Zhone Turnaround a Buying Opportunity ZHNE

by Hilary Kramer | October 29, 2013 2:00 pm

As a communications network equipment manufacturer, Zhone Technologies (ZHNE[1]) was one of the most well-funded tech start-ups of all time when it was incorporated in 1999 in the midst of the technology boom.

However, after the failure of many dot.coms killed demand for networking equipment, a planned IPO in 2000 had to be scraped.  The company then took its current form in 2003 after it was acquired by Tellium, but retained the Zhone name.

After several years of losses, ZHNE turned profitable this year with cost cuts, continued acceptance of the company’s core products, and less price competition from Chinese manufactures all driving the improvement. This return to profitability has led to strong gains so far in 2013, but I see more upside potential ahead as the company continues its turnaround story.

Much of the company’s success this year has been driven by its flagship MXK IP Multi-Service Terabit Access Concentrator (MXK) and multiple new Optical Line Terminal (OLT) and outdoor units in late 2009.

Management believes these products, along with its mature single-level multi service (SLMS) architecture offerings, allows its carrier service customers to offer new services that are essential for their revenue growth, such as Internet-based entertainment and  the convergence of voice, data and video.

In 2012, ZHNE shipped more than 2,200 MXK systems to new and existing customers globally. It now has over 4,400 total MXK units deployed at over 150 service providers in more than 40 countries.

But ZHNE isn’t stopping there. A critical new product for the company is its FiberLAN (Local Area Network) Optical LAN Solution. The company believes that FiberLAN is the most cost-effective, efficient, and environmentally-friendly alternative to traditional copper-based Ethernet switches on the market today. That may not mean much to you and me, but it is an attractive product to the wireless operators ZHNE serves. FiberLAN offers superior bandwidth and connectivity as new cloud computing environments continue to restrict clogged LAN arteries. The company has just started shipping this product, but believes it is already being well received by customers and could generate $20-$40 million in revenues next year.

With carrier and cable competition providing growing triple play services (including high-speed Internet access and television, plus telephone) in individual residences, ZHNE believes that fiber in these home products will provide the best experience and become standard. Just this week, the company introduced a new digital subscriber line access multiplexer, called DSLAM. The product comes in a compact form that makes it ideal for deploying fiber in home products while providing very strong triple play services.

Zhone offers all these products to a widespread customer base, as 750 network providers on six continents have deployed its products. Domestic revenues accounted for 44% of the total revenues in 2012, followed by Europe, Middle East and Asia (30%), Latin America (24%), and Asia Pacific (2%).

ZHNE Back on Track

After years of inconsistent sales, declining margins and operating losses, Zhone turned a fourth-quarter profit last year of $805,000, with EPS of 2 cents per share strictly on lower operating expenses. Sales and gross profit in the quarter declined 15% and 13%, respectively.

However, results have been much more robust here in 2013. Through the first nine months of the year, revenues have grown 1%, but a better price margin allowed gross margins to increase significantly to 37.8% from 29.7%, and the company realized EPS of 9 cents a share versus a loss of 31 cents a year ago.

It should be noted that sales growth accelerated in the third quarter, with sales up 5% to $30.5 million. In addition, gross profit margins increased to 37.8% from 28.2%, and operating expenses continued to decline, which led to earnings of 5 cents a share versus a loss of 14 cents per share a year ago. Furthermore, management guided the fourth quarter to be the best of the year, so we could see improvement over not only last year’s first fourth-quarter profit of 2 cents per share, but also the 5 cents per share earned in the third.

After years of struggles, ZHNE has turned its business model around and is in a good position to keep growing. Management believes the better pricing environment will stick, and its exciting new product offerings are helping the company change with an evolving tech environment. If FiberLAN produces the $20-$40 million in sales management expects next year, it would represent a significant add-on to the $120 million in revenues the company should achieve in 2013.

Zhone also has a strong balance sheet, with $67.2 million of assets versus only $32.8 million of total liabilities. This nearly $35 million of net current assets could help finance an acquisition of the company, which has total market capitalization of just $120 million. It is also a potential acquisition target, as larger networking players may be interested in gaining its new technology.

I strongly recommend building your position in ZHNE slowly over time.

  1. ZHNE: http://gamechangers.investorplace.com/breakoutstocks/stock-report/?t=ZHNE

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