Riding the Coattails of an Activist Investor in CAPS, A New Type of Special Situation Trade
Last week I briefly mentioned that I went long a company called Aviant Network (AVNW) in CAPS in an attempt to ride the coattails of an activist investor on what appears to be a cheap company. Following in the footsteps of an activist investor is a somewhat new investing strategy for me, but it is a type of "Special Situation" that I am trying to become more familiar with. What better place to experiment with new investing strategies than CAPS?
I just noticed that Aviant was featured as the main story in the "13D Monitor" section of this week's Barron's.
Fist a little background on AVNW. Aviat Networks engages in the design, manufacture, and sale of a range of wireless networking products, solutions, and services. This small company, with a market cap of only $220 million, was absolutely crushed by Mr. Market over the past six months...falling from $8/share all the way to its current $3.91.
Enter a hedge fund named Ramius. While I follow the trades of a number of funds, I am not personally familiar with this one. Apparently, Ramius is one of the United States' largest hedge fund managers. It merged with with a small investment banks called Cowen Group in June of last year.
Ramius recently revealed that it has a 6.2% stake in AVNW and sent the following open letter to the Company's Chairman and CEO: Ramius Reports 6.2% Ownership in Aviat Networks, Inc..
As the press release states, Ramius believes that Aviant is significantly undervalued and it offers several suggestions to the company on how to improve its operating performance. In short, Ramius thinks that AVNT should circle the wagons so to speak by dramatically cutting back on its expenses and expansion initiatives and instead focus on the things that it does best.
Aviant certainly is cheap. The Compay has net current assets of $3.35 per share. When one adds its long-term assets in, that figure rises to a tangible book value of $4.37 per share. AVNT is currently only trading at $3.90.
As I mentioned, I am not personally very familiar with Ramius, so the logical question arises...how successful has this fund been at squeezing value out of companies in activist situations in the past? According to the Barron's piece, in the recent past Ramius has filed five 13Ds with similar strategies to its suggestions to the ones that it has given to Aviant. In those five instances, the stocks of these companies has risen 16.5% versus a loss of 12.3% for the S&P 500 over the same time period. That's an outperformance of 28.8%. A similar rise in Ramius' latest 13D filing would would cause AVNT to rise to $4.75/share in a flat market (its average purchase price is $3.69/share). That's some nice CAPS points.
Below are several key excerpts from the letter that Ramius sent to Aviant:
At the current time, the public market is attributing almost no value for the operating business at Aviat. As depicted in the table below, the Company ended the last quarter with approximately $390 million of current assets including assets such as cash and cash equivalents, accounts receivables, and inventory. After subtracting the total liabilities of the Company from this amount, the Company is left with nearly $200 million of net current assets, or $3.35 per share. We believe this methodology provides for a fair assessment of the potential liquidation value of the Company's balance sheet. The current stock price of $3.46 represents a mere 3.3% premium to this value clearly indicating that the public market is attributing essentially no value for the Company's operating business. This analysis does not even take into account the value of Aviat's long-term assets of $61 million, or $1.02 per share, which, when added to net current assets of $3.35 per share, equates to tangible book value of $4.37 per share...
We believe the current market price reflects a lack of confidence in the business strategy at Aviat. Over the past two years since FY 2008, revenues have declined by over $200 million. Yet, as shown in the table below, operating expenses have actually increased over the period by approximately $3 million. This has resulted in nearly a 70% decline in Adjusted EBITDA in just the past two years.
Aviat has taken little action, to date, to adjust the cost structure in-line with current business prospects. In fact, the Company has publicly stated that the current cost structure is designed to achieve a target operating margin of 10% only if quarterly revenues reach $150 million. For each of the past three quarters, revenues have been approximately $120 million and revenue guidance for 4Q 2010 is in a range of $120 million to $130 million.
Based on our research and analysis, we believe a significant opportunity exists to adjust the cost structure of Aviat to achieve acceptable operating margins even at the current revenue run rate. This can be achieved by re-focusing the Company on its core wireless backhaul and private network businesses and de-emphasizing growth investments in non-core product lines such as WiMAX. Our estimates indicate that the Company is currently spending between $15 million and $20 million per year on the WiMAX initiative. To date, the Company has recognized negligible revenues from this business making it a substantial drain on Company resources.
Additionally, the Company has made substantial investments in sales and marketing and research and development to drive penetration into new geographic markets. We believe the Company should focus its resources on markets where it has substantial penetration, a large installed base, and a stable pricing environment. In other non-core markets the Company should look for opportunities to utilize distribution partners or exit.
Even if you assume that the Company can only reach 50% to 75% of its target operating margin of 10% due to lower revenue levels and less absorption of overhead costs, the results still imply that Aviat is significantly undervalued. As demonstrated in the table below, at an annualized revenue run rate of $120 million per quarter and a 5.0% to 7.5% operating margin, Aviat would be trading at an Enterprise Value / EBITDA multiple of between 1.3x and 1.6x. The two closest public competitors, Ceragon Networks Ltd. (CRNT) and DragonWave Inc. (DRWI), currently trade at Enterprise Value / forward EBITDA multiples of 6.5x and 3.5x, respectively.