DragonWave caught in the wake of the telecom giants

July 8, 2010

The world's largest telecom providers are awfully selective when it comes to choosing vendors and new technologies: They have tens of millions of subscribers that rely on their wireless networks, and faulty hardware could throw thousands offline, making them more likely to sign up with a competitor.

So the top providers are understandably cautious when they pick equipment-makers, and usually stick to a handful of experienced global giants. For smaller companies in the same space, that's a problem. For tiny, Ottawa-based DragonWave it has become a very large one.

On Wednesday, DragonWave reported first-quarter results that beat profit estimates, missed on revenue, and more importantly markedly lowered expectations for future revenues.

"This stock's going south," said Kris Thompson, a veteran technology analyst with National Bank Financial Inc.

Hampered by lengthy sales cycles, revenue forecasts for selling more of DragonWave's innovative microwave technology – which carriers use to more efficiently transfer wireless data – have failed to materialize, leaving the company reliant on one customer, Clearwire Corp., for nearly 90 per cent of its revenue in the previous quarter.

That was 78 per cent this quarter, as Clearwire scales back its network build-out plans. But by next quarter, Clearwire will only account for 25 per cent of DragonWave's revenue – a vertiginous drop that came much earlier and much harsher than analysts had previously thought, and a sign that Clearwire may be considering other equipment vendors in the highly competitive space.

Because revenue from Clearwire is withering, DragonWave is only forecasting $25-million in revenue for the next quarter, compared with Mr. Thompson's prediction of $36-million and the Street's consensus of $48-million.

"That's a major miss," Mr. Thompson said.

These results will likely fuel negative market sentiment since the company's results in the fourth quarter, when poor guidance and an inability to assure sales sent DragonWave's stock into a freefall, obliterating 25 per cent of its market cap on the day after it reported.

But this new drop in revenues and equipment orders from Clearwire – a wireless broadband company formed by Google Inc., Time Warner Inc. and Sprint Nextel Corp., among others – make it even more crucial for DragonWave to bag a new client, which would almost have to be a major wireless carrier.

Given the uncertainty surrounding the likelihood of a client win, analysts remain cautious in making predictions and continue to consider this a volatile and risky stock. When DragonWave reported back in early May, around 30 per cent of its outstanding shares were being shorted, a number that has declined to around 8 per cent.

Mr. Thompson believes the stock has not yet bottomed out, and had recommended clients reduce their stakes ahead of yesterday's results and bide their time before buying back in.

For the company the focus is on expanding its sales force in emerging markets. It has recently doubled its total work force to about 270 employees and as it grows, the hope is that it will be able to find new clients outside of North America.

Eyal Ofir, an analyst with Canaccord Genuity, recommended buying the stock in the lead up to results, on predictions that Clearwire would continue to make big purchases over the next quarters and that DragonWave could convert overseas opportunities into actual sales. He appears to have missed on the first point, but could still be right on the second.

Mr. Thompson, for his part, believes DragonWave has long term potential, but he will be watching to see whether the company begins burning through cash, or needs to explore cost-cutting as it seeks more clients.

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