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Play the telecommunications glut with this highly profitable Israeli tech stock
by James Passin
DSL... Satellite... Third Generation Cellular... Hybrid Fiber-Coaxial Cable Modem Systems... Packet-Switched Fiberoptics Networks... Digital Circuit Switched Networks... ATM... Internet Telephony... Blah, blah, blah...
It's almost impossible to stay on top of the latest telecommunications jargon. Standards appear and disappear faster than DOJ investigations of Clinton. The late Internet Bubble has funded the fastest build-up of telecommunications assets in the history of the world.
While this massive global investment in data and voice transmission infrastructure will ultimately lower phone bills and improve the Internet experience, the frantic pace of the rollout has created crushing inefficiencies as incompatible technologies and standards are wired together. Endless venture capital and public capital has supplied the bricks and slime for a post-modern Tower of Babel.
The rapid proliferation of myriad telecom networks has created the need for solutions to speed up network performance and optimize network interaction. While "network optimization" may not be the sexiest-sounding investment theme, it's a solid business opportunity for niche technology companies. Whatever happens to Internet hysteria in the short-term, the bull market in cleaning up telecommunication assets will remain intact for the foreseeable future.
 One of the few pure plays on network optimization is ECtel (ECTX:NASDAQ). I have followed ECtel since I met with the CFO in early 2000. In my opinion, ECtel represents one of the only exciting opportunities left in Israeli high tech (other than ELBTF and ELRNF). Unlike most "New Era" tech deals, ECtel actually generates profits. At 27x estimated 2001 earnings, ECtel is attractively valued against a 5-year estimated growth rate of 40%. ECtel's low US$300 million market cap represents a 70% discount from the sector average. I love the stock: ECtel represents a significant holding in my fund. As a pure play on telecommunications network optimization, I rate ECTX as a Strong Buy with a twelve- to eighteen-month target of US$40.
Tower of Babble
Bears argue that there is overcapacity in the telecom space. Too much capital chasing diminishing returns... Over-investment in fashionable "Internet infrastructure" projects has created excessive competition, leading to a downward spiral of profits and capex... From the point of view of the bears, speculating in telecommunications technology today is like buying semiconductor manufacturers in 1996 or railway shares in 1845.
I don't accept the blanket views of the bears. First of all, the majority of Internet users don't have high speed Internet connections (I just got a Toshiba cable modem at home from Time Warner and it has changed my life.) Secondly, the widespread proliferation of high speed Internet connections will lead to what Christian DeHaemer calls "the Digital Media tsunami:" the next generation of multi-media, streaming audio/visual websites. This quantum evolution in the Internet will not only build traffic, but also require exponential expansion of server and wholesale data capacity. Third, most if not all voice traffic will be converted to data traffic. And finally: TV, radio, Internet, and telephony will converge into a seamless communications medium.
Don't get me wrong. I'm not buying the hype and loading up on dot-com paper or even overvalued juggernauts like Cisco. But there is clearly room for growth in telecommunications capex. The key is avoiding commoditized or excessively promoted industries (semiconductors, CLECs, etc.). In this environment, ECtel represents an excellent conservative bet.
Even if the telecom bears are right, even if telecommunications technology spending spirals downward, the Tower of Babel hypothesis supports continued growth in network optimization solutions. If the big telecoms scale back investments in fancy new networks, they will most likely spend their remaining budget on improving the performance and interoperability of their existing assets.
Blue-blooded Israeli
ECtel was spun off from parent company ECI Telecom (ECIL:NASDAQ) in October 1999. ECIL owns 78% of ECtel. ECIL is a world class player in high speed telecommunications systems, with over US$1.1 billion in sales. ECIL's product portfolio includes end-to-end digital networks, from DSL and fixed wireless to DWDM and SONET.
With a massive sales and distribution force, as well as outstanding technology, ECIL represents a direct competitive threat to players like CSCO and Lucent (given ECIL's low US$2.8 billion market cap, I wouldn't be surprised to see a tender for the company). While ECIL's top and bottom line growth was sluggish in 1999, the company is positioned to enjoy explosive and sustained growth from the Internet convergence revolution. (For the purposes of disclosure: I myself believe in this company so much that I hold a position in ECIL).
ECtel inherited ECIL's massive customer base. And ECtel still benefits from ECIL's sales/distribution channels. ECIL has a majority control of ECtel's board of directors. I believe that Ectel benefits from ECIL's management experience, avoiding the crazed delinquency of many VC-bred orphans.
Given ECIL's strategic relationship with ECtel and solvent financial position, I expect that ECIL will hang on to its ECtel shares until the stock reaches a significantly higher trading range. This will keep the supply of stock restricted. Since ECtel generates cash from its operations, it won't need to sell additional shares to stay afloat (aside from, potentially, any new shares used to make acquisitions). Given ECtel's tight 3.3 million share float and the absence of new supply, it won't take much institutional interest to drive ECtel back to its 52-week high of $41.25.
