A closer look at Ruckus Wireless RKUS

Ruckus (RKUS – $10.37) came public in November of 2012 at $15/share which was the high end of their filing range. The sought-after duo of Goldman Sachs and Morgan Stanley brought the deal. The stock “popped’ to $24/share on general enthusiasm and has steadily declined to the current price since then. [Clients can refer to the Ruckus IPO roadshow slides for more background.]

Ruckus makes WiFi networking technology. Their niche is denser “carrier class” solutions. Much has been made of the “data explosion” and the need for wireless networks to find new ways to cope with it. This has contributed to the adoption of “4G/LTE” networks and increasing acceptance of WiFi as a supplemental networking method for wireless data.

So far the WiFi opportunity has been a very mixed bag for investors. For example Ubiquiti Networks (UBNT) has been a shining stare with the highest revenue growth (65%) and fattest operating margins (30%) in the group. The stock has performed very well – even with the recent 30% pullback it’s still up 80% in the last year. For anyone who may have missed the Ubiquiti IPO back in October 2011 it is worth revisiting. The CEO, Robert Pera, takes an unorthodox approach to running a company by putting all their money into R&D and relying on “communities” to handle much of what other companies spend on SG&A expenses to cover. Their margins speak for themselves and after pricing their IPO at $15 and after over two years are changing hands at $35. [Use these links to access the UBNT IPO Roadshow Slides or the UBNT IPO Roadshow Transcript.]

Another very positive example is Globalstar (GSAT) which is known as a satellite network provider but is in the process of getting a chunk of their spectrum reallocated to terrestrial use. This WiFi like network might be used by Amazon and others to reach consumers directly.

Making money in WiFi isn’t easy. In fact operating profit is basically zero for the group (not including the satellite companies since they are not really WiFi). A few “enterprise WiFi” plays seem to be headed for oblivion including Towersream (TWER), iPass (IPAS) and Meru Networks (MERU). We say “oblivion” partially tongue-in-cheek because some, like Towerstream are “successful” in getting their WiFi offload solution accepted but it appears to be an artistic rather than a capitalistic triumph.

What kind of Ruckus will Google Make?

An announcement that Google (GOOG) was working with Ruckus to provide a kind of “SMB WiFi Service” it attracted our attention and made us wonder if a “carrier grade WiFi technology” might not turn out to be a profitable niche. As defined by Ruckus this type of technology requires very high density (imagine a city or stadium of users), demands much greater interference mitigation, and needs to be integrated with other carrier data networks.

Results so far support the Ruckus stated scalability advantages over major players including Cisco (CSCO) and Ericsson (ERICY). In addition to Google the company announced a partnership with Boingo (WIFI) for WiFi infrastructure. Corporate performance has remained strong in terms of revenue growth, geographic diversity, and high gross margins.

There’s also a precedent for a natural split between carrier-focused and enterprise-focused solutions. Many of us have grown up with the battle between Juniper (JNPR) and Cisco (CSCO) over the last decade. Although the battle lines are blurred today for a long time Juniper had a very clear advantage in meeting carrier needs while Cisco dominated the enterprise. The feature sets and support requirements definitely differ between these two markets.

Details of the Google/Ruckus cooperation are scant it’s fairly clear that the jewel in the crown here is the software that allows a kind of software-defined and managed WiFi deployment that a service provider (like Google) can use to efficiently roll-out and support these distributed networks.

Valuation & Stock Conclusion

Building an intrinsic valuation (IV) model for Ruckus is fairly straightforward since revenue growth and gross margins are well-established and overall operating targets are on a fairly linear path from current levels. Our IV estimate of $15 to $16 is consistent with the current street consensus of $15.42.

That gives us about 50% upside from current levels. We know that business with carriers can be lumpy (both good and bad) but Ruckus has been gaining share in the enterprise market as well on the back of their own efforts and channel partners. A partnership with Google could help continue to drive those share gains.

One “wildcard” in terms of upside is the licensing potential for Ruckus on the software side. It’s not a stated goal but it’s a visible enough opportunity that we think it has at least come up in discussions with players like Google. Two point of additional margin adds about $2/share to our IV estimate so it could be material if the company can achieve it.

As a pure network equipment company, even one gaining share, Ruckus doesn’t get the heart thumping. But some enhanced visibility on how their overall approach and software solution could represent some kind of “CloudOS” for WiFi services might get investors to reconsider their views on this name.

We would quantify the impact of a licensing deal to be $4-5/share based on some expanded margin *and* a bit of multiple expansion. We’re using a 20x multiple now which is consistent with the expected longer-term growth rate.

An Aside on xG Technologies

We’ve been asked from time to time about this little company, xG Technologies (XGTI $2.58), which provides what they call “cognitive radio” technology that enhances the performance of wireless networks over limited spectrum. Everyone wants to squeeze more from less spectrum so on the surface the xG story is attractive. The shares up up 100% recently on the announcement of patents awarded to them.

XGTI is development stage without any real revenues and a $43M market capitalization. The challenge that management admits to struggling with is getting installed and into production with customers that can reference their positive experiences. We’ve put some feelers out to some industry insiders to try and get a useful verdict on whether or not this technology is really important or not. If it is then a little speculation in this tiny company might also be rewarding.

Peer Analysis

We’ve included below our table showing some of the relevant peer companies. Not the biggest like Cisco but many of the similar sized companies. Most investors would consider UBNT, ARUN and HIVE to be the closest ones. We’ve included the satellite companies because recently some, particularly GSAT, have started to be viewed in the same context as WiFi network providers by some.

Disclosure: The SoundView TechFund currently has a small long position in shares of Ruckus Wireless.