In the Zhone

03/11/2005 12:00 am EST


Michael Murphy

Former Editor, New World Investor

While a low-priced, high-tech stock is certainly not for the faint of heart. However, for those aware of the risks, Mike Murphy  not only covers conservative core tech holdings, but often features some speculative plays on emerging technologies, such as Zhone.

"Zhone Technologies (ZHNE NASDAQ) is an ‘arms merchant’ in the telecom/cable convergence war, and is very well-positioned directly in the path of Voice over Internet Protocol. Telephone and cable TV companies need to offer voice, data, and video services in one convenient package to stay competitive. Zhone has worked towards being a one-stop shop for telephone companies over the past few years. Instead of buying equipment from a bunch of small companies to offer these three services, telephone companies can turn to Zhone to supply much of the access equipment that is located at the customer’s premises.

"The company has become a leader in network access products because they were able to sell to any telephone company, with both the old copper system and the new all-optical networks. In the past year, they acquired a cable equipment supplier to offer converged service equipment to telecom’s major competitor, cable, effectively playing both sides of this competitive war. I believe this is the smartest strategic move ZHNE could have made and that it solidifies its position in converged network spending for years to come. On its recent conference call, management pointed to current strength in their optical transport and single-line multi-service products and increasing interest in convergence solutions such as TV over Internet Protocol.

"Although we've been following this company for some time, Zhone only recently garnered attention from Wall Street, thanks to a 1.3 million share purchase from an insider. Dick Kramlich, head of the $6 billion venture firm New Enterprise Associates and a ZHNE board member, bought 1.3 million shares from $2.06 up to $2.30. After he filed the SEC report on February 9, Wall Street was impressed, and the stock headed up. Then he bought a little more at $2.42 a share. Dick, who has a longer time horizon, knows that ZHNE has made the right moves to build a big, long-term business.

"Mory Ejabat, the often-controversial CEO, previously built Ascend Communications and sold it to Lucent for $24 billion. Ejabat, along with Kohlberg Kravis Roberts and Texas Pacific, have spent over $500 million acquiring Internet access companies to serve both telephone and cable customers. Zhone is currently valued at around $250 million. That’s less than one-third of the $862 million in paid-in capital. Even adjusting for acquisitions, we’re getting in at one-third to one-half of what the venture capitalists paid. This is the compelling driver that has Kramlich putting his money on the table.

"Wall Street forecasts almost no growth in 2005, yet the company has already indicated that the March quarter should come in around $28 million, up from $21 million in the March 2004 period. I think ZHNE can easily beat the consensus for the full year. If ZHNE can maintain its status as a primary access products supplier to the warring telephone and cable companies, they could earn 30 cents a share in 2010. They should sell for at least 30 times that figure, or $9 a share. We rate ZHNE a buy under $4 for a move to $7 by the end of 2005 and $9 or better by 2010."

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