Quality of Service
I wrote about Quality of Service (QOS) in my analysis of ELBTF in the May 2000 issue of Taipan. I continue to believe that QOS will become a "hot" investment theme. The total QOS market is currently estimated to be over US$300 million — and is growing over 30% per annum. Cisco's (CSCO:NASDAQ) recent purchase of ELBTF's Hynex subsidiary for US$127 million in cash and stock supports my bullish views on QOS.
ECtel's QOS platform allows customers to comprehensively monitor the performance of their networks in real time. QualiView is a non-intrusive measuring solution that monitors data traffic and provides real time reports. Quali.net is an intrusive measuring solution that can test the performance of specific circuits. ViewPoint is a software add-on to QualiView that allows multiple users to view network performance in remote locations. QualiWeb is essentially an Internet version of ViewPoint.
ECtel's complete, broad, complementary product line will ensure the company's participation in the coming boom in QOS. As voice-over-IP networks are built up, demand for QOS products like QualiView and Quali.Net will explode. (VOIP chops up voice into discreet data packets and reassembles them on the other side, creating technical difficulties that require constant network performance monitoring).
Milking the cash cows
"Interconnect billing" may sound as thrilling as a trip to a 16th-century dentist, but it's an exploding market. The blitzkrieg expansion of competing telecommunications networks has made it difficult for telecom providers to accurately charge each other for trans-network data transmission. However, this is a key component to telecom profits (and losses). SS7Counter is ECtel's interconnect billing solution, a product that is fully consistent with my Tower of Babel hypothesis.
The real growth engine
If you've ever fought with the phone company over bogus charges on your bill (like the mysterious 3-hour call to a 900 sex line in Bermuda), you understand the prevalence of telecommunications fraud. The global telecommunications infrastructure is so complicated and decentralized that there is a huge opportunity for fraudulent practices. While fraud is an inconvenience for customers, it's a US$10 billion black hole for telecoms. The greater the investments in fancy technology, the bigger the opportunity for fraudulent activity.
ECtel's FraudView product offers a complete solution for detecting and preventing fraud in real time. It would take too much space to discuss all of the common scams perpetrated on telecoms. However, FraudView not only has outstanding growth prospects, but the clearest psychological appeal to retail stock speculators (assuming there's any left).
Hard to believe: a recent IPO with 55% gross margins!
While ECtel is a small tech company, it is obscenely profitable. In Q1 2000, ECtel posted a 55% gross profit margin! As sales to governments shrink as a percentage of total sales, gross margins should remain robust — even in the face of heavy competition.
Management has kept tight control of expenses. General and administrative expenses were only 6% of sales in the last quarter. Selling and marketing expenses remained relatively stable, in the mid-17% range over the last three quarters. The combination of robust profitability and financial discipline has yielded an outstanding net profit margin of 17%. In other words, for every US$1 in sales, 17 cents go directly to the bottom line!
Since ECtel is an earnings story, not just a tech story, I expect the stock will participate in any material bounce in NASDAQ. Since the company is cashflow positive and has US$40 million in balance sheet cash, ECtel does not need to sell shares to stay in business. In my opinion, solvent, cashflow positive companies will outperform the rest in the telecom technology sector.
There is plenty of risk to the ECTX story: ECTX's products use Windows NT. It is possible that the Windows hegemony could be destroyed by the Justice Department, creating an environment in which products based on competing operating systems like UNIX or Linux grab market share at ECTX's expense. ECTX is not particularly liquid, making it difficult to sell if the NASDAQ keeps crashing. ECIL may decide to extract value out of ECtel at the expense of minority shareholders (I have seen this happen with other Israeli stocks).
However, ECtel is down almost 60% from the March peak. The stock is cheap enough for me. ECtel's market cap of US$280 million is low relative to the few directly comparable companies. Based on the attractive forward Price/Earnings/Growth (PEG) ratio of 68%, I rate ELBTF as a Buy with a US$40 target.
For more information, review the company's website, www.ectel.com, or contact ECtel Ltd., 18 Hasidim Street, Peach Diva Israel, 49130, Tel: +972-3-9263055 / 3080, Fax: +972-3-9263088 email: ectel@ecitele.com.
| ECTX is cheap compared to the sector average! |
| company |
market cap |
price/sales |
| ECTX |
$282,000,000 |
6.7 |
| CATT |
$110,400,000 |
4.3 |
| CCRD |
$474,000,000 |
6.5 |
| CAIR |
$421,000,000 |
6.3 |
| INTI |
$1,924,000,000 |
16 |
| MUSE |
$4,298,300,000 |
51.1 |
| TLKC |
$2,222,500,000 |
8.7 |
| average |
$1,390,314,286 |
14.2 |
| ECTX |
$282,000,000 |
6.7 |
| discount |
80% |
53% |
James Passin is a Portfolio Manager with Firebird Management and Contributing Editor to Taipan. The views expressed are strickly Mr. Passin's and not necessarily those of Firebird Management or Taipan.
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