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Stratos International (STLW): An Optical Value Play?

Posted on July 10, 2006

I believe that Stratos International (STLW) is an excellent low risk investment "gamble" at its current price of about $6.80, with potentially good odds of providing investors with an above average market return over the next year or two.

Before reading on, please note that STLW is extremely thinly traded, so if you plan to invest in this company, you should use limits. Also, as always, please read the disclaimer at the end of this post.

Background Data:

STLW Share Price as of this post: $6.80
Approximate Shares Outstanding: 13.8 million
Net Cash: $30 million
Market Cap: $95 million
Enterprise Value (Market Cap - Cash + Debt): $65 million
Average Total Revenue Last Three Years: $70 million
Total Revenue Fiscal 2006: $79 million
Estimated FCF (EBITDA-Cap Ex 2006): $2.8 million (is likely higher, see analysis below)
Enterprise Value(EV) to Average 3-Year  Revenue: 0.9 X
Enterprise Value(EV) to Average 3-Year  Revenue: 0.8 X
Enterprise Value(EV) to FCF (EBITDA-Cap-Ex): 23X

So what does Stratus do?
From the company´s 10K: "Stratos International is a leading supplier of shielded electronic and optical interconnects, plus the transceiver components that are used to connect these two transmission line mediums. We design and manufacture interconnect components and subsystems used in telecom communications, datacom, military and video markets for signal networking.      Our company has a rich history of optical, electrical, and mechanical packaging expertise and has had a continuing positive role in developing innovative products often involving miniaturization. We have an intellectual property portfolio of more than 100 patents. We are a market leader in several niches including specialty optical products such as small form factor transceivers, coax/optical media interface adapters, optical flex circuits, microwave flexible cables and cable assemblies, and radio frequency (“RF”) and microwave coax and triax interconnect products. We currently serve more than 1,000 active repeat customers."
What does this all mean? Honestly, I´m not in the least bit of an expert on these types of products, so if you are really interested in understanding the company´s complete product line, I suggest reading more at their website at: http://www.stratosinternational.com. However, from my perspective it´s not really that important to understand the business in detail for this particular stock pick. The key idea is that Stratos is basically a third-tier supplier in the much maligned and highly commodotized optical and electrical components industry. The company´s largest customers are TellLabs and General Dynamics UK.

Why is the downside risk in Stratos low at the  current price?

Despite the negatives surrounding Stratos, which I´ll get to below, here´s what I like about STLW:

• Firstly, and perhaps most importantly, Stratos has recently received an acquisition offer at $7.50 per share. Back
  in June, Stratos received an offer from Steel Partners, one of the
  company´s largest shareholders (15%+) and one of the more successful hedge
  funds in the US, to acquire all the shares of STLW for $7.50 per share.
  This provides at least some basis for estimating a fair value for the
  shares of STLW that is north of the current price. My basic feeling is
  that since Steel is a value investor, it´s likely that the ulimate
  value of STLW is probably alot higher than $7.50 per share. In fact, in
  Steel´s proxy filing they left open the possibility of raising their
  offer for STLW. You can access Steel´s filing, by clicking here. In the filing Steel states:
  "If as a result of our due diligence we find  evidence of  additional  value
  inherent in the Company  based on operating  results or  otherwise,  we would be
  willing to upwardly adjust the offer price to reflect such additional  value. We
  invite the Board to share with us any  documentation  in the Board’s  possession
  which it believes  reflects  additional  value in the shares that it believes is
  not already known to us." Steel is also looking to elect five new board members to STLW at the next proxy meeting.
• The financial condition of STLW is solid.
  STLW has about $30 million in net cash or over 30% of the current market cap. There is no real debt to speak of. The company has some preferred stock on the balance sheet (about $2 million), but I expect that to paid off shortly.
• Stratos is generating cash on an EBITDA and free cash flow basis.
  You can verify this by perusing the company´s last few 10Q´s and by reference to uses of cash as described in the next point. In addition, the company´s cap-ex needs are minimal. This ability to generate cash in this type of environment for the optical component industry is quite remarkable, especially considering the situation at other competitors. The low expense base also provides optimism that the company can generate fairly strong profits should the industry ever turn around on a sustained basis (something, which I admit is quite uncertain).
• Stratos is using excess cash to buy back shares and reduce other liabilities.
  In the last quarter, Stratos purchased $800 thousand dollars worth of shares in the open market for an average price of $7.50. In addition, during the last quarter, STLW eliminated about $3 million in redeemable preferred stock.
• Stratos´s valuation is cheap.
  Last years sales came in at about $80 million. So the company is trading at a reasonable EV/Sales ratio of 0.81X based on last years sales and EV/Sales ratio of 0.9X based on an average of sales over the last three years. A quick glance at other industry competitors (e.g. JDSU, BKHM, OPLK etc.), will reveal ratios ranging from under 1 to well over 2. It´s not entirely clear what ratio STLW deserves on a relative basis, particularly given certain unique aspects of its business, such as its large military contracts. However, I´ve rarely lost money buying stocks trading beneath 1X sales where the business is profitable, the balance sheet is clean, and there are growth opportunities. So an absolute basis the stock seems cheap, at least using this simplistic metric. Importantly, I am not focusing on  free cash-flow measures here, as the company has yet to file its latest 10-K and hence my EBITDA figures are not completely accurate at this time. Nevertheless, the company is generating cash, and the EV/Free Cash Flow figure based on initial estimate is also clearly reasonable, if you assume this is still a company operating in the midst of an industry downturn.

