Spectra7 reported Q2/17 results that contained few surprises as the company pre-released its key financial metrics for the quarter. Revenue was in line while higher gross margin and lower operating expenses resulted in an adjusted EBITDA loss that was better than consensus. The company highlighted that it secured three Tier-1 mixed reality (MR) design wins subsequent to the quarter for a total of eight new Tier-1 wins in 2017 YTD. The press release indicated that the new designs are expected to ramp into production throughout Q3/17E with significant revenue contribution expected for Q4/17E. This provides us with greater confidence on our outlook which forecasts an acceleration of top-line growth in the second half. The stock has been under pressure over the past month despite consistent top-line growth, lower operating costs and operational momentum over the past three quarters. We view the current dip as a buying opportunity for investors and remain SPECULATIVE BUY rated with a C$0.75 target price.
Investment highlights - Solid Q2/17 financials support our outlook. Revenue of $3.1 million was in line with our estimate and consensus while gross margin of 62.8% was ahead of our forecasted 59.6%. Higher margins and a sequential decline in operating expenses resulted in a +24% improvement in the company's operating loss QoQ, which was nearly $0.5 million ahead of our forecast. We believe that another quarter of sequential revenue growth and stable operating expenses supports our outlook which expects improved operating leverage as revenue growth accelerates in H2/17E.
- Multiple catalysts in H2/17E. Spectra7 has displayed operational momentum throughout H1/17 which could materialize into multiple catalysts for the stock in the second half. This includes (1) a production ramp-up for new Tier-1 virtual/augmented/mixed reality (VR/AR/MR) clients ahead of the 2017 holiday season, (2) wider consumer adoption of VR/AR/MR hardware, (3) the potential sale of non-core patents as a source of non-dilutive financing and (4) greater visibility on the timing of data centre revenue as we approach H1/18E.
- Balance sheet improves operational flexibility. The company finished Q2/17 with $3.8 million of cash on the balance sheet and we estimate the current cash balance is roughly $4.5 million when accounting for the July close of its C$1.4 million private placement. Under our current forecast, which doesn't include the sale of non-core patents, we estimate this level of cash will support the company over the next 4-5 quarters.
Valuation We rate Spectra7 a SPECULATIVE BUY with a 12-month price target of C$0.75 based on our DCF analysis (WACC 14.0%, TGR 2%), which implies a valuation of 3.0x 2019E EV/Sales and acknowledges the operational risks of entering the data centre vertical and the potential for future dilutive financing. The company currently trades at 1.3x 2019E EV/Sales versus peers at 3.4x and the stock has pulled back nearly 15% over the past month while the company has displayed strong operational progress. We view this valuation as an attractive entry point for investors when considering the company's positioning in high growth niche markets and the potential for an acceleration of top-line growth in H2/17E.