Sangoma Technologies (STC.V, $.295) is a provider of hardware and software solutions to the rapidly growing Voice-over-Internet Protocol (VoIP) industry. The company is a tale of two businesses – growth in new products has masked the inevitable decline of their legacy business. Despite management’s progress in saving the business, shares remain dirt-cheap, trading at a 5% discount to net-net working capital and under 7X depressed earnings levels.
Founded in 1984, Sangoma built up its legacy business as a manufacturer for hardware and software that enabled computers to communicate with telephony networks and other Wide Area Networks (WAN). In short, this meant connecting a PC to the Public Switched Telephone Network (PSTN – legacy global telephone network) or a Private Branch Exchange (PBX – enterprise telephone system). The company developed a reputation as a market leader behind Digium, creator of Asterisk, the original open source software that became the standard for these telephony applications.
Sangoma’s legacy business was a good place to be. Gross margins were over 70% and business boomed in the early 2000’s.
In 2008, a shift in Voice over Internet Protocol (VoIP) methodology from PSTN-based to internet-based was underway. Technology to support voice transmission over the internet had evolved and enterprises jumped at the opportunity to reduce costs by running voice/data communications on a single network. Despite the warning signs, previous management stood idly and milked the PSTN business just as competitors started fleeing the market.
New management was brought on in 2011 and saw two choices for Sangoma: innovate or die. Fortunately, they chose the former and launched an accelerated product development program that pushed new product introductions from 3 per year to 10. Now after burning through half their cash reserves, Sangoma has a full product line of session border controllers, VoIP Gateways, and innovative Microsoft Lync products for small business.
In layman’s terms, these products ensure security and interoperability between various enterprise communication systems (fax, voicemail, SMS, etc.). The trend, dubbed Unified Communications (UC), has grown in complexity as companies now want all communications delivered via any means to any device.
Sangoma is a small fish in a big pond but industry trends are on their side.According to Infonetics research, the VoIP/UC market grew 8% last year to $68B and is projected to grow 6% over the next five years. The main driver cited is “SIP-trunking” (50+% growth), which is the key technology standard Sangoma’s products address.
Sangoma’s picture is neatly painted in the financials:
Note: R&D expense was not broken out until 2011
The years 2005-2009 were heady times for Sangoma. They had strong brand recognition and didn’t need to ramp marketing spend. R&D spend was kept modest because competitors were leaving the market. The result was big profits, topping out at $4.6M in EBIT and $2.5M in FCF in 2008.
With new management’s strategy came soaring R&D and marketing expense to build out new product lines. These investments appear successful as profitability was maintained and the revenue decline reversed. But the consolidated financials don’t tell the whole story. Here’s the breakdown of new product and legacy sales over the last few years:
Note: This breakdown is not disclosed in details and these figures are my estimates based on management’s comments in the conference calls
We can now see management grew the new business from nothing in 2011 to a nearly $7M run-rate today. As tough as 2013 was for Sangoma, it would have been a disaster without new products to offset a 30% dip in legacy sales.
Whether we’re looking at assets or earnings, Sangoma appears quite cheap:
The market is valuing Sangoma at a discount to NNWC and less than 7X EBIT. The EBIT multiple doesn’t look unduly low but remember the company has spent heavily to build out new products and sales channels. Profitability may never reach 2008 levels, but I think we could easily see $2M in a couple years.
And what happens if they fall short of achieving scale in the new business? Well then I think a competitor come in and sees a full product suite and high-margin revenues available for 40 cents on the dollar. A strategic acquirer could easily combine sales forces and merge R&D to lower the purchase price – taking just 10% out of Sangoma’s OPEX would effectively double EBIT.
From this angle, I’d argue for a valuation at 1X revenues + excess cash. This would put shares at $.55 on a FD basis, leaving 85% upside.
Even this valuation would be at the absolute low end of their industry. Direct comps include AudioCodes (AUDC) at 1.1X revenues/26X EBITDA and Acme Packet, acquired by Oracle in early 2013 for 6.2X revenues. Less direct comps include 8×8 (EGHT) and Shortel (SHOR), both of which are viewed as premier plays on VoIP/UC trends and command high valuations (2-5X sales, 40-50X EBITDA).
The biggest concern I have with this investment is technological obsolescence. A shift in technology already threatened their existence and another shift could happen any time. Their products are also not simple to understand and I doubt I’d be able to keep up with shifting trends in the industry.
Sangoma arrived late to the VoIP/UC party and faces the challenge of making inroads on competitors with far higher engineering/marketing budgets. Results will be lumpy as they sell to larger OEM customers and I believe the longer sales cycles will be a drain on their resources.
Insiders collectively own 20% of the company, with Chairman David Mandelstam having the largest stake at 18.5%. Current CEO Bill Wignall and CFO David Moore both came from Truition in late 2011 and have led the effort to revitalize Sangoma’s business.
I’ll credit current management with transparency. They go to great lengths on conference calls to detail their strategy and address the company’s challenges. Management ownership is not as high as I usually like to see, but they have acted like owners thus far, returning the business to growth and buying back shares at depressed prices.
I like the risk/reward scenario with Sangoma. As I see it, either management will be successful in scaling the new business or a competitor will come in and seize the opportunity. And in the worst case, Sangoma’s rock-solid balance sheet should provide downside protection if business falls off a cliff again.
Personally, I don’t have much cash available for new ideas so I’ll be on the sidelines for the time being. I’ll be closely watching the company’s progress in stabilizing their legacy business and growing new product sales.
Disclosure: No position