advantage of the convergence of telecommunications and data networking.
- Track Record of Innovation: MRVC has a history of being first to market with leading edge fiber optic networking technologies including its Linux Switch Router, Terabit Router and many others.
- Sum of the Parts is Greater than the Whole: Management recently stated that it plans to maximize the value of its divisions and subsidiaries through strategic partnering, spinning-off or doing an IPO.
- Committed Management Team and Employee Base: Management has major equity incentives with 18% insider ownership and has a loyal employee base reflected by its exceptionally low turnover.
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Company Description:
MRV Communications, Inc. is a world class leader in the rapidly expanding area of optical network components and systems. MRVC designs, manufactures, and markets leading edge high speed network switching, routing, remote access, and fiber optic transmission systems for the data, telecommunications and cable TV networks. The Company's current business is approximately 78.5% networking and 21.5% fiber optics. These products are marketed by MRVC's rapidly expanding direct sales and support staff, distributors, VARs, systems integrators, and to most major OEM customers. Over the past several years, International operations have become increasingly important and currently make up 59% of MRVC's product sales.
MRVC was founded in 1988 designing, manufacturing, and marketing fiber optics components. Through internal development and acquisitions, the Company has been able to transition seamlessly from optical components to stackable workgroup switches to enterprise class and, more recently, to backbone switch routers and remote access products.
Due to the lead-time needed to sell and develop optical networks and routers, in mid-1998 MRVC announced a delay in product launches. Other factors, including increased price competition in the low-end switches and slowing international demand from both Asia and Europe, have driven the stock price well below its $40 per share high. Fortunately, MRVC is well capitalized, well managed, and the various markets for their products are expected to grow at a rate from 20% to 100%+ annually for the next three to five years.
We believe that MRVC's share price largely reflects both the changes in the macro-environment and the recent product delay. It is our opinion, that MRVC is at the final stages of its transition from a "best of breed" low-end switching company, to an end-to-end optical networking company with leading edge technology and the marketing distribution and support to capitalize on it. As the company executes the monetization of its various subsidiaries, we feel these events will lead to the realization of shareholder value.
Based on these long-term prospects, we believe MRVC shares offer a favorable risk adjusted return. We are initiating coverage of MRV Communications, Inc. with a Strong Buy recommendation. Our 12- to 18-month price target of $40 (+166), is based on 3x FY 2000 sales, which is half the industry multiple.
Investment Considerations:
- Outstanding growth: Driven by underlying networking and fiber optics industry growth (expansion into high-end products and acquisitions), MRVC has grown revenues from $39 million in 1995 to $165 million in 1997 (+112%/yr., net of acquisition +70%/yr.) and to $265 million in 1998 (+60%). Given the Industries strong growth prospects and higher margins associated with MRVC's new products, we expect MRVC to achieve a 20%+ revenue and 30%+ earnings growth over the next three to five years (this assumes no contribution from MRVC's three subsidiaries: Charlottes Web, New Access and Hyperchannel.com).
- Rebounding gross margins: Gross margins expanded from 29% in the fourth quarter of 1998 to 35% in the second quarter of 1999. The recent expansion was largely due to the rebound of low-end switch margins, which were depressed to 18% in the fourth quarter as the Company cleared out old inventory. Low-end switch margins are now improving towards normalized margin levels of 30% driven by the Company's updated NBase switch line. We expect to see modest increases over the next two quarters and accelerate the margins expansion as the Company begins to see sell-through of its higher-end products. Higher-end products, versus lower-end, do not face the commodity like pricing pressure of the low-end and also benefit from the higher margins associated with its higher software content. Margin improvement should also be fueled by an increase in higher margin, fiber optic component sales, which are expected to grow from 21% of sales this quarter to 30% of sales in 2000. Additionally, increased operating efficiencies should be derived from MRVC's new Fiber Optics Fabrication facility that began production as scheduled this quarter.
- Unique strategic position: MRVC is one of the few companies with expertise in both fiber optics and networking. We expect this competitive advantage to become increasingly important as: 1) the backbone telecommunications networks (that currently transmit over fiber) begin to handle more data; and 2) as fiber rolls out into the metro area networks, the enterprise, and to the consumer.
- MRVC has a solid track record of being first to market with leading edge networking and fiber optic technologies. MRVC has built its reputation as an industry leader in the early stages of the Ethernet and has had many industry firsts such as its 10/100 Ethernet Switch and its Gigabit Ethernet products. [* The Company has also been equally as innovative in its fiber optics business establishing some of the first Fiber to the Curb (FTTC) solutions including its Duplexer and Triplexer which has rolled out to over 100,000 sites. *] More recently, MRVC has developed a strong pipeline of high end product launches, including its patent pending Terabit Router, Linux Switch Router, Dynamic Dense Wave Division Multiplexer [sic MetroFusion?], and Wireless Fiber Driver. We believe that these products and other near term product releases will enable MRVC to capture some of the outstanding growth in the most explosive areas such as the Internet backbone.
