Monday, February 21, 2011

Tellabs - Playing Dead

Attention private equity groups, activists, cigar-butt investors, and thrill seekers of all ages, Tellabs (TLAB) may be worth a look.

In the past 12 months, this telecommunications equipment company has generated over $200 million in cash, most of which found its way to shareholders.  The company is a regular buyer of its own shares and it pays a modest dividend.   One might think this would attract some positive investor attention.  Not so.  While euphoria reigns in much of the equity market, Tellabs remains pegged at its 52 week low. 

The reason is that operationally, Tellabs has earned a reputation for being yesterday’s news, a company that can no longer compete with the industry giants.  One need only listen to the most recent conference call (or read the transcript) to know that there is truth in this notion. 

CEO Robert Pullen himself posed the rhetorical question:  
Where is Tellabs today? 
The answer:
We are managing a core business in secular decline. That's also as we nurture the growth of new and more global business. A key challenge since I took this job has been to replace our core product revenue with new growth product revenue and diversify our customers. We're making progress here. With our solid balance sheet, we have resources that we need to manage successfully through this transition, but we will manage through the transition. We could be solidly profitable today if we have reduced our investment in growth technology and growth markets, but that's not the right thing to do for the long term. I believe that creating shareholder value is all about building a bright future for the business. Sometimes it takes longer than we like. But I'm confident we're in the right path. We will stick with our strategy to invest in key technologies and markets. We'll also exercise continued discipline to drive down our expenses in other areas of the business. We'll do what's right for our shareholders, our people and our customers. And that's what we believe in.
Secular decline?  Transition?  Not exactly a rallying cry for shareholders, employees, or customers, is it?  Frankly, it’s a pretty vague statement of purpose at best.  And a tacit admission of failure at worst. 

The analysts on the call took their cue and stuck to the small issues.  Questions abounded about inventory, new product initiatives, and the direction of AT&T (Tellabs’ largest customer).  These wouldn’t ordinarily be considered small if they weren’t viewed in context.

In short, investors don’t have to have an opinion about Tellabs’ underlying business to consider buying shares at the current price. 

Tellabs has 363 million shares outstanding.  At $5.54 each, the company’s market value sums to a very modest $2 billion.  For this, investors get $1.2 billion in cash and that troubled business that is buried underneath.  Oh, I almost forgot.  Tellabs also owns a modest $200 million stake in Cisco Systems (CSCO).  The only debt the firm has is a loan against that stake. 

So for all the consternation about Tellabs, fully 60-70% of the company’s value has nothing whatsoever to do with the underlying operating business.  And adjusted for all this cash, that business is only valued at $800 million.  Recall here that this is a business that generated over $200 million of cash in the last year.  So at roughly 4 times free cash flow, it can be argued that “secular decline” is more than reflected in the price.  All Tellabs has to do is NOT die and investors should be rewarded.

And what if there are signs of life?  Well, if you are skeptical that this team can manage that, so am I.

For, in truth, this company’s pathetic valuation is only partially due to operational issues.  Nonetheless, these issues were the sole focus of the company’s conference call.  There was not one question about the massive cash balance.  No questioning about the merits of holding so much indefinitely.  No inquiry into the aforementioned CSCO stake.  Nothing.

One almost gets the impression that management is in its comfort zone – the role of victim.

Look too closely at anything outside the core business and investors will begin to wonder who the real victims are.  Has the world passed Tellabs by?  The cash flow seems to show otherwise.  However small, does Tellabs have a future?  Could it do something to wake up the investment community to its potential?   Absolutely. 

But, instead, this is a management team that seems to just be going through the motions.

For one, consider the stake in Cisco Systems – the most recent 10q addresses it this way:
As a result of the acquisition of Advanced Fibre Communications, Inc. (AFC) in 2004, we acquired 10.6 million shares of Cisco common stock, shown as Other marketable securities in Current Assets. AFC owned this stock as a result of its investment in privately held Cerent Corporation, which was acquired by Cisco in 1999. In 2000, AFC entered into two three-year hedge contracts, pledging all of the Cisco stock to secure the obligations under the contracts. When the hedge contracts matured in 2003, AFC entered into stock loan agreements with a lender, borrowing 10.6 million shares of Cisco stock to settle the hedge contracts on the Cisco stock. The aggregate amount of the fair values of those stock loans is reflected as a current liability on the balance sheets as of October 1, 2010, and January 1, 2010. The values of both the asset and liability move in tandem with each other since each is based on the number of shares we hold at the current stock price. At October 1, 2010, Other marketable securities and Loan related to other marketable securities was $231.4 million at a market price of $21.91 per share and $252.8 million at a market price of $23.94 per share at January 1, 2010. The fees associated with the stock loan agreement were $0.3 million for the third quarter of 2010, $0.4 million for the third quarter of 2009, $1.1 million for the first nine months of 2010, and $1.1 million for the first nine months of 2009.

When contacted about why Tellabs doesn’t unwind this transaction and divest the Cisco stock, the answer was akin to: “Well, we inherited this from our Uncle Alfred.  It isn’t hurting anybody.  And hey, we’ll have to pay taxes on any sale!”

In other words, just leave it (and us) alone.

The Cisco stake has been floating around on Tellabs’ balance sheet since 2004.  The company continues to pay fees to maintain this byzantine arrangement.  And for what?   You can just see the collective shoulder shrug at TLAB headquarters!

And, how about all that cash?

