CanaccordLowering Target Price
Balance sheet still under strain
Investment recommendation
Spectra7 closed a challenging 2018 with modest sequential improvement in Q4.
The company continues to report strong demand and industry acceptance of its DCI
solution which gives us confidence in product market fit. Management noted a record
backlog and expected DCI deployments to a major Chinese datacenter operator, which
we estimate will generate meaningful revenues in the APAC market. Timing of DCI
deployments are slated for H2/19 after delays; the company needs to navigate H1/19
without DCI revenue which likely extends the cash burn.
We remain SELL rated principally due to liquidity concerns as the company bridges the
gap to H2/19. Aggressive working capital management has afforded some breathing
room; however, a Dec 2018 closing cash balance of $0.9M and an estimated $(2.0)M
quarterly cash burn suggest an immediate need for financing. We will become more
constructive on the name should the company successfully raise capital to fund
operations, whether through a dilutive equity raise or ideally a strategic option. With an
unchanged WACC of 19.6% and reduced estimates following Q4 weakness, we remain
SELL rated with a DCF-based price target of C$0.09 (from C$0.12) which implies 1.7x
2019E EV/Sales.
Investment highlights
• Estimates revised - We have pulled down our revenue estimates for 2019/2020
to reflect a pushout in the DCI ramp. We model revenue of $13.0M/$32.2M (from
$17.9M/$37.2M), respectively. We model GM% margins of 55.9%/59.7% (from
56.9%/60.4%) for the two periods, to reflect a prolonged mix shift to the more
profitable DCI segment.
• Liquidity concerns top of mind - Spectra7 ended 2018 with $0.9M of cash on the
balance sheet. This benefited from consecutive private raises of net US$2.2M and
US$3.5M in H2/18. While the DCI opportunity remains on the horizon, our analysis
depends on the company’s ability to successfully continue to raise capital.
• Strategic options for financing - Excluding additional dilutive equity raises,
management has suggested that strategic alternatives exist which would not affect
the cap structure. Management indicated it is currently evaluating a loan based on its
patent portfolio. The closing of a sizeable loan on favourable terms would be a positive
catalyst for the stock. Alternatively, we believe options include a strategic investment
from downstream partners or the sale of non-core patents.
• DCI ramp to show meaningful growth in H2/19 - The company has announced
collaborative product demos in 2019 with Foxconn, Luxshare, and other major
interconnect solutions suppliers. In addition, Spectra7 has been selected by a major
Chinese datacenter operator, providing incremental confidence in the H2/19 timing.
Valuation
We rate Spectra7 a SELL with a price target of C$0.09 (from C$0.12). Our DCF analysis
remains unchanged (WACC 19.6%, TGR 2.0%) and reflects ongoing liquidity risk in the
business. The valuation implies a multiple of 1.7x 2019E EV/Sales. SEV trades at 1.9x
2019E EV/Sales versus peers at 3.7x.
Balance sheet still under strain
Strategic alternatives to raise capital. The company announced that it is exploring
various capital raise options, including a loan based on its patent portfolio. We have
modelled an asset backed loan in 2019 alongside a single equity raise to provide
working capital support through the year. The announcement of a sizeable debt
arrangement ($10M+) would provide much needed breathing room without diluting
the company’s equity.
We applaud Spectra7 management for controlling its costs and stretching its
payables. In Q4/18, the company lowered expenses again. Looking into Q1/19, we
expect the company to see a higher level of marketing costs related to DesignCon and
OFC and costs in support of the company’s planned production ramp for H2/19.
Following two private placements in quick succession in H2/18, we believe the
company will require further financing as soon as Q2/19.
Q4 recap. The VR/MR market has not improved in 2018, while the company’s DCI
ramp remains in its initial stages. Specific financial metrics, variance from the prior
year, and CG estimates are included in the figure below. The company reported Q4
sales of $1.4M, behind our estimate of $2.6M. The company posted an adj. EBITDA
loss of $(1.7)M, broadly in line with our estimate. This benefited from a controlled cost
profile which is expected to continue into 2019.
DCI ramp gaining traction in APAC region. Spectra7 has announced partnerships with
four top global DCI suppliers, and expects an H2/19 deployment with a major Chinese
datacenter operator. Despite the positive announcements, however, the ramp has
been pushed out beyond our original expectations which leaves a gap in the balance
sheet and reaffirms the liquidity concerns we raised when originally downgrading
Spectra7. A steeper-than-expected ramp in DCI sales, VR/MR recovery or a strategic
financing would make us more positive on the stock.
VR/MR market appears to be improving. We have seen a marked increase in activity
at CES and MWC, particularly in AR, and Spectra7 has announced wins. Spectra7
reported 44% growth in H2 over H1 although lower margins have been a headwind.
This has been driven by a mix of lower margin product destined for low end VR
headsets. Limited end user adoption in NA and Asian markets have been driven by a
lack of content and expensive retail price points; management anticipates a pickup in
volumes in 2019, albeit backend weighted. On the other hand, we have also seen
continued development of wireless solutions which disrupt Spectra’s tether solutions.
Estimate revisions. We have updated our model to reflect Q4/18 results and
management’s outlook for the DCI segment. We have reduced our sales estimate for
Q1/18E to reflect continued challenges in the core business and a delayed ramp in
the DCI segment. We have reduced revenue and gross margins in 2019E to reflect a
prolonged DCI ramp, the higher margin segment. We continue to model sub-60%
margins for 2019E/2020E but management has indicated that ~60% will be the
longer-term goal for the business.