- Sum of the Parts is Greater than the Whole: Management recently stated that it plans to maximize the value of its subsidiaries through strategic partnering, spinning-off, or doing an IPO. We feel there is a great opportunity to take advantage of the hidden value lost in the turnaround of MRVC's largest division N-base - Xyplex by valuing each division on a stand-alone basis. Assuming any one of MRVC's now four subsidiaries - with a fifth subsidiary to be announced at the NetWorld Interop in September - achieves the success and valuation given to many of its peers, it would be valued at an equivalent amount, or significantly more than the whole company is valued at currently. As the company executes the monetization of its various subsidiaries, we feel these events will lead to the realization of shareholder value.
- Expanding Sales and Distribution in the U.S. and Abroad: With the Company's acquisition of Xyplex Networks, MRVC continues to focus on enhancing its direct sales and distribution in the U.S. and abroad, particularly in the service provider arena. MRVC's direct sales force has more than doubled since 1996 to current headcount of approximately 365. Additionally, the Company continues to strengthen its relationships with its distributors, VAR's, systems integrators, and OEM's.
- Solid Balance Sheet: In June of 1998, MRVC raised $100 million in a Convertible Debenture strengthening the balance sheet. They are now well capitalized with $4.90 per share in cash and equivalents and over $7 per share of working capital. Although the Company's debt and equity have been trading at attractive levels, management has limited its repurchase program to $10 million of its Convertible Debenture, opting to reserve its capital for funding its internal projects. In an effort to maintain its solid balance sheet, management has focused on tightening its financial discipline and we expect the Company to meet its cash flow neutral objective.
- Committed Management Team and Employee Base: Management runs a lean operation and takes moderate compensation. They repurchased stock in the low $20's and have major equity incentives with 18% insider ownership. The Company has also developed a loyal employee base reflected by its exceptionally low turnover. Additionally, we believe MRVC's new spinout strategy will offer key employees and management the equity incentives to burn the midnight oil and stay ahead of the rapidly changing technology curve.
Unique Products Targeted at High Growth Markets:
MRVC has targeted it's new products at markets with outstanding growth prospects such as:
- LAN Layer 3 switch spending is expected to grow from $637 million in 1998 to $3.4 billion in 2001 (Source Dell'Oro Group)
- Internet backbone router spending is expected to grow from $169 million in 1998 to $5.3 billion in 2003 (Industry sources)
- Metro Area WDM spending is expected to grow from $200 million in 1998 to $1 billion in 2003 (Source: Pioneer Consulting)
- The Optical Component market is expected to grow from $3.4 billion in 1998 to $8.1 billion in 2001 (Source IGI Consulting)
Given the outstanding growth prospects, we view our estimates for sales growth and gross margin expansion to be conservative.
Additionally, inline with management's guidance, we have not added the potential upside impact of MRVC's three startups: Charlotte's Web, New Access, and Hyperchannel.com, each of which we believe could contribute as much as $50 million per startup in 2000.
A few of MRVC's new patent pending products include:
- AcceleRouter (Beta Q2, Ramp Q3 1999) - The AcceleRouter is a plug and play Router that has the ability to increase the speed of any Router up to 100x with full adherance to network security, QoS and differentiating service support, and flow queuing at any layer. It is estimated that there are over 500,000 software based Routers that can benefit from the addition of an AcceleRouter.
- GFS3016 Switch Router w/ Coarse WDM (CWDM) & Gigabit Ethernet. (Availability Q2 1999) - MRVC is the first to introduce CWDM and GE. At $5,000 per wavelength per node versus $24,000 of D(ense)WDM, CWDM is a cost-effective alternative to Dense WDM alternatives under 20Km.
- Metro Fusion Dynamic DWDM - patent pending - (Beta Q4 1999, Ramp Q1 2000). New Access's award winning DDWDM unique Metro Fusion architecture allows any node to directly communicate with any other node, as well as to a high bandwidth uplink out of the Metropolitan ring, using only a single wavelength per node. This more efficient distribution of bandwidth provides a low cost alternative of [* $6,550 per wavelength per node versue $24,000 of Dense WDM *].
- Terabit Router - [* patent pending *] - (Beta Q1 1999 [sic Q1 2000], Ramp Q3 2000). Charlotte's Web Networks Terabit Router, the ARANEA-1 is expected to be the most powerful atomic router on the market with a 128 Gbps [sic now 200Gbps] non-blocking switching fabric versus Avici's 100 Gbps, Lucent's 64 Gbps, Juniper's 40 Gbps and Argon's 20 Gbps.
