FTE Networks (FTNW) shares are under pressure. This is a buying opportunity.
What’s creating this opportunity? It’s a combination of fear and misplaced concerns. The fear in the market revolves around a declining share price coupled with a late 10-K. Add to this, uncertainty around the numbers that have been reported and it becomes a total buyers market; i.e., there are only sellers around.
It’s certainly not uncommon for investors to hold off on purchasing shares when a K is delayed. This is a red flag that is best not ignored, and the delay in filing their K is certainly overhanging FTNW; especially since EBITDA appeared to be weak in Q4. Throw in the fact that anytime a stock is down, weaker shareholders get rattled, and you have a fear index reading approaching the boiling point for FTE.
The concern about the late 10-K is completely understandable…and 100% misplaced in my opinion. As I said, red flags are best not ignored, but that doesn’t mean you panic every time you see a red flag. Instead, investors should do their homework and try to understand the cause of the red flag warning. And, if it’s justifiable, instead of a panicked sell, you may find yourself with a unique buying opportunity. In my opinion, that’s what’s happening here with FTE.
In an effort to address the doubts in the market, I’ve had multiple conversations with management of FTE. During these calls they not only allayed any concerns but spoke very confidently about the future. Below I’ll discuss what I believe are the key questions from investors and what the Company said in response to those questions.
Realize, please, that I’m paraphrasing the Company, along with adding my own thoughts and opinions. So, these responses are not direct quotes from FTE Networks, rather my understanding of the situation.
Why is the 10-K delayed?
The not-surprising answer is this all relates to the acquisition of Benchmark, which closed during 2017. To put it simply, little FTE swallowed a whale, buying a company more than 10X bigger in terms of revenues.
But it gets trickier than a simple acquisition. Benchmark, prior to the deal closing was an S-Corp., which they acquired through an asset purchase. However, they claimed a 338 tax exemption on the asset purchase. If you’re a tax specialist, this all makes sense. For the average person, the tax accounting here is a nightmare. Regardless, it has taken a lot of time to sort this transaction out from a tax standpoint.
My understanding is the K is essentially done…actually, it has been pretty much good to go for a while. The “issue” revolves around tax provisions and we’re talking specialized accounting professionals coming in and working on wrapping this up.
My opinion here, it makes sense that the K is delayed. Having worked with auditors before, I know they push smaller companies aside until the end of the window. Delays by an auditor are very common without major hurdles like a large acquisition. This is totally understandable and, more importantly, my conversations with the Company left little to no doubt in my mind that this “issue” will be laid to rest very soon.
Why was the 4th quarter EBITDA weak?
FTE put up a huge revenue number in Q4, at $110M. Blows away my estimates, yet EBITDA was down from $11.6M in Q3 to $3.5M in Q4. What’s up with that?
First off, dig into the numbers a little. Gross margin dropped from 19.6% in Q3 to 13.4% in Q4. So, that basically takes about a million, eight hundred thousand off of EBITDA right out of the gate.
The reason behind the dramatic change in GM revolves around the timing of Benchmark contracts. Which also accounts for a large jump in revenues. Several projects ending, or beginning, can really cause the numbers to leap around, which is why the Company reported 6 month numbers. They want investors to look at the longer term trends, not quarter by quarter (at least until they start getting more recurring CrossLayer revenues).
So, EBITDA was already going to be a little lower. But, now you’ve got a situation where there were substantial expenses and one-time charges related to the closing of the Benchmark acquisition. How big were these expenses? There were around $10M in one-time expenses during the quarter. Let’s list a few of them.
- Legal fees
- Accounting/auditing expenses
- Tax related work
- Due diligence expenses
- Year-end employee expenses
I’m sure there were more. These were one-time, non-recurring (except annual bonuses) expenses and they ate up EBITDA rapidly in the Q.
On a side note, someone might ask (I certainly did) why these expenses weren’t amortized over several quarters? They could have been. However, by the time Q4 came along, it would have required restating prior quarters, so they elected to take a hit on Q4 numbers. This is another reason they presented 6 month numbers, not just Q4, this week. Would I have preferred they amortize? Sure. Do I care that they aren’t worried about massaging numbers, but are more focused on the big picture and driving this business? Much more important to me, so I’m over the charges being levied all at once.
The bottom line here is that Q4 was a super strong quarter from a revenue perspective. Not as much fell to the bottom line as we’d have liked to see, but I fully expect that trend to reverse itself. The numbers were just fine.
Who is selling? Where is the supply coming from?
I thought I’d throw this question in the mix since I’m scratching my head to figure out where all the supply is being generated. The investors I talk to are asking questions, but not selling. It turns out the Company is basically on the same page as me…the holders they speak with aren’t selling a share.
The best guesstimate here is that the selling is coming from holders who purchased on the most recent financing in the fall of 2015. These investors are in around $10 and, with the stock spiking to $25, it makes perfect sense they would be coming out of stock.
Bottom line…Expect to see a big bottom line in 2018.
I’m of the opinion that FTNW is a bargain stock. The revenues they put up in Q4 were huge and, along with the new contracts they are signing, demonstrate a strong trend towards adoption of CrossLayer.
We are on the cusp of them going from zero in CrossLayer revenue to a run rate of over $30M at year end. This is recurring, high margin business and the growth rate will remain impressive for the next few years. FTE is going to start throwing off cash this year and it will only generate more going forward.
Meanwhile, the Company is back to trading at a market cap less than 2X EBITDA for 2018. The K is coming. When it does, the Company will have a call and all investor questions will be answered. Meanwhile, there is selling taking place from investors who are panicking. This is an opportunity for those of us willing to do the work necessary to gain the confidence that everything is okay and that the big picture is more intact than ever before.
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