RuggedCom excels once again

If you ever wonder what Canadian venture capitalists can achieve when they are married up with super entrepreneurs, look no further than RuggedCom (RCM:TSX). The players involved (Emerald, EPCOR Corporate, and Quantum Leap Co) should be proud of RCM’s continued success following its June 2007 IPO.

Here is today’s research note on another great quarter from GMP Securities:

RuggedCom reported strong Q4/F09 results after markets closed May 20, 2009. The company, which went public in June 2007, has reported 19 quarters of sequential revenue growth and 16 quarters of
profitability. ROE and cash generation have been rising steadily.

Details:

– Industry segments: Sales in the electric power segment accounted for 63% of total revenue in the quarter and rose 43% YoY to US$11.0mm. Military sales were US$3.0mm up 112% from a year ago and accounted for about 17% of total revenue. Transportation accounted for 12% of total revenue in the quarter at US$2.1mm and grew 115% YoY. Sales in the industrial segment totalled US$1.3mm or 7% of total revenue, flat vs a year ago.

– Large customers: RuggedCom has two traditionally large customers, ABB and Siemens (identified as customer A and customer B), which account for typically about 10% of revenue each. In the quarter, customer A accounted for 7.1% and customer B, 9.1%. RuggedCom’s top 10 customers accounted for 39.6% of revenue, down from 43% in the prior quarter, showing good diversification of the customer base.

– Geographic segments: By geography, the North American market remains the largest contributor, generating 52% of revenue, up 45% YoY. Sales in Europe, Middle East and Africa were strong, rising 43% YoY and accounting for 24% of total revenue. Asia Pacific grew
sharply, up 94% YoY and accounted for 19% of revenue. Sales in Latin America accounted for 5% of revenue and grew 42% YoY.

– Gross margin: RuggedCom reported a strong increase in gross margin to 63.4% versus our forecast of 62%. Gross margin has been consistently above 60% for five quarters, which we take as a sign of sustainability. RuggedCom has cited cost-reduction efforts in products,
better terms from parts suppliers, and product mix, as important contributors to gross margin.

– Spending slightly higher on forex: Total operating expense was US$5.9mm vs $4.7mm in the prior quarter. Operating expenses were above our forecasts with total opex at 34% of revenue vs. our forecast of 31%. This was primarily the result of higher General and Admin which included a foreign exchange loss of US$45k. Foreign exchange gains of about US$600k contributed to 50% lower opex in the prior quarter.

– EBITDA rising: Management reported EBITDA of US$5.5mm in the quarter up 72% YoY, and an EBITDA margin of 31% vs 28% a year ago.

– ROE rising: RuggedCom has reported strong improvement in ROE to 25% in the quarter, vs 17% year ago and 30% in prior quarter. For the full year ROE was 23% vs 16% a year ago. We consider this an important positive signal to investors.

– Cash from operations: Operating cash generated in the quarter was US$3.8mm (vs. an outflow of US$0.7mm a year ago) or 22% of revenue, an exceptional performance.

– Orders: The company booked US$16.5mm in orders, an increase of 23% YoY and slightly lower than $15.3mm booked in prior quarter. This included a record order from a U.S. electric utility in the quarter. Book-to-bill ratio of 0.95 was slightly lower than 0.97 last quarter, and at the low end of a historical range of 0.9-1.2. We do not consider this a signal of economic pressure on spending. RuggedCom has traditionally operated with very low backlog and low visibility to individual orders. Book-to-Bill has occasionally dipped below 1.0 in the September and December quarters in recent years. Variability in revenues remains a risk for short-term investors. That said, the company has been increasing its customer base which reduces some
of the risk. Our discussions with customers and partners in the power sector suggest that RuggedCom’s growth prospects should be strong over the long term.

VALUATION

RCM shares trade at about 17.4 times our F2010 (March 2010) forecast earnings, and about 15.1 times calendar year 2010 earnings. This is in line with the valuation of Cisco which is 15.0 times C2010
earnings. We think this is very compelling valuation for RuggedCom, especially considering the financial strength of the company and the growth prospects.

A group of mainstream networking stocks, generally with lower growth, are trading at about 25.1 times calendar year 2009 earnings. A group of Canadian small-cap tech stocks trades at about 14.2 times
calendar year 2009 earnings.

Our target price is based on the assumption of a premium valuation of about 20 times our F2010 (March 2010) EPS forecast of US$1.50 and implies a share price of about US$30. We believe that this premium valuation is warranted given the company’s strong historic financials, our expectation of high growth in earnings and our view that RuggedCom’s leadership in the power sector would be difficult for
competitors to match.

RISKS

Key-man risk: RuggedCom has an experienced management team, but we think the driving force of the company and a major source of success is due to the efforts of founder and CEO Marzio Pozzuoli.
As RuggedCom grows, we believe the company likely should consider ways to retain and add breadth to its management team.

Revenue difficult to forecast: RuggedCom’s customers are typically utilities, public agencies or regulated entities, whose slow approach to capital projects result in long sales cycles, and purchase order
based sales which make sales difficult to predict. RuggedCom also achieves high gross margin from its military sales which are typically long-term projects and are also difficult to forecast.

RuggedCom’s track record for growth in sales and earnings in the past three years is remarkable. However investors should expect that at some point, increased volatility (and even a down quarter) could result. Based on our discussions with RuggedCom’s customers, we believe the long-term growth trends are sustainable. International growth entails new challenges: Our growth forecasts, and RuggedCom’s business expansion plans, also include an implicit assumption of increased business in growing markets such as China and India, where there is a risk of government intervention and local content requirements which can produce unexpected challenges and delays for foreign suppliers.

RATING AND TARGET PRICE

We maintain our BUY rating. Our target price of C$35 is based on a premium valuation of about 20 times our F2010 (March 2010) EPS forecast of US$1.50 and implies a share price of about US$30. We expect to revisit our forecasts and may make small adjustments following the conference call.

MRM