- OSR8000 Linux Router - [* patent pending *] - (Beta Q3 1999, Ramp Q4 1999). MRVC's Linux Router is the industry's first high-end switch router based on the Linux operating system. The Linux "open" architecture operating system challenges the dominant proprietary systems required by most major switch router vendors - such as CSCO's IOS or Nortel's BayRS - by offering third party developers, Carriers and ISP's both, the flexibility to tailor applications and the ability to optimize bandwidth of the highly scaleable open cell based switching fabric.
- Redex Carrier Class Switch Router - (Beta Q3 1999, Ramp Q4 1999) MRVC recently announced the introduction of a Carrier Class Switch Router, which is expected to be competitive with Redback Newtorks (RBAK) product line. Similar to RBAK's offering, MRVC's Redex product line is expected to support [* DSL, Cable, PTSN, and Wireless Access to the Telco Core. *]
Valuation: Sum of the parts is Greater than the Whole
At the current price, MRVC is trading at 1.4x sales, a fraction of industry multiples. We believe the valuation of MRVC is currently depresed due to difficulty MRVC has had in the low-end switch market and upgrading of the Xyplex switch router [sic EdgeBlaster and EdgeGuardian?] to new technologies such as VPN and VoIP. Compounding this is the added R&D expense associated with the Company's three new start-ups: Hyperchannel.com, New Access, and Charlotte's Web.
We believe that MRVC has turned the corner and is on the verge of recognizing the value of these endevours. As noted, during the second quarter gross mrgins improved from a low of 29% in the fourth quarter to 35%, and both sales and backlog were significantly higher than the prior year's second quarter. The Company has now upgraded it's low-end switch line, begun deriving revenue from it's subsidiaries, added VPN and VoIP to it's switch router and has completed the capacity upgrade to it's Fiber Fabrication facility. Additionally, the Company continues to introduce leading edge new products.
We feel there is a great opportunity to take advantage of the hidden value lost in the turnaround of MRVC's largest division Nbase-Xyplex by valuing each division on a stand-alone basis. For this analysis, we have listed MRVC's core division, four subsidiaries, and added a special Enterprise Switch Router carveout [Redex?] to represent MRVC's past and future products, which we expect to be competitive on price, speed, and functionality versus Extreme Networks. [?] As noted in the table below, whether one assumes modest success (achieving 50% of the industry average multiple, using low end of sales & multiple range), or success (achieving industry's average multiple), the sum of the parts is greater than the whole.
Price per Share
Possible Ind. Modest
MRev. 2000 P/S Success Success
1. Nbase-Xyplex - LAN, WAN and RAS $ 259 6-8x $29.08 $77.40
2. Optical Access - Fiber Optic Components $ 91 6-8x $10.22 $27.40
3. Hyperchannel.com - E-Commerce $ 25-50 20x $ 5.05 $20.20
4. New Access - Optical Networking Company $ 25-50 20x $ 5.05 $20.20
5. Charlotte's Web - Terabit Router $ 25-50 20x $ 5.05 $20.20
6. Carveout - Enterprise Switch Router $ 25-50 20x $ 9.36 $37.42
Total Value $450-$550 $63.80 $202.82
Given the continually improving prospects of MRVC and it's subsidiaries, our 12 to 18 month price target is $40 (+166%). We are basing this price target using the Modest Success price-to-sales multiple of 3x and applying it [only] to the 2000 estimated sales of Nbase-Xyplex division and Optical Access subsidiary. We would expect to increase this price target as: 1) MRVC adds the necessary partners, management and staff securing sellthrough of it's subsidiaries high-end products - this is already beginning with a Cisco executive running Hyperchannel.com; 2) MRVC executes a monetization strategy - management recently stated they are already engaged in discussions with external parties; and 3) a takever premium is added, which we would expect to be in line with legacy system industry multiples of 6x to 8x sales and inline with firms focused on the higher growth segments multiples of 20x to 2[?]x sales. It is worth noting that the convergence of voice, video, and data continues to fuel acquisitions. Several recent transactions include General Electric Co., p.l.c.'s purchase of FORE Systems, Siemans's purchase of Argon Networks (a private terabit router company).
Monetization Strategy:
Management stated that it plans to maximize the value of it's divisions and subsidiaries though strategic partnering, spinning-off, or doing an IPO. Management's monetization strategy aims to take advantage of th highest growth segments within the networking and fiber optic marketplace. By spinning out seveal of its divisions and subsidiries, the Company has shown it can attract the management and engineering talent interested in the high potential rewards of significant equity ownership and the excitement of an entrepreneurial environment. We believe that as MRVC executes its monetization strategy, not only will it add to management's focus, but it will offer investors [hey that's us] and acquirers a clearer vision.
