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Why I haven't abandoned BigBand Networks

BigBand Networks, Inc. (BBND) develops, markets and sells network-based platforms that enable cable operators and telephone companies to offer video, voice and data services across coaxial, fiber and copper networks. The stock first showed up as a pick in the TradeRadar model portfolio (read the original post) back in March 2007 just after the company went public in a well-publicized IPO. There was a good deal of buzz about the company at that time and it was even discussed by Jim Cramer on TV.

Still, after an initial run up, BigBand's stock price has lately been rapidly declining and I have been wondering why. There has been no particular bad news since its 8-K earnings report was filed back on May 3 and its 10-Q quarterly report on May 9. Since that time the stock has been in a free fall despite positive news of new contracts, good product reviews, etc.

Looking at the chart, it now looks like a classic head-and-shoulders top was formed and confirmed in early June when the price finally fell below about $17. That level has now become a resistance point. In any case, based on the head-and-shoulders we could have expected BBND to fall to about $13 and that's exactly what it has done. Will it stabilize at that level? We'll have to wait and see but at least it seems to be trying.

So what caused the stock to fall so precipitously? Certainly, many IPOs tend to behave like this but BBND seemed to be a more mature company, coming to market as it did earlier this year with real revenues and earnings, a well respected product line and some buzz about its prospects and industry niche. Looking for other reasons among thecompany fundamentals, I dug into the 10-Q and 8-K.

Here is what I found:

In general, on a non-GAAP basis the company was profitable but on a strict GAAP basis, the company incurred a loss.

Excluding charges, net of tax, non-GAAP net income for the first quarter of 2007 was $5.8 million, or $0.09 per diluted share versus a loss of $0.06 the year before.

On the other hand, GAAP net loss in the first quarter of 2007 of $0.05 includes an aggregate of $7.5 million in non-cash charges (including $5.0 million in preferred stock warrant expense, $2.4 million in stock-based compensation expense and $0.1 million in amortization of intangibles), while such non-cash charges represented an aggregate of only $0.5 million in the first quarter of 2006. Clearly, expenses are jumping and, in general, BBND does report that they are continuing to incur increased research and development, sales and marketing and general and administrative expenses.

This reported loss in its first quarter as a public company comprises the primary bad news that caused the stock to tank. Analysts were expecting, rather than a loss, a per-share profit of $0.03. Compounding the problem, BBND offered forward guidance that was toward the low end of analyst expectations.

On the positive side, the 8-K and 10-Q showed net revenues of $52.8 million, up 62% over the same quarter in the prior year. Nothing wrong with that! Gross margin of 57.5% is quite high for a hi-tech hardware company and some 6% higher than the previous year's first quarter. The cash flow situation looks good. Net cash provided by operating activities is nearly three times higher than the prior year's quarter. Including investing and financing activities, cash and cash equivalents at end of period are five times higher than the prior year's quarter.

Another weak spot identified in the 10-Q, however, is international sales. The company failed to increase international sales yoy; in fact, international sales dropped a bit.

As always, there are risks that, should they come to fruition, may affect the company's profitability.

One risk identified in the 10-Q is related to concentration of sales in a relatively small number of large customers. The company's top five customers in the United States accounted for 82.9% of net revenues compared to 71.1% in the three months ended March 31, 2006. In the three months ended March 31, 2007, Cablevision, Cox Communications, Time Warner Cable and Verizon each represented 10% or more of our net revenues. Loosing just one of these customers would be a serious blow to BBND. On the plus side, these are the North American heavyweights and it is good that BBND has been able to sell into these companies and it validates BigBand's value proposition.

Another risk is related to competitors. BBND competes principally with Cisco Systems, Motorola and Arris. In the video market, they compete broadly with system suppliers including Harmonic, Motorola, Scientific Atlanta (a division of Cisco Systems), SeaChange International, Tandberg Television (which recently announced that it will be acquired by Ericsson), Terayon Communication Systems (which recently announced that it will be acquired by Motorola) and a number of smaller companies. Competition is stiff, to say the least and many of these companies, being larger than BBND, have greater financial, technical, marketing and other resources they can bring to bear in competing with BBND.

Looking to the future, the company expects second-quarter earnings of $0.02 to $0.06 a share, or $0.06 to $0.11 a share excluding items, on revenue of $52 million to $56 million. Results, in other words, will be flat to slightly above the first quarter but at least the company should swing to profitability. BBND has also forecast 2007 earnings of $0.06 to $0.11 a share, or $0.30 to $0.35 a share excluding items, on revenue of $225 million to $230 million.

So what conclusion can we draw from this data? BBND is a small company with good products but it is competing with industry heavyweights and selling into a small set of large companies, primarily in the US. Its revenues grew 62% over the prior years' quarter but its expenses grew 52%. The expenses, combined with the non-cash charges described above were enough to tip the company to the unprofitable column. Still, the company shows good cash flow and strong margins and is undeniably operating in a market segment where there is excitement and opportunity. Indeed, revenues derived from the video related portion of its product line have shown growth of 125% over the prior year's quarter.

The company expects to return to profitability in the coming quarter. If BBND can get a handle on expenses and increase international sales, it should be able to increase EPS at a faster rate in coming quarters. And with the stock over 50% off its peak, it seems there should be minimal risk in buying now or continuing to hold. Wall Street seems to agree, with three analysts rating the stock a buy and four rating it a hold.

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