Earnings Perspective: Sycamore Networks – Market’s Reaction Seems Backwards

On Wednesday, September 5, 2007, before the opening bell, Sycamore Networks (NASDAQ: SCMR) reported their financial results for the 4th Quarter and Fiscal Year Ended 2007 financial results. The markets were not pleased with the results and it sent SCMR down nearly 8% to close at $3.73. SCMR also missed analyst expectations. The markets were expecting $0.03 EPS for Q4 2007 and $46M in revenue for the same period. SCMR came in at $0.02 EPS and $38M of revenue, respectively. To seemingly make matters worse, SCMR’s Vice President of Finance and Administration stepped down. Sounds like things are falling apart at the Chelmsford, MA based manufacturer of networking hardware and equipment.

Certainly, it could be the case and SCMR could be falling apart and is dead in the water, but I want to point out some observations which suggest to me, that at the very least, SCMR is not going away.

First, since it is a short issue, as for missing analyst expectations, well, really, there is only one analyst – so, what do you expect? While it is no fun to show-off a missed quarter, one estimate – the miss does not carry a great deal of weight.

Regarding the department of the company’s finance chief, the negativity surrounding this event appears to be exaggerated. Certainly, the CFO leaving can easily be interpreted as a red flag, but it certainly does not appear that Mr. Gaynor left on bad terms. Per the conference call, Mr. Gaynor will remain with SCMR for the remainder of the month before pursuing another employment opportunity. He was not fired and it certainly seems that he did not smell a rat, as if he did, he likely would not hang around for the rest of the month. As a shareholder, you never like to see any member of your key management leave, often times, it is just the natural course of things. SCMR should be able to find a competent replacement. The headlines reading “CFO Steps Down” or “Resigns” are technically true, but imply that there is some form of accounting scandal about to come out. This can happen, as anything is possible, but per the nature of his departure, at worst, it is a neutral event.

A big element that has attracted much attention to SCMR over the past few months has been their enormous cash and cash equivalents stash, which grew to $925M from the $904M since the close of Q3 2007. This nearly $1 billion balance translates into about $3.27/share of cash, or about 88% of SCMR’s market value per their September 5, 2007 closing price. SCMR has no debt, either. Although not the ideal way to do it, SCMR continues to produce positive cash (albeit, the huge interest income makes that possible) and this provides a certain baseline to the stock price, which it seems we are close to it at these levels.

A big knock on SCMR has been their inability to produce positive cash flow from operations. Q4 2007 was no exception with a non-GAAP loss from operations of about $5.3M and an operating loss of $19.3M for FYE 2007. Again, the interest on the cash hoard has enabled SCMR to show non-GAAP income from operations. There is little discussion of the revenue growth SCMR has demonstrated the past 12 months. Granted, and SCMR blatantly acknowledges such, that the revenue growth is a result of an acquisition completed in Q1 2007. The growth is not staggering by any means, but showed 133% increase in revenue in Q4 2007 vs. Q4 2007 and 79% revenue growth when you compare the same two periods to each other. This trend, per SCMR’s numbers, appears to be sustainable and the conference call suggests the revenue growth will continue. So, here we have SCMR – showing strong revenue growth and not burning through cash to do so. That is no small accomplishment and does appear to have been ignored by the rest of the world at this stage. Consider an extreme example in XM Satellite Radio which has seen huge revenue growth, but has yet to show an operational profit. However, since they are growing – it is ok to take on debt and post operating losses. SCMR may be being a little too conservative, but imagine being able to have triple digit revenue growth, post very natural (and often widely expected) operational losses for showing revenue growth, and be able to add cash to your bank account – all without taking out loans or debt.

Another noteworthy item, which is not a big secret, is that only a few months ago, SCMR finally cleared up their stock-option backdating situation. SCMR announced that there would be some additional GSA and restructuring charges associated with the completion of the investigation and some subsequent housekeeping. SCMR clearly warned that Q4 2007 would include some additional expenses related to some of these activities. Starting fresh in Q1 2008, the GAAP financial implications of the past should, well, be a thing of the past.

Now, in the words of Yogi Berra, when you come to a fork in the road, you have to take it. That is where SCMR is at now. The healthy balance sheet and revenue growth are very attractive as is SCMR’s exposure to providing equipment to the cable companies and MSOs to service the flexible bandwidth needs of the high speed Internet and digital phone services. However, as everyone knows, SCMR has been unable to show any form of operating profit the past several years. The pieces are in place for SCMR to turn the corner and should they show an operating profit, which I believe they will in Q2 or Q3 2008 (or perhaps Q1 2008), the company’s stock price should respond very positively and very quickly.

Now obviously, SCMR needs to perform and unfortunately, some of the executive’s answers during the conference call were somewhat vague and perhaps indicate a disinterest or mild incompetence to really make this thing go.

However, even if the above is the case, SCMR is now trading where it was when it was showing less revenue growth, had less cash in the bank, and was mired in non-compliance and options back-dating issues. It would suggest that the pieces (cash, revenue growth, industry with demand) are in place for SCMR to be a potential 2x-5x bagger over the next 12-24 months. Now, granted, that may not happen and it absolutely is a gamble – but what’s the downside? Considering you are basically buying the stock at a slight premium to book value (with over 90% of that book value being in greenbacks), this looks like a win or no-lose scenario. I used today’s dip to increase my holdings by 17%.