CAPS' Weekly Top Stock Idea

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DragonWave profile

Sources: Capital IQ (a division of Standard & Poor's), Yahoo! Finance, and Motley Fool CAPS.

This week's pitch
DragonWave is a maker of wireless equipment used to transmit network traffic between base station endpoints (think cell towers) to the high-capacity fiber optic "backbone" infrastructure that is the core of most wireless networks. DragonWave's products are marketed under the Horizon brand name. The technologies are most applicable to supporting high-speed cellular voice and data traffic, specifically 3G, WiMAX, and LTE ("4G") protocols. DragonWave is based in Ottawa, Canada, and just started trading in the U.S. on the NASDAQ last October -- the offering price was $10.29, well above current trading levels in the low $6's.

This is a high-risk, high-reward Magic Formula stock, so let's first look at the "reward" part of the equation. Backhaul is an important part of wireless networks, and as mobile device traffic continues to grow, it will be imperative for the cell providers to expand the bandwidth and coverage of their networks. Think about streaming Netflix (Nasdaq: NFLX) on your new iPhone 4 and you get an idea of the nearly limitless appetite for data coming down the pike. Currently, the cell networks like AT&T (NYSE: T) and Verizon (NYSE: VZ) have neither the bandwidth nor the speeds that are going to be necessary to support these kinds of traffic demands. Upgrading to higher bandwidth and faster speed protocols like LTE is practically a given.

The backhaul portion of the network involves connecting the endpoints with the main backbone network. DragonWave's products provide wireless, microwave transmission of this data, in Ethernet form, at high capacities. This provides advantages over the traditional fiber landline backhaul option, as fiber is expensive and time-consuming to lay, particularly when building endpoints far from the backbone. DragonWave is in a "sweet spot" as these carriers compete to add customers by boasting the largest and/or fastest and/or most reliable networks. It is much faster (and cheaper) to upgrade and expand networks using a wireless backhaul solution.

These facts make the growth potential for DragonWave's Horizon products significant. The company's primary customer (accounting for >80% of sales) is Clearwire (Nasdaq: CLWR), who is building Sprint Nextel's (NYSE: S) much ballyhooed 4G network in the U.S. Expedited buildup of this network has led to explosive growth for DragonWave. Fiscal 2010 (February) revenues tripled from 2009, and in Q4 alone they grew nearly [fivefold]. Operating income and free cash flow ballooned to nearly $31 million CAD. The balance sheet sports nearly $120 million CAD in cash and no debt, so about half of DragonWave's $250 million market cap is supported by cash on hand. The company also has a strong competitive position, with a leading 35% market share in microwave backhaul equipment.

On top of this, there is a very valid case to be made for continued strong growth. Clearwire is nearing completion of their initial build-out phase, covering 120 million people by the end of August. The ultimate goal is to cover 270 million, but it is unclear when that expansion will take place. If it is soon, and it could be given the intense competition among carriers, DragonWave will benefit huge. Additionally, there have been rumblings of DragonWave winning business to build out Verizon and AT&T's 4G capabilities, although the timing of these potential deals has been disputed. Finally, the company is making a concerted push into international territories to win foreign carrier business. This is a potentially lucrative market given the increased importance of wireless connectivity where there is generally less wired infrastructure than in North America.

So why is the valuation so low, with a trailing earnings yield over 25%? There are concerns, obviously. If Clearwire/Sprint defers further build-out of their 4G network, sales here would certainly plummet. There have also been rumblings that Clearwire is looking to diversify their suppliers, potentially shifting some business to DragonWave's competitors (notably Ceragon (Nasdaq: CRNT)). These concerns were solidified by weak Q1 revenue guidance of $50 million, whereas previous expectations had pointed to a figure near $60 million. Certainly, the 80%+ coming from one customer is the major, major risk here.

Concentration and competitive concerns considered, MagicDiligence believes that the current dirt-cheap valuation mitigates a lot of the concerns and underestimates the potential upside here. This is a very long-term growth market with a clear trajectory -- it is very close to guaranteed that mobile Internet demand will grow at a brisk pace for a long time. DragonWave as strong market share and a solid product and stands to benefit. An exciting [magic formula investing] purchase opportunity that may be considered as a future Top Buy candidate.

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Pitches must be compelling, made in the past 30 days, and be at least 400 words.