Description

Aviat Networks: Successful Turnaround, Fundamentals Outpacing the Stock

Aviat Networks (NASDAQ: AVNW) is a small-cap provider of microwave and millimeter wave wireless backhaul communications solutions to service provider and private networks. The company was previously written up on the VIC in May 2023 and I encourage you to read that write-up as well for context. Investors currently hate the small-cap telecom equipment sector for good reason, as the space tends to feature competitively disadvantaged companies selling against larger integrated multi-product vendors who bundle and discount equipment sales to a concentrated customer base of struggling, levered service providers. Many companies in the space experienced a boom during COVID as connectivity needs accelerated in the face of supply chain difficulties, only to face a subsequent bust as the equipment suppliers, distributors and end customers built too much inventory in the face of shortages at the same time demand slowed down.

At the same time, small specialist companies who execute better can frequently outperform larger, bureaucratic organizations. Given the difficult competitive environment and poor valuations accorded the sector, telecom equipment currently receives little attention and funding from the venture capital community, limiting competition from emerging startups. Geopolitical issues have kneecapped Huawei and ZTE, two of the most aggressive price-focused competitors in the space. I believe the post-COVID inventory correction in telecom and networking equipment has largely run its course. In fact, interesting long opportunities in well-managed companies with differentiated products in secular growth markets have emerged. Aviat represents one such opportunity. The company has executed well since bringing on a new CEO in January 2020, and largely sidestepped the recent issues plaguing the small-cap telecom equipment sector. At the same time, its stock has largely languished over the last three years. I believe the market will eventually take notice of the business improvement at Aviat and the stock price will catch up.

Company Overview and History:

Aviat specializes in designing, producing and selling wireless microwave and millimeter wave backhaul equipment and related software. The company sells the equipment either through distribution, its own salesforce or even an e-commerce store for smaller customers and also does turnkey network implementation projects for certain organizations who lack technical deployment capability. Backhaul refers to the portion of a communications network where the network traffic aggregated from the subscriber-facing equipment is exchanged with the core of the network. Wired fiber optic connections are generally preferred for network backhaul, however, due to geographic constraints and fiber availability network operators frequently need to deploy wireless backhaul connections utilizing the microwave wireless frequencies. These generally require line-of-sight connections but can provide multi-gigabit bandwidth. Large diversified communications equipment providers Nokia, Ericsson and Huawei sell microwave backhaul equipment alongside their mainstream business providing subscriber-facing Radio Access Network (RAN) gear, competing with independent providers like Aviat and Ceragon (NASDAQ: CRNT) among others.

While the largest portion of the wireless backhaul market gets deployed for the mainstream cellular broadband service, a significant portion of wireless backhaul equipment is purchased for private cellular networks or Land Mobile Radio (LMR) public safety networks. In its current configuration Aviat’s business splits roughly 50/50 between service provider networks- both mainstream cellular and Wireless Internet Service Providers (WISPs)- and private networks. Recent estimates size the market at approximately $11B per year growing high single digits compared to Aviat’s expected $500M in revenue for calendar year 2024. Wireless backhaul providers compete on the basis of product features, interoperability, software capabilities and other attributes that boil down to total cost of ownership to a network operator. I believe Aviat is the leading independent provider of microwave backhaul technology and the company holds over 200 patents after its decades of work in the space. The company is also working with MaxLinear (NASDAQ: MXL) on a custom semiconductor system-on-chip that should extend its technical competitive advantages.

Aviat Networks’ heritage can be traced back to the early stages of wireless microwave communications, and the company became independent from former parent L3 Harris Technologies Inc. (NYSE: LHX) when it was spun out and merged with Stratex Networks in 2007. I have followed this company for a long time off and on, in fact one of my first trade recommendations at a former fund was to sell the fund’s position in what was then called Harris Stratex networks, as the company was an operational mess with poor leadership under pressure from its larger diversified competitors who could bundle wireless backhaul with RAN equipment- especially emerging low-price Chinese companies ZTE and Huawei.

This sale recommendation proved prescient, because from 2010 to 2020 the renamed Aviat struggled with shrinking revenue, uneven financial results and poor stock price performance, at certain points trading well below tangible book value. Aviat retained solid technical capabilities and continued to invest in research and development, but could not translate their effort into the consistent profitable financial results required of a seasoned public company. During this time revenue declined from $465M in their fiscal year ending June 2010 to a nadir of $242M in FY 2017. Along the way activist investor Steel Partners acquired over 10% of the company and participated in a restructuring of the board of directors in 2015. The reconstituted board brought on experienced industrial and electronics executive Peter Smith as CEO in January 2020.

Current Situation:

At this point, a reader of this write-up might be wondering what attracted me to investing in a company with such a dismal recent history. The answer is twofold: Under the leadership of Pete Smith, Aviat has positively transformed its operational execution and financial results at the same time that the outlook for the industry has improved. Aviat has also commenced an industry consolidation strategy that should cement its position as the leading independent provider of wireless backhaul equipment and software and improve margins through economies of scale.

