Sandvine gets taken out and shot

As the trading desk saying goes, Sandvine was taken out yesterday and shot.

It was but a couple of days ago that VC-backed Redline Communications (RDL:TSX) was being showcased here as a case study of what happens when public companies fail to manage the expectations around their growth rates. In Redline’s case, year over year revenue growth of almost 40% drove investors to drink for the simple reason that Redline management had previously put out guidance of 60%.

Redline shares fell from the TSX IPO price of $6.50 to $1.70 as a result (see prior post “Redline Communications a classic tale“, March 3-08).

Today’s poster child for expectations mismanagement is Sandvine (SVC:TSX). Sandvine’s offering focuses on providing deep packet inspection for “intelligent broadband networks” at the cable companies. According to The Yankee Group, DPI “technology plays an important role in enhancing customer satisfaction and reducing churn. DPI helps realize these goals by improving performance of IP-based multimedia applications, mitigating network attacks, and controlling network congestion.”

The elevator pitch on Sandvine went something like: cable companies never dreamed of the demands that file sharing and video download traffic would place on their networks. Companies such as Sandvine have only one way to go, and that’s up. That’s likely still true, but not up in the “straight line” sense.

Having touched close to a $1 billion market cap last September, the 19 million share rout of yesterday puts Sandvine firmly back in small cap land with a new market cap of just over $200 million.

Having fun yet? It was just 6 weeks ago that the National Pest was trumpeting Sandvine as the “main prize” in the DPI market. Stock was over $4 at the time. And while Sandvine management think the firm can still do $80-85 million of revenue for 2008 (versus the old guidance of $100-110 million), the first quarter of 2008 (ended February) is looking like $8.2 million.

Q3 2006 quarterly revenue was $8.1 million. No one in the fund management world likes to see signs of flat revenue over a 6 quarter period.

If you’re a portfolio manager who bought shares at $6.80 last October when management did their second third secondary transaction, you can be forgiven if you don’t want to hang around to see if the implied 7x Q1 revenue run rate multiple (Q1 revenue of $8.2MM x 4 = $32.8MM juxtaposed against a market cap. of $212MM) turns out to be cheap.

Speaking of that second third management secondary trade, and the broader challenge of managing expectations, here is the timeline:

March 5, 2007:

Company announces that a major tier one broadband provider has chosen them, and that they now count 7 of the top 20 U.S.-based broadband providers as customers. The stock is around $2.75.

April 11, 2007:

Q1 is announced (quarter ended Feb . 28/07). Revenue of $15.4 million, profit of $0.045/share, and annual revenue guidance of $50-$60 million is reaffirmed: “Sandvine continues to expect total revenue for fiscal 2007 in the range of $50 million to $60 million, based on the following assumptions: i) In aggregate, existing customers will contribute as much revenue in fiscal 2007 as they did in fiscal 2006; ii) One or two Tier 1 DSL companies will begin deploying Sandvine’s solutions in fiscal 2007, iii) Up to 20% of revenue will be delivered through Sandvine’s sales channel partners.” Stock is at $4.25.

April 17, 2007:

Several Canadian VC firms are bid for part of their block of shares. Rumours are that some members of the syndicate agreed to sell close to 12 million shares around $4. Always good to bank profits.

April 24, 2007:

Three senior Sandvine executives decide that selling some of their stake is a good idea, too, and lighten up by 1 million shares at $4.30, a nice uptick from where the VCs were rumoured to have done their print. Hint for other entrepreneurs: It is always good form for management to sell when your key backers are selling, and not wait a week to realize $0.25 or $0.30 more per share.

This could have been interpreted as an omen to the VCs at the time.

May 29, 2007:

Sandvine CEO Dave Caputo flies all the way from Waterloo to Halifax to collect his Canadian Venture Capital Association Entrepreneur of the Year award at the CVCA’s AGM. Mr. Caputo dines on the free lobster (thanks to a generous corporate sponsor), swigs a few free beers, and then proceeds to take out an AR-15 and empty the entire clip into the assembled venture capital industry (see prior post “Sandvine CEO named ‘Entrepreneur of the year’“, May 30, 2007). It appeared that Mr. Caputo was still cross that when he was out raising money as a private co., some VCs wanted to tie high valuation demands on the Series B round to Sandvine actually achieving the revenue forecast being proffered by management to warrant the “high” valuation. Sacré bleu!

