Somera: A Secondhand Rose Set to Bloom?
By Sam Jaffe
The telecom-equipment industry's walking wounded comprise almost all its players: Lucent Technology (LU ) stock is down 73% from its high. Nortel Networks (NT ) has plunged 92%. Motorola (MOT ) is 34% lower, and Ericsson (ERICY ) has declined 73%. The companies are watching profits and revenues fall along with their stock prices.
Tiny Somera Communications (SMRA ) has had a rough year, too. Its stock is down 59% from the 52-week high of $12.81 and now stands at a puny $5.06 a share as of Oct. 11. Yet Somera is enjoying record quarterly growth in revenues, and its profits are expanding.
Why the disparity? Because investors are lumping it in with the rest of the beleaguered industry. But that may be a mistake. Somera's market capitalization is still well below its expected revenues for 2002, and its price-to-earnings ratio (p-e) for next year's earnings is well below its expected annual growth rate. This is one of those rare stocks (especially for the telecom sector) trading at very cheap valuations while exhibiting healthy growth.
Somera's secret is selling used telecom equipment to carriers that need to plug holes in their networks and don't want to spend a fortune on new machines. The company has two things going for it. The first is that the telecom industry remains in a ferocious hangover resulting from its costly spending bender of the late '90s, when tens of billions of dollars were invested in building networks that weren't needed. As a result, purchasing managers still employed at telecoms have become more value-conscious than a Depression-era grandmother shopping for Christmas presents at a flea market.
The other favorable element is that the used-equipment market is overflowing, thanks to dozens of bankrupt telecom carriers. But Somera does more than offer these items for sale. The million-dollar pieces of equipment are designed, configured, and tested for the specific needs of a particular carrier and are practically useless in their "as-is" condition. Although it's easy enough to find switches, routers, and lasers for sale on eBay, you won't find many bidders.
Somera, in business since 1995, has a vast database of carriers' equipment inventory and needs. It can take an order for a particular suite of equipment and then buy those pieces piecemeal from several different defunct or soon-to-be defunct carriers, reconfigure the pieces, test them, write new software, and then seamlessly integrate them into the customer's network.
"There's lots of equipment out there, but no warranty on them and no service," says Jeff Miller, executive vice-president of sales and marketing for Somera. "We connect the buyers and the sellers and, more importantly, we provide the service."
The average piece of used -- or "de-installed," as Miller likes to call it -- equipment can be bought for one-third to one-quarter the original price, even if it has never been turned on. Somera's service and installation charges are higher than they would run for new equipment, but the buyer gets a reliable product with a full-service warranty for half the price of buying it new.
"Anyone can buy used equipment, but it's impossible to recreate what Somera can offer," says Dain Rauscher Wessels analyst Troy Jensen, who has a buy rating on the stock. "The value they add is the service aspect, and that's their expertise."
Because of its unique business model and profitable niche, Somera reported record results in its second quarter, when it produced $60 million in sales and 6 cents in earnings per share. Because of a seasonal slowdown, the company is expected to come in with $55 million in sales for the third quarter, to be reported on Oct. 18, and should have EPS of about 9 cents, according to First Call.
The company does face challenges. In the near term, its greatest obstacle is keeping gross margins fat while original-equipment manufacturers such as Cisco Systems (CSCO ), Lucent, and Nortel sell their products at deep discounts. That trend started at the beginning of this year, and Somera so far has been able to maintain a gross profit margin in the mid-30% range.
"Pressure on de-installed systems' gross margins will continue to decelarate in the third quarter," says Steve Levy, an analyst with Lehman Bros., who rates the stock a strong buy. Nevertheless, he doesn't see gross margins going below 32.5% and expects them to start expanding again in the fourth quarter.
If Somera continues on its roll, its future is even brighter as the telecom environment improves. "This is a company that did fantastically when the telecom spending spree was happening, and continued its growth when it stopped," says Dain Rauscher's Jensen. "They are only partially countercyclical. When the cycle is down, they do well, but they also do well when it's up."
IN THE DOGHOUSE.
Plenty of growth opportunities are on the horizon. One area is in overseas sales, which currently account for no more than 10% of revenue. "International carriers are much more willing to purchase de-installed equipment and are much more value-conscious than U.S. carriers," says Miller. Jensen thinks international sales will make up one-third of revenue in coming years.
Meanwhile, Somera's stock is stuck in the doghouse along with every other telecom-equipment company. It's now trading at nine times 2002 earnings, while Somera is expected to increase earnings 20% each year for the foreseeable future.
Using the old saw that annual growth expectations should equal forward p-e for a reasonable valuation, Somera should be a $12 stock. That's comforting to current shareholders, who are holding it at around $5 a share.
Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column
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Edited by Beth Belton