We believe the two near term candidates to be spun out are MRVC's rapidly growing Optical Access subsidiary [* and it's Hyperchannel.com subsidiary *] The Company has taken the initial steps in the process this quarter, noting that it has separated the Optical Access as a subsidiary, retained a leading banking firm to offer advice on the process, and will be reaining an investment banking firm. Given the long history of MRVC's Optical Access division and it's accellerating growth, we believe an offering would be well received by an Internet hungry market.
MRVC's Hyperchannel.com subsidiary is also another likely candidate to be spun out in the near term considering [* it's current $8 million annual revenue run rate *], the fact that it is operationally breaking even, and it's lose [sic loose] strategic fit. The other subsidiaries are likely to follow shortly after they begin to ramp up revenue, which is expected to begin the first half of 2000.
Optical Access Subsidiary
MRVC's Optical Access subsidiary was established in 1988 and designs, manufactures, and markets it's optical components to the majority of the OEM's in the Data Networking, Telecommunications, and Cable business. Since it's inception, the business has grown steadily and has built a reputation as an innovator in WDM solutions (with it's Coase WDM for the Data Communications market) and as a leader in it's Fiber to the Curb (FTTC) solutions with it's duplexer and Triplexer. The Optical Access subsidiaries current sales mix consists of 30% discrete devices for the cable, PCS, and instrumenation markets, 40% long reach, single-mode solutions for the Data Networking Industry and 30% FTTC solutions.
We believe MRVC's eleven years of research and development in both fiber optics and networking is about to pay off. As previously noted, the WDM Metro Area WDM spending is expected to grow from $200 million in 1998 to $1 billion in 2003 and th Optical Component market is expected to grow from $3.4 billion in 1998 to $8.1 billion in 2001. We believe that the complexity of the products and MRVC's early to market advantag, particularly in he access an metro markts, offer a significant barrier to entry and will allow the Company to capture a large portion of this spending.
Over the last twelve months, the explosive deployment DSL and cable modems are dramatically increasing the demand for bandwidth. As a result, MRVC's Optical Components business has begun to accelerate it's growth rate to 30% up from 20% in 1997, and has reached an annual revenue run rate of $63 million. We expect this trend to continue and [* estimate sales could reach $91 million in 2000 *]
40% over the 1999 estimates of $65 million. [*A large part of this demand has been derived from Bell South's FTTC project, which has deployed over 100,000 of MRVC's Duplexers and Triplexers. ] We estimate that this project will add an additional 200,000 to 300,000 units by year-end and [* may potentially double in 2000. Additionally, we expect other Telecommunications and Cable companies to adopt MRVC's FTTC solution and ramp up over the next 18 months. *]
In an effort to service this demand, the Company has recently doubled the capacity of it's Optical Access operation and adopted a modular footprint build-out strategy, which will allow rapid capacity expansion in any geogrphical region. MRVC has also added approximtely 45 new production employees, grew it's Chatsworth Fiber Optics Foundry by 4x to 80,000 square feet, and spent $2.5 [million] on new equipment. The Company feels its current capacity will allow it to scale up to a $200 million run rate with minimal efforts and is prepared to take advantage of fibers progression from the network core to the network's edge.
Hyperchannel.com Subsidiary
MRVC's UK subsidiary Hyperchannel.com was founded in 1997. Hyperchannel is rapidly establishing itself as a leading provider of specialist services distributor for Internet security, e-commerce, and networking. Hyperchannel offers resellers a fast, efficient solution to establish an electronic storefront for their products and services. Of the approximately 7,000 resellers in Europe, the Company has captured 300 customers in the past 18 months. Hyperchannel.com is currently producing an $8 million annual revenue run rate and is operationally breaking even. The Company has also attracted some top management talent, namely NickKandola, CEO/President - previously a VP of Marketing at Cisco, a COO previously with Alta Vista and two board members from IBM and 3Com. We believe that Hyperchannel's early lead servicing the networking reseller niche will allow them to be a major player in the digital evolution of this channel.
Conclusion
Based on MRVC's unique position as a vertically integrated fiber optics networking firm, our growing confidence in management's continued ability to deliver innovative leading edge products and the potential to realize shareholder value through monetization of subsidiaries and divisions, We are initiating coverage of MRV Communications, Inc. with a Strong Buy recommendation. Our 12- to 18-month price target of $40 (+166), is based on 3x FY 2000 sales, which is half the industry multiple. .
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