June 13, 2007:

Sandvine announces higher guidance of $62 – $67 million, and secures a new Tier 1 service provider customer. Stock is at $5.45.

June 21, 2007:

Company raises $45 million in a bought deal at $5.05/share. The quarter ended in May and the numbers hadn’t even been released yet: that’s a confident sign! Canaccord and CIBC WM are co-leads on what was probably one of the most sought-after mandates in tech i-banking last year.

July 5, 2007:

Q2 is reported: revenue of $20 million and EPS of $0.079. Stock is at $6.60. Everyone is happy with the 33% revenue growth vs. Q1, and the stock is up 50% as a result.

October 3, 2007:

Q3 is reported: revenue of $21.2 million and EPS of $0.02. Revenue guidance is bumped to $70-$75 million. Stock is at $7, likely due to the guidance bump, as revenue is modestly up versus the prior quarter, and earnings aren’t growing.

October 9, 2007:

Management sells 765,000 shares at $6.80 via a block trade, just shy of the $7.30 all-time high. Unfortunately for shareholders, Sandvine’s stock has gone down, almost in a straight line, ever since.

December 20, 2007:

Sandvine issues 2008 revenue guidance of $100-110 million. Q4 revenue estimated to be $17 million, with $73.6 million for the full fiscal year.

January 16, 2007:

Q4 2007 is released, and the company hits the full year guidance of $70-$75 million, coming in at $73.6 million to be precise. But the quarterly momentum isn’t improving, as Q4 wound up with $17.6 million on the topline and break-even earnings. CEO Dave Caputo’s statement looks prophetic in hindsight: “while we expect strong growth in revenues in 2008, we are focused on the long-term opportunity”.

Whenever a public company misses their guidance they invariably say that they are focused on the long term. What else have you got but the “long term” when the short term, umm, sucks? Mr. Caputo may well be the first CEO to use that line before announcing a miss.

Guidance for 2008 of $100-$110 million is affirmed by management.
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Let’s review: Q2 revenue was $20 million. Q3 generated $21 million. Q4 came in at $17 million. And Sandvine’s market cap almost touched $1 billion last Fall? Crikey!

What was it about that revenue trend that suggested to management and the research analysts that 2008 would generate $100-$110 million of revenue? Prior to the release of the 2008 guidance, the media was full of stories about a pending U.S. recession. Even us bloggers has stumbled across the topic (see prior post “Buckle up – the wheels have come off” August 13-07).

Now shareholders are left with the sad reality that the go-go days are over. And that U.S. Tier One clients might be pulling in on the reins a tad. CIBC’s tech analyst threw the towel in yesterday, having stuck with his $7 share price target through thick and thin. Even though the quarterly revenue trends were suspicious, he apparently believed management’s guidance. Of course he did, management are the ones with the unique access to so much of the relevant information:

“Q1 Will Significantly Miss; 2008 Guidance Has Been Rebooted

SVC issued its second warning for F2008. SVC’s Q1 outlook was reduced due to slowing capex at its existing cable customers. SVC also lowered its 2008 forecast ($80M – $85M vs. $100M – $110M) as the slowing economy has pushed out DPI spending by cable and DSL service providers. The Q1 outlook was very weak at $8.2M (vs. est. of $17.4M). We reiterate our Sector Outperform rating but have reduced our price target to $2.50 (from $7.00).”