Well, to listen to the company, its customers have asked that it maintain a certain level of cash to ensure its viability.  Seriously?  Well, how much cash is enough?  Clearly the current balance is more than sufficient.  The idea that nobody will do business with poor Tellabs unless it holds 60% of its market capitalization in cash is patently absurd. 

Frankly, this sounds like a concocted excuse to justify holding all that excess cash forever.

One has to believe that customers have bigger concerns than Tellabs’ cash balance.  And if viability is the issue, isn’t being cash flow positive and debt free enough?  Either way, a boost in market value might help the way Tellabs is perceived more than the balance sheet.  Because most investors seem to be oblivious to it.  The focus is squarely on TLAB’s operational missteps and its very obvious inferiority complex.   

For this reason, the cash looks more like a crutch for management than a weapon for survival. 

If there ever was a company that could benefit from an intervention, this is it.

Is anybody being well served by Tellabs (or its cash) these days?  It’s a glorified savings account.  And her management team seems positively paralyzed, a bit like an opossum playing dead hoping a predator will just walk on by. 

The opossum analogy works in many ways, but I’ll resist the urge to carry it too far.  Suffice it to say that many opossums are killed every year while scavenging for food.  Most are run over by fast moving vehicles.

Ironically, the company’s laissez faire attitude and abundance of caution when it comes to their capital structure may be leading up to a “roadkill” moment for TLAB.  All while management believes it is forestalling this eventuality.

It is long overdue for Tellabs’ managers to throw off their expensive cash security blanket and start being proactive.  What has been done in the name of prudence seems to have hastened the decline (or the appearance of it).

Is it any wonder that TLAB shares have fallen by nearly two thirds in 5 years, despite buybacks and dividends?

It is obvious that Tellabs has considerable economic weight that is not reflected in the current market value.  I can only hope management uses the tools at its disposal to illustrate this.  Exclusive of anything operational, this would include something as minor as a special dividend (see HOTT) or as major as a total recapitalization (see WCRX).  It would also mean the elimination of the Cisco holding and the debt arrangement surrounding it.  The incremental tax consequences would be minor relative to the benefits (economic and otherwise). 

Undoubtedly, few potential shareholders know the cash and securities even exist.  So any announcements along these lines would see throngs of investors coming to take a first (or second) look at Tellabs. 

And the prospect of some additional incremental taxes probably isn’t high on the worry list for current TLAB shareholders.  One has to wonder how out of touch this management team really is?  With the current valuation, this company is priced for certain (if slightly delayed) death. 

With some very simple actions on the part of management (and exclusive of any good news on the operating front) there seems to be little reason why TLAB shares could not double in the next year.  Perhaps this would be more solace to customers than a mountain of greenbacks?

Nonetheless, it seems management is more interested in considering acquisitions at this point.  But, to be fair, aren’t they all?  Nonetheless, perhaps Mr. Pullen and his team can hold off until AFTER they demonstrate an ability to run the business they already own and to allocate the capital they already control.  Or at least they should wait until assets under the Tellabs’ umbrella don’t get an automatic 50% haircut.  Closing this value gap should be Job #1.  And this (almost by definition) will involve digging out from under a mountain of cash. 

If management isn’t willing, the investor community should force the issue.

Tellabs has played opossum long enough!

Disclosure:  Long TLAB.


  1. This write up is similar in ways to way people own Apple as a "value" play today (Einhorn...). Simply subtracting out the cash from the market price & then valuing Tellabs at 4X cash flow is something I take issue with.

    You won't be receiving a special dividend of all that cash tomorrow and thus gaining a stake at this great 4X cash flow price. You also don't have enough money to buy the whole thing out & pocket that extra cash, so you won't be able to subtract out the cash in that fashion.

    The business could continue to generate $200 MM in op. cash and just hold that cash, or use it all to repurchase shares at roughly a 10% yield on its earnings. Therefore, you're getting a 10% return on money earned & a huge stake in cash on balance sheet. It could compound as a savings account around 10%, but serious slip ups at the corporate level could have you losing some of that cash heap.

    Nice read again, I just am more concerned with the act of subtracting out cash for valuation purposes than your actual selection of Tellabs. It may indeed be a good holding today.. I'll take a look

  2. My back of the envelope valuation method is far from perfect. In fact, I didn't even attempt to calculate a price target using that approach. Its sole purpose was to illustrate for readers that there is plenty of pain baked into the current price of TLAB.

    If it appears as though I sold that model as a comprehensive means of valuing the company, I apologize.

  3. Don't apologize or anything of that sort; just because I take any issue with the principle behind what you're doing doesn't mean I don't agree with the selection you made. Tellabs looks very appealing at today's prices for the reasons you outlined. I'd just be concerned with the future of voice & data equipment.. it would take a lot of reading for me to get comfortable with technology I don't understand well.

    I'm curious, with most of your holdings, are you pretty diversified? Or do you have large holdings in your write ups about tellabs & loews, among others?

  4. Sorry just saw this - we typically hold 30 companies in our portfolio. Loews is our top holding at 5+ percent. And it goes down from there... but nothing is less than 2 to 2.5% because below that level, there is no point. We want all our ideas to have a significant impact on the portfolio.

    One last thing on that valuation... again, I am NOT saying that is the way to value the company but the calculation does illustrate the point I was trying to get across. It is an oversimplification, but one that has informational value.

    Just because I didn't upload a pretty Excel spreadsheet does not mean that the back-of-the-envelope approach is the only valuation we did.

    The article is supposed to be a start for people (and a means of providing a point of view). It is not a comprehensive research report.

    We prefer people do their own homework, especially when we give these ideas away for free ;-)

  5. Its not playing dead - its dead