Why might Stratos shares rise in the next year or two?

Since I´m more interested in downside protection than upside potential, I´ll keep this section short. Aside from the obvious fact that STLW´s stock is still trading at a discount to Steel´s offer and there remains the possibility that Steel will raise their offer, I think that STLW´s stock can rise in the next year as FTTP installations gain momentum. STLW has several products that address the FTTP and HDTV growth markets. I encourage you to visit the company´s website to see the products that they offer for these markets. If you would like an introduction to the FTTP opportunity, please click here for an article from Wikipedia. From a financial perspective, it seems possible that with some additional revenue growth, STLW can easily trade at 2X Revenue + Cash. This would yield a potential upside price target of about $190 million or $13.75 per share, or about 100% above the current price.

In sum, Stratos´s strong financial condition, cheap valuation, shareholder-friendly actions, and an acquisition offer at 10% above the current market price of $6.80, provide solid downside protection for investors in the company. At the same time, there is enough potential in new product lines to possibly lead to an upside re-evaluation of the shares at significantly higher price in the next year or two.

What´s NOT to like about Stratos and what are the risks here?

There´s alot not to like about Stratos, and here are two of, what I feel are, the biggest negatives:

• STLW Operates as a Third Tier Player in the Optical Component Industry
  The optical component is highly competitive and seemingly always faces severe pricing pressures. The industry that has been in a downturn for years and the stocks in the sector have been miserable performers over the last five years. For a full account of the bearish argument for the sector, you can click here for an article from Seeking Alpha. What´s my answer to this potential risk? It´s simple. The industry situation is not going to get any worse, so it´s bound to get better at some point. Incidentally, I believe it will get better throughout 2007. In any case, if you time your stock purchases correctly by looking for absolute values in the sector, rather than relative values, I´m not sure the negative aspect of the optical component industry should scare you away. In particular, STLW, despite its small size, appears, at least from a financial perspective, to have weathered the industry storm quite well, and to have positioned itself nicely to profit from any upturn.
• Stratos is dependent on sales to the military/aerospace industry, including U.S. and foreign government entities.
  Approximately 36% of STLW´s sales in fiscal year 2005 came from direct and indirect sales to the military/aerospace industry, which is heavily dependent on sales to U.S. and foreign government entities, either directly through contracts with such entities or indirectly through distributors and to prime contractors or subcontractors who are building systems or subsystems for them. A significant decline in U.S. and foreign government expenditures could have a material adverse effect on STLW´s shares.

The bottom line is that despite these negatives, the shares already reflect these potential risks and the offer on the table from Steel, which is above the current price, should provide investors with the courage to buy the shares in the hope of potential upside, via either a higher offer or improving financial results.

Disclaimer
I,
Yehuda Fruchter, own shares in the stock mentioned in this report. In
addition, this report includes market analysis. All ideas, opinions,
and/or forecasts, expressed or implied herein, are for informational
purposes only and should not be construed as a recommendation to
invest, trade, and/or speculate in the markets or in any particular
stock. Any investments, trades, and/or speculations made in light of
the ideas, opinions, and/or forecasts, expressed or implied herein, are
committed at your own risk, financial or otherwise. Yehuda Fruchter
maintains no legal responsibility to update this report or his holdings
in the stock mentioned in this report.

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Disclaimer:
This site may include market analysis and we may own shares in the stocks mentioned in our reports. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

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