Ride the 5G wave with Spirent

Spirent Communications (SPT) has had many faces since it listed on the London Stock Exchange in 1955. It first dealt in electrical and electronic components. But later a dot-com era pivot toward high-growth, technology-driven markets saw the stock reach astronomical highs. 

The group suffered the lows of the dotcom bust too, but its move toward tech-testing proved to be a smart one. After decades in the lab, Spirent now offers services that accelerate the development and deployment of equipment and applications for both cloud and mobile networks. 

But the complexity of Spirent’s products, and the fact that it has historically been exposed to capital expenditure cycles in telecoms, means that it is often overlooked by investors. We think the company deserves attention, especially as it still sits at the early stages of a wave of 5G potential. 

The Spirent model 

Today Spirent’s largest business is its networks and security division, which accounts for 60 per cent of its top line. It provides performance and testing solutions to support equipment, networks and applications for big telecom companies such as Sprint, Ericsson (US:ERIC) and AT&T (US:T). 

That is followed by lifecycle service assurance, where Spirent monetises its expertise in the lab into active test and assurance solutions that automatically monitor live networks. In 2020 the business made up a quarter of Spirent’s revenues, before it absorbed the smaller connected devices business, which contributed the remaining 15 per cent. 

Spirent’s corporate home is in Crawley but it has evolved into a global business, with operational headquarters in California. Its clients too are largely based outside of Europe; with 89 per cent of sales derived from the Americas and the Asia Pacific regions. 

Most of Spirent’s testing products are virtual, with software and services making up close to two-thirds of sales. That has catapulted Spirent’s gross margins beyond the industry norm to 73 per cent, beating US rivals Viavi (US:VIAV) and Keysight Technologies (US:KEYS), where margins stand at 59 per cent and 60 per cent respectively. Meanwhile, Spirent’s return on capital employed, which measures how effectively money invested into a business is turned into profit, sits at an enviable 23 per cent – and free cash conversion has averaged 133 per cent over the past four years. 

Source: FactSet

These metrics may soon improve further. While the company has historically sold its digital products via one-off transactions, the group’s new management team has drawn up a strategy that is more akin to a subscription-based software-as-a-service (or ‘SaaS’) model – in Spirent’s case, test-as-a-service (‘TaaS’) and lab-as-a-service (‘LaaS’). In time, this shift should boost margins frurther, as well as improve the group’s overall revenue visibility. The reclassification of Spirent products into clients’ operating expenditure rather than capital expenditure should also help mitigate against the cyclical nature of telecom spending.

5G explosion

Data volumes are exploding. As cloud computing, video calls, smart devices and gaming continue to grow, the products that support our digital infrastructure have become more integral to most, if not all, business operations. The mobile operator industry body GSMA not only expects that 5G spend will be at least 50 per cent higher than 4G, the pace of adoption is also expected to be much faster. According to research firm Gartner (US:IT), worldwide 5G network infrastructure revenue is on track to grow 39 per cent to $19.1bn in 2021 alone.

Spirent revealed in its results last week that it had already secured more than 400 5G deals in the first six months of 2021. Revenues are typically weighted towards the second half, so it looks on track to beat last year’s 600 5G-related deals. 

The huge 5G market opportunity is not the only growth driver for Spirent. The company has also begun a targeted acquisition strategy, having completed the takeover of Octscope, a wireless testing specialist, for an initial cash consideration of $55m this year. 

“We like the approach of bolt-on M&A rather than the risk of something much bigger or transformational,” says chief executive Eric Updyke. “We’ve got a funnel of opportunities.” 

The company has more than enough cash to pursue those opportunities, with $221m on the balance sheet (even after a $45.6m special dividend last year) and no bank debt, although some lease liabilities. Telecom clients are usually conservative, often sticking with suppliers they already have a working relationship with – so a bolt-on M&A strategy is a smart way to expand Spirent’s product suite, as well as acquire new business. For example, Octoscope not only has bolstered Spirent’s position in the Wifi testing market, but has added blue-chip clients such as Google parent Alphabet (US:GOOGL) and Facebook (US:FB). 

The risks 

While Spirent’s technology is highly rated, investors should be aware that it operates in a competitive industry. As such, consistent spending on product development is critical to the company’s long-term success. Spirent has historically spent around $100m a year on research and development, or roughly20 per cent of its sales. That level of spending is typical in a tech-based industry, although Spirent’s product development allocation as a percentage of sales has been slipping since 2016. In absolute terms it has been relatively static. This could cause a lag in product quality as the company continues to scale up. Rivals Viavi and Keysight, for example, spent $194m and $715m, respectively, on research and development in 2020. 

Investors should also note that while none of the company’s customers currently account for more than 7 per cent of its overall revenue, consolidation in the wider telecom industry is progressing at pace – and could result in some concentration riskfor Spirent. 

Overall, though, the company has navigated the pandemic with limited operational disruption. 

Management warned last week that Covid-related challenges are likely to continue in the second half of the year, but told Investors’ Chronicle that so far it had managed to weather the global chip shortage – arguably the most pressing issue facing tech companies – while continuing to meet customer demand. 

“We’re seeing lead times extend, and some suppliers decommit. It’s a much more challenging environment,” said Updyke, who described the chip challenge as an everyday battle. Still, any impact should be relatively limited for the group, since most of its products are virtual. “We think in terms of total magnitude for us, it is in the single digits of millions of dollars in terms of revenue that is at risk.”  

Ultimately, trading looks safe: order intake grew by 14 per cent in the first half to $264m, and book to bill (the ratio of orders booked against revenue recognised in the period) stood at 103 per cent. Yet even after a largely upbeat set of half-year results, the shares are still trading at a forward price/earnings multiple of 24. We think this looks attractive given the company’s robust cash profile, industry-leading margins and scope for both organic and inorganic growth. Spirent has had a long history on the London Stock Exchange, and the next generation of tech should give it fresh legs for its next run. Buy.