In 2019, the last full fiscal year before Smith took over, the company reported roughly flat revenue, 32.5% gross margins and sub-4% EBITDA margins. The company underwent a significant operational restructuring in fiscal years 2020 and 2021 and in FY2023 improved to revenue growth of 14%, gross margins of 36% and EBITDA margins of just under 14%. Aviat did experience COVID-related demand growth alongside many other communications equipment providers as the network capacity demands rapidly expanded, but admirably navigated the demand surge and related supply chain challenges without the blow-out of lead times and inventory accumulation that plagued other comm equipment vendors. The company’s successful management of these issues evidenced itself in calendar year 2023 as it kept growing year-over-year in each quarter while many of its peers reported revenue declines due to the COVID inventory hangover.

I believe part of the reason Aviat’s business has held up better than many other independent communications equipment providers is that the underlying long-term demand picture has improved. The biggest portion of the market serves the cellular broadband providers, who are in the midst of upgrading networks to the newest 5G standards. 5G networks were first rolled out in dense urban areas that tended to be backhauled by available fiber, but as the buildout continues on to the periphery (and in developing countries with much less fiber infrastructure) microwave backhaul has become a larger part of the network mix. At the same time WISPS, which largely serve rural populations where wired broadband infrastructure is unavailable, have continued to invest in their networks backed by government stimulus dollars which are forecast to continue and even accelerate under the $42B Broadband Equity, Access and Deployment program meant to expand high-speed internet access in underserved areas.

The largest portion of Aviat’s recent business actually serves private as opposed to service provider (subscriber-oriented) networks. Positive demand tailwinds have also improved the outlook for these markets. There is a significant upgrade cycle ongoing in public safety LMR networks once again backed by federal government stimulus dollars. Motorola Solutions (NYSE:MSI), a key Aviat integration partner for LMR, has reported steady improvements in their public safety business and backlog. Aviat also sells backhaul equipment for private industrial and utility broadband networks. Many of these networks are undergoing an upgrade from narrowband networks to LTE. In particular utilities need to upgrade to more capable networks to serve distributed alternative energy generation sources, smart meters and wildfire mitigation technologies and Aviat has multiple active projects in this sector.

As mentioned above, along with improving operational results, CEO Peter Smith has positioned Aviat as a consolidator of a somewhat fragmented industry where independent backhaul providers have struggled in recent years. He first proposed to buy the largest other independent equipment provider, Ceragon Networks, which would have almost doubled Aviat’s scale. The two sides could not reach an agreement, so Aviat instead acquired a smaller provider of radio access network equipment to private industrial broadband networks, Redline. The integration of Redline has progressed smoothly, and in May 2023 Aviat announced a larger deal to acquire the wireless backhaul business of Japanese conglomerate NEC (Tokyo: 6701) for $65.5M of cash and stock, adding approximately $140M to Aviat’s revenue base and significantly increasing their scale. The NEC acquisition closed in November 2023.

Forward Prospects:

I believe that investors will look back on Aviat’s calendar Q4 2023/fiscal Q2 2024 earnings as the moment where the thesis for investing in the company really became obvious. The metrics for the base Aviat business continued to look positive, with continued modest revenue growth and margin improvement as well as a book-to-bill ratio above one and core Aviat backlog up 24%. More importantly, the company announced that it believed that the NEC acquisition would be accretive by the third quarter following its close, rather than after a full year. The company eventually expects the NEC business to reach its corporate goal of 15% EBITDA margin, meaning Aviat prospectively bought the business for just over 3x EBITDA, a wildly accretive multiple. Aviat raised guidance for the remainder of fiscal 2024 to account for the acquisition.

Aviat’s valuation really looks attractive as I look forward to a fully integrated NEC business. My model shows the company hitting an approximate $1.25 in quarterly pro-forma EPS by the quarter ending June 2025. This requires that the NEC acquisition be successfully integrated and brought up to corporate average operating margins, but I believe given the track record of Aviat under Peter Smith this should be achievable. Even at an un-demanding 12x multiple of the run-rate annual EPS of $5.00, the stock would reach $60, up around 65% from current levels. After its years of wandering in the wilderness, Aviat has a large net operating loss carryforward, so cash taxes should be minimal for the foreseeable future, and there will be high flow-through of EBITDA to earnings and free cash flow.

Longer term, I believe the company can create additional value by utilizing excess cash to accretively buy back shares at its current single digit P/E multiple and the company has a small buyback in place. However, in the near term I think the company may build up excess cash with an eye towards further consolidating the sector once it digests the NEC business. This could come in the form of another run at Ceragon or carving out the backhaul portion of one of the larger integrated competitors, leaving open the possibility of further growth and multiple expansion as Aviat cements itself as the leading independent provider of wireless backhaul solutions.

Despite all the financial and operational improvements of the last few years detailed in this write-up, AVNW trades at around the same level as it did in February of 2021. There are a lot of potential reasons for this- Aviat’s history, its small size and relative lack of liquidity, small caps being out of favor and the poor performance of many of its peers, among others. For a company and CEO with a good recent track record of execution, the stock seems cheap at 8x forward earnings and 6.5x EBITDA, and I suspect that expectations have been conservatively set with respect to the NEC acquisition’s revenue and margin potential. Overall, I think the stock has a lot of catching up to do.

Catalyst

• Integration of NEC Pasolink business and merger synergies
• Revenue and earnings growth
• Potential future consolidation of wireless backhaul market