One of the most conservative ways to calculate the value of a company is by using the cash on its balance sheet. After all, a company should be worth at least its net cash; otherwise, someone could make a profit simply by buying the entire company and taking the money. So when a company's stock price starts to approach its net cash per share, I get really interested. If the cash provides a floor on the stock price, then there really is nothing but upside. It becomes a heads-I-win, tails-I-break-even scenario.
One company that is in that position right now is Sycamore Networks (NASDAQ:SCMR).
The company
While you likely connect your computer to the Internet over copper wires -- either the telephone line or a cable modem -- your Internet service provider generally uses optical fiber to send information over long distances. Optical fiber communicates information faster and more accurately. This is where Sycamore comes in. Sycamore's business is selling optical networking equipment to telecom service providers around the world.
Of course, this was a great business to be in back in 2000. The Internet bubble was encouraging existing telecom companies to expand their networks and new companies to enter the market. And every one of these companies was a potential customer for Sycamore. Sycamore took advantage of the excitement, and parlayed a short operating history in a hot niche into a successful IPO and a ridiculously strong balance sheet.
Since that time, things have been bumpy. As good as the bubble was, the party eventually ended -- and took the stream of new customers with it. Back then, Sycamore was in the unfortunate position of trying to sell to existing companies that had already binged on equipment. Sycamore's sales plummeted from $375 million in 2001 to $38 million in 2003. The company has since started to recover. For the first time in years, it should have both positive net income and free cash flow, and its revenue is approaching $100 million.
The competition
Unfortunately, Sycamore is a relatively weak player in a crowded market. It's tiny compared with its competition. Cisco Systems (NASDAQ:CSCO), with its $30 billion in revenue, is the largest competitor. But you also have smaller companies like Alcatel (NYSE:ALA), Ciena (NASDAQ:CIEN), Lucent Technologies (NYSE:LU), and Tellabs (NASDAQ:TLAB) that are still way bigger than Sycamore.
And this is an industry where size matters. Larger companies not only gain manufacturing economies of scale, but they also have much larger research budgets for creating new and better products. Plus, they have established customer relationships and broad product portfolios that can address all their customers' needs.
As if this weren't enough, the communications industry has been consolidating for years, reducing the number of potential customers to whom Sycamore can sell.
Valuation
Despite all of these disadvantages, Sycamore is still intriguing because of the $900 million of cash the company has on its balance sheet. Since this is roughly $3.20 a share, I would expect that this cash would put a floor beneath the shares at about $3.00. And, unlike many other companies trading close to their cash per share, Sycamore is actually cash flow-positive and growing.
Analysts expect the business to earn $0.16 per share next year and to grow those earnings at a rate of 20% per year. Suppose that the company makes only $0.15 of free cash flow per share next year and grows at 17% for the next five years, then 12% for five years, then at 3% in perpetuity. Then, using the Inside Value discounted cash flow calculator (available here, for subscribers), the company's business alone is worth about $2.60 per share. If you were to add in the $3.20 of cash, you'd get a valuation of almost $6. Which makes the stock, currently trading at about $3.75, really cheap.
However, the problem with this argument is that the majority of Sycamore's profits come from interest on its cash hoard. If the company distributed this money to shareholders, the earnings would vanish. So, by adding both the cash and the income generated on that money, I'm really double-counting.
Instead, it's worthwhile to consider how much cash the actual operations of the company generate. If Sycamore were able to make 10% net margins on its revenue, the company would still only be making $0.04 a share in non-interest income. That would give the operations of the business a value of $0.70 a share. Add to that the $3.20 of cash per share, and the shares are worth about $4. In other words, despite Sycamore's having cash almost equal to the share price, the shares are only slightly undervalued.
Risks
Even looking beyond valuation, this stock has warts. The issue that's been getting the most press -- an options pricing scandal -- causes me only mild concern. Although it indicates something about the integrity of the company's management and directors, I don't think it will seriously affect the company's value; it likely won't affect cash, nor the ongoing operations of the business.
Instead, my biggest concern is that this company is at a competitive disadvantage to the bigger players. It's hard to make money in technology if you aren't a gorilla. To add to the uncertainty, Sycamore derives most of its revenue from a handful of big customers. So if it loses one customer, Sycamore's revenue could take a significant hit.
The other major concern, since cash is such a large component of Sycamore's value, is that the company will blow its cash on a stupid acquisition. While it would be good to see the cash deployed in some way that adds value, there are good acquisitions and bad acquisitions, and the latter are uncomfortably frequent.
This is a real risk. IPass (NASDAQ:IPAS), a company that I bought partly based on a huge amount of cash on the balance sheet, spent a third of that cash to acquire GoRemote. This acquisition has done little to improve iPass' declining revenues and has made the stock a less attractive investment. That said, Sycamore isn't iPass. Sycamore's had years make dumb decisions with its cash, and it hasn't blown it yet.
Fool's final word
Though I love to find investment opportunities where there's a limited downside and a large potential upside, Sycamore doesn't make the grade. Sycamore's cash limits the downside, but it's way too difficult to see the upside for the business. So I'll pass. I'd prefer to own a business trading significantly under its fair value, one with a solid competitive position and some growth potential.
These are the sorts of stocks we target at Inside Value. So, if you're looking for stock ideas, you can check it out here with a free pass. That pass will also allow you to use our discounted cash flow calculator, with which you can work out the fair value of any stock.
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Fool contributor Richard Gibbons starts to twitch uncontrollably whenever he sniffs a stock that looks cheap, but really isn't. He still owns iPass but does not have a position any other stocks discussed in this article. The Fool has a disclosure policy.