Thomas Weisel’s research analyst is no less unhappy with the turn of events. He slashed his 2008 revenue estimate from $109.7 million ($300k below the top end of managements’ old guidance range) to $64.1 million. Although he says he’s “not capitulating” before the April 9th company Q1 call, his price target dropped to $1.50 from $6:

“Customer Spending Delayed at Best: Sandvine expects Q1/08 (February) revenue of $8.2 MM compared to consensus expectations of $19.7 MM. F2008 guidance was reduced to $80 MM-$85 MM from $100 MM-$110 MM. F2008 guidance assumes that 50% of revenue is from existing customers, that channel partners will drive 15% to 20% of total F2008 revenue and assumes Canadian/U.S. dollar parity. This would assume that revenue from existing customers would decline by 45% compared to F2007 results. This higher than previously expected decline from existing customers may be from lower revenue into Comcast’s (CMCSA-Q; US$19.71; not covered) installation given an ongoing FCC inquiry into Comcast’s bandwidth management practices. Relying on partners to execute 15%-20% of forecast revenue is also a concern to us given their lacklustre contribution in 2007.

Lowering Estimates: While we have seen some anecdotal evidence of weakening capex spending at U.S. service providers, the magnitude of this preannouncement took us – and the street – by surprise. We are lowering our F2008 revenue to $64.1 MM, which is considerably below management’s revised guidance. Our primary concern is that deals in the wireline segment are delayed longer than expected (or pulled) and/or pricing is pressured downwards as service providers reevaluate their capex plans. We do not expect significant revenue from the wireless segment until 2009. We are also concerned that Sandvine’s operating cost structure may be significantly inflated if revenue growth does not accelerate in H2/08 (which could lead to certain one-time charges).

Share buyback Announced: Sandvine’s Board has approved a 10 MM share buyback program (7% of outstanding shares). The buyback still requires regulatory approvals. Sandvine had $113 MM in cash ($0.82 per share) at the end of November 2007.

Not Capitulating before Q1/08 Conference Call: Sandvine will host its Q1 results conference call on April 9. We will revisit our recommendation after participating in the conference call. We will be focusing on Sandvine’s progress in transitioning customer discussions to purchase orders and the company’s potential requirement to realign operating costs based on its revenue outlook.”

This situation cannot be fun for anyone. The question must be asked, however: what happened to the stock? How did “it” figure out what others missed?

Between October 9th and December 20th, Sandvine fell from $7 to $5. When the Q4 results were put out on December 20th, the stock dropped more than $1, even though management’s guidance for 2008 suggested robust topline growth would continue. $73 million of revenue going to $100 or $110 million? Who couldn’t love that?

More than a few shareholders weren’t confident that it was actually doable, and 10 million shares traded hands on December 21st. Weren’t they right to bail.

From October 9th to January 16th, the NASDAQ dropped from 2800 to 2400. About 15%. Sandvine peeled off about 40%.

When the actual Q4 results were released on January 16, 2008, the market couldn’t deny that quarter/quarter revenues were slogging. The stock continued its swoon, dropping another $2, from $4.50 to $2.60 over the next six weeks.

With the new guidance of yesterday, 19 million shares traded hands, sending the stock down to $1.55. A valuation of $212 million. I wonder how that compares to the last VC round prior to the AIM IPO.

For the venture capital community, it isn’t pleasant seeing our “2007 Entrepreneur of the Year” drinking his own bathwater. And I mean that. Celebrating a great Canadian success story is a treat. We need more than RIM to crow about.

The VCs behind Sandvine who believed management’s guidance and held on to their positions have suffered serious pain. And that’s not good for the many Canadian VC funds (or the entrepreneurs that want to raise capital) that are out in the market right now trying to raise their next fund.

Sandvine was one of those rare Canadian VC 10 baggers. At least it was. Now it is just another small cap Canadian tech firm with a share price in and around $1.50 (Arise, Certicom, Kaboose, MKS, Redline, Zaio, etc.).

Had the guidance been better managed, the market might have thought that a growing, profitable, well-capitalized firm with an important product was worth owning. And that might have produced a 5 bagger for the original VC backers. Stil a big win.

Instead, unless they sold most of their position on the two three occassions when management let some of their own stock fly, the VCs are stuck having to explain to their current and prospective limited partners why they placed so much faith in management’s rosy 2008 guidance and didn’t sell their positions — even when the quarterly revenue figures suggested things in Sandvine’s end markets were clamping up.

MRM