NetComm: Rise of the machines

Should you be alarmed that device maker NetComm Wireless (NTC) has surged to its highest level since the dot com “boom”?

Some are getting that creepy déjà vu feeling, with several market watchers warning that the technology sector is running too hot and this boom could turn into another “kaboom”.

It is not a view we subscribe to and NetComm’s stellar rise isn’t giving me any anxiety attacks, even as it has rallied around 150% over the past year to close today at 59.5 cents. This is just below the 60 cents close it hit three weeks ago – its highest since 1999.

According to my estimates, the market is assuming around a 20% annual increase in sales for the next two financial years as that would generate a price target of 54 cents on a discounted cash flow (DCF) basis.

You wouldn’t base your investment decision on DCF for small caps, such as NetComm, because it requires you to guess what the long-term growth rate of the company’s cash will be. But it is useful to have to compare against the price-earnings (P/E) based target for the stock.

A 20% increase in revenue to $72 million for 2014-15 would put the stock on a P/E of 21.5 times. The multiple looks appropriate for a company facing an important inflection point and implies that investors are reasonably confident in management to deliver robust earnings growth.

The balance of probability suggests that top-line growth will come in well in excess of the annualised 20% number for the next two years, although it’s really anyone’s guess if and when the machine-to-machine (M2M) component maker will get a new order from its global partners.

M2M refers to the technology that allows equipment to communicate with other machines, such as smart meters in a power grid and contactless payment solutions. The market for M2M is tipped to be the fastest growing space in the wireless market, with Ericsson predicting that around 85% of the 50 billion connected devices in 2020 will be in the M2M space.

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NetComm makes chips and components that go into M2M enabled devices. Investing in NetComm requires you to believe in some of this blue-sky market valuation, and investors have every right to be sceptical as that is a huge market for a tiny Australian-grown player.

I bought the stock a few years ago and still hold it in my portfolio, which is published on the Eureka Report site, as there are a few factors that lead me to believe in the NetComm story.

First is the management team’s ability – led by chief executive David Stewart – to secure contracts with global giants, and that is no small feat for what is essentially a microcap stock. Perhaps the biggest coup in NetComm’s recent history is the M2M supply agreement it signed with Vodafone, one of the world’s largest M2M solutions providers.

NetComm has a similar deal with Middle Eastern telecom giant Etisalat and has struck a partnership with Verizon Wireless to enter the United States market.

This creates multiple opportunities for NetComm to realise its full potential in the M2M space and diversifies the risk for investors. Given that sales are coming off a relatively low base, it won’t take much to see the stock re-rate again. For instance, securing a second smart meter contract (its first was with SP AusNet in Australia) alone with a global partner could see revenue double from the $60 million sales NetComm is expected to make in the current financial year.

The timing of a new order and recognition of the resulting profit is up in the air, but we should see a significant step-up in sales over the next few years. I am forecasting sales growth of 25% in 2014-15 (bolstered in no small part by sales of wireless equipment to the NBN) and a further 33% uplift to $100 million in 2015-16 as initial revenue from new contracts kick in.

This would give me a target price of 86 cents on the stock, and you can click on the link below to see my financial forecasts.

The third reason to like the stock is management’s ability to launch new products quickly. NetComm has proven it can develop and market new devices within a couple of months, while a contact in Cisco Systems told me it would typically take a year for them to pull off the same feat.

If there is one industry where speed is a necessary ingredient for success, it would be technology.

To see NetComm’s earnings forecasts and financial summary, click here.