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Ubiquiti Networks: Case Study in Business Model Disruptions

Capitalize for KIDS Monthly Manager Insight – Ubiquiti Networks, A Case Study in Business Model Disruption, June 2017

“Real investment risk is measured not by the percent that a stock may decline in price… but by the danger of a loss in earning power through economic changes or deterioration in management” – Ben Graham

Ewing Morris & Co. Investment Partners

  • Ewing Morris & Co. Investment Partners is a Toronto-based investment firm founded in 2011
    • Private equity mindset means conducting deep research and placing heavy emphasis on people to build a concentrated portfolio of investment opportunities that exceed a 15% IRR hurdle
    • Apply investment Playbook approach based on two core thesis types: Cheap Assets and Compounders
  • Ewing Morris & Co. believes that Ubiquiti Networks (UBNT) is an example of a compounder with a great business

Business Model Innovation: A Case Study

  • Our observation has been that capital markets are often willing to pay a high price for potential profits from new products (Tesla Model 3, GoPro) or services (Snap) but are much slower to appreciate new business models (Dell, Price Club, Southwest Airlines)
  • One such business model disruptor is Ubiquiti Networks (UBNT)

People

  • Prior to founding UBNT, Robert Pera worked at Apple as an engineer designing Wi-Fi products
    • Identified an opportunity to improve a wireless router’s performance by increasing its power
    • He realized that customers in remote areas without cable or telephone connections represented a market for high-power Wi-Fi
  • Recognizing the opportunity, Pera left Apple and founded UBNT in 2005 when he was 27
  • UBNT reports its results under two segments: Service Provider Technology ($450M in revenue) and Enterprise Technology ($370M in revenue)

Service Provider Technology

  • UBNT’s first product was a mini-PCI radio card that it sold to Wireless Internet Service Providers
    • Although this product was successful it was easily copied by other component suppliers
  • Pera adopted an integrated business model and began selling complete systems that allowed his customers to focus on selling their services rather than assembling equipment from a variety of suppliers
  • Network performance improved when customers bought all components from UBNT because the equipment was engineered to work together
  • Important to note that UBNT’s success was attributable to successful business model innovation rather than having better technology or protected intellectual property
  • Allowed UBNT to grow its Service Provider business from $0 to $450M of revenue by 2014 with EBIT margins in excess of 30%

Enterprise Technology

  • In 2010, UBNT entered the enterprise market selling Wi-Fi access points
  • Revenue from this business has grown from $35M in 2013 to almost $400M today with consolidated EBIT margins remaining above 30%
    • This success resulted from a second business model innovation
  • UBNT was using low-end disruption to provide less expensive solutions for Enterprise customers that were otherwise overpaying for expensive, over-engineered products and unnecessary service contracts

Business Model Sustainability

  • Investors are skeptical of the sustainability of business model disruption as they assume competitors will copy the model
    • For example, why can’t Cisco attack UBNT with lower prices?
  • Answer is UBNT’s low cost structure: UBNT has built a strong online forum community of over 4M registered users and distributors who act as evangelists for the company’s products and help troubleshoot technical issues
  • If Cisco dropped prices to UBNT’s level, its operating income would fall by 50% barring a major restructuring of overhead
    • Public companies rarely pursue strategies that require so much short-term pain which explains why incumbents facing low-end disruption rarely emerge victorious

Risk Factors

  • Bulk of our analysis is focused on risk assessment and the research process attempts to identify and avoid situations with a material risk of permanent capital loss
  • With stocks, there are 3 common causes of permanent loss: overvaluation; industry change; excessive debt
  • Most significant risk facing UBNT is loss of focus and execution
    • Executions has not been flawless but believe that Pera is very competitive, highly motivated, and is still only 39

Valuation

  • Business model disruptors tend to be discounted by the market and are often priced attractively relative to their current earning power and especially relative to their future earning potential
  • Company has net cash of $320M and recent market cap of $3.8Bn
  • Trades at 12x trailing EBIT and ~16x trailing EPS
  • Recently, company has been making substantial investments in its working capital, but over time, we would expect accounting earnings and cash flows to track closely
  • Unlike most tech companies, UBNT rarely grants options, which are a real economic expense often excluded from earnings of comparable companies

Conclusion

  • Valuation is surprisingly low for a company that has compounded revenue over the past 5 years at 27% and operating profit at 31%, while growing its net cash balance by close to $300M and reducing the number of shares outstanding by 12%
  • Not only is the historic track record impressive, but believe the company’s prospects over the next 5 years are more exciting than they have been at any point over the last five
Image Source: Ubiquiti Investor Presentation
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