This structural growth stock’s sell-off looks overdone

But 5G – shorthand for the fifth-generation technology standard on which broadband cellular networks depend – is different. Complex, hugely data-generative and in need of constant upgrades, the demand for Spirent’s services was forecast to be constant, resulting in a decoupling of sales growth from the wider economy. 

On 4 January, analysts at Numis published a 23-page note titled “Why Spirent is now a structural growth stock”. The brokerage explained that 5G was much more complex, required multiple different vendors to set up and many upgrades over the coming years to reach its full potential. Because of increasing competition, Numis argued, telecoms companies would need to continue investing in 5G through any recession, or risk falling behind.

There was some evidence of this. In October, when economic forecasts were at their gloomiest, John Stankey, the chief executive of Spirent customer AT&T (US:T), said the long-term rationale for the US giant’s investments in 5G and fibre remained “fundamentally sound”, and committed to continued investments “through this cycle to support future growth”.

Weakness creates opportunity

This may have been true, but two weeks after the Numis note landed, Spirent acknowledged that “global market economic conditions have been impacting some of our customers, resulting in delays to their investment decisions”. The share price promptly dropped a fifth.

This drop seems like an overreaction. Spirent’s management used the same trading update to state that results were in line with market expectations, to reaffirm the strength of the order book and reiterate plans to keep investing in its technology across the portfolio. Given that orders were already at record levels, confirmation that orders climbed 7 per cent in 2022 (from a base of £270mn at the end of 2021) suggests customer momentum didn’t exactly evaporate in the final quarter.

Numis downgraded its forecast for Spirent’s 2023 earnings per share (EPS) by 10 per cent, but still believes a target price of 350p would better reflect the company’s exposure to long-term structural growth trends. Consensus EPS estimates are brighter and are now down just 3 per cent in the year to date, meaning Spirent shares are now priced on 15 times this year’s earnings. Meanwhile, Keysight (US: KEYS), one of Spirent’s biggest rivals, currently trades on a much pricier forward PE of 22.

5G driving growth

5G networks include the towers that transmit the radio waves, data centres to do the computing and the ethernet cables needed to get the data there. The system has changed a lot since the 2G days when telephone towers just facilitated phone calls. Nowadays, our phones are simultaneously used for complex computing processes and streaming. This increased complexity needs constant monitoring, and this is where Spirent makes its money.

Spirent’s business is split between its lifecycle service assurance division on the one hand and network and security on the other. The former tests 5G products’ proper functioning both before any network is rolled out and then on a monitoring basis after installation, to create a more constant revenue stream. The latter provides ethernet performance testing; as 5G develops, more data will be produced, which means more stress on the ethernet network.

In the six months to June, assurance revenue rose 10 per cent to $125mn and networks increased 9 per cent to $154.5mn, meaning the divisions are fairly evenly split. Both also boast stable gross margins at just above 70 per cent. The fact Spirent could maintain this level of profitability despite rising costs last year suggests the company has a degree of pricing power. This is expected given the essential nature of the product.  

To keep ahead of the competition, Spirent has been investing consistently to keep up with the developing telecoms technology. In the first half of 2022, product development costs hit $57.2mn, from $52.5mn in the same period in 2021. Although this led to a slip in the assurance division’s adjusted operating margin from 19.9 per cent to 17 per cent, the spending enabled the release of a new assurance product called Vantage. With £134mn of net cash on the balance sheet, there are plenty more opportunities for investment.

Prospective investors can be confident that the company has its finger on the pulse on this question: having started life in Crawley, the company’s operational headquarters are now in California. Its clients are largely based outside of Europe, with 55 per cent of revenue coming from the Americas and 35 per cent from Asia Pacific.

The lack of exposure to Europe is also a bull point, given European operators and their customers appear to have been hit harder by the cocktail of inflation, high energy prices and pricier debt. Vodafone (VOD), for example, has seen its German revenue falling, resulting in a markdown to free cash flow forecasts. AT&T, meanwhile, expects cash flow to increase by $2bn next year, and it plans to maintain capital expenditure at the same level.

While the promise around 5G has bubbled for years, the rollout has been slow. This is because it is expensive. While 5G can carry more information thanks to its higher radio wave frequency range, this results in a shorter range, meaning more hardware needs to be installed to get complete coverage. Currently, only 30 per cent of all operators globally have deployed initial 5G networks and only 3 per cent have installed the first major upgrades.

Pessimists would say that 5G champions have overpromised and that complete rollout will never happen. The flipside of this argument is that it leaves lots of room for growth. As greater numbers of phone applications incorporate AI models, and cars become increasingly connected, consumers and businesses are likely to seek and then demand faster communication speeds. Electric vehicle maker Tesla (US:TSLA) is already capable of rolling out software updates to its vehicles, but doing so requires super-fast connectivity.

According to Grandview Research, the 5G market was worth $60.6bn in 2022, and is expected to grow at a compound annual growth rate of 59 per cent until 2030. The research cited virtual reality, augmented reality and gaming as strong drivers. If Spirent can grow at half the speed of the wider market, then its current valuation is likely to prove cheap.

Risk of consolidation

There is a chance this growth doesn’t materialise. Telecoms businesses are struggling to maintain margins given rising costs and increased competition. Vodafone has been trying to consolidate its business by selling off subsidiaries in less profitable geographies, while pursuing a merger with Three in the UK. Meanwhile, on the fibre-optic side, BT (BT.A) is lowering prices to try to drive alternative providers out of the business.

If the future of the industry is one with a few big players, then they may have greater negotiating power over testing providers such as Spirent, although one assumes repeat longstanding customers are awake to the need to maintain good business terms.

Beyond the hypotheticals, what is known is that increased connectivity is needed and we are still far from a conclusive 5G rollout. As infrastructure investment continues to increase, so will Spirent’s profit growth. It is possible to have the odd cyclical and brief dip amid an extended period of secular growth.