EXFO Inc (TSX: EXF) develops smarter test, monitoring and analytics solutions for fixed and mobile network operators, webscale companies and equipment manufacturers in the global communications industry. The group is headquartered in Quebec, Canada. It provides communications service providers (CSPs) and data center, cloud and Web-scale operators with the field test, service assurance and analytics solutions to ensure the deployment, maintenance, and management of physical, virtual, fixed and mobile networks. The group provides a unique blend of equipment, software, and services to accelerate digital transformations related to fiber, 4G/LTE and 5G deployments.

Investment rationale

• Solid Liquidity Position: As on May 31, 2020, cash and short-term investments totaled US$20.5 million, while the company’s working capital was at US$31.6 million. The company believes that its cash balances and short-term investments, combined with available revolving credit facilities of up to US$39.7 million, would be sufficient to meet the company’s capital requirements for the foreseeable future. In addition to these assets and credit facilities, the company has unused available lines of credit of US$19.2 million for foreign currency exposure related to forward exchange contracts. Further, as on May 31, 2020, the company’s current ratio stood at 1.45x, which implies that it has adequate liquidity to cover its short-term obligation.

• Lucrative Valuation: From the valuation standpoint, in terms of LTM Price to Sales and Price to Cash Flow multiples, shares of EXF trading at a discounted valuation against the industry average. LTM Price to Sales multiple of the EXF stood at 0.82x, whereas industry average LTM Price to Sales multiple stood at 1.84x, which reflects a valuation gap of 55.4% against the industry average. Further, EXF is trading at and LTM Price to Cash Flow multiple of 22.3x, whereas industry average multiple stood at 38.58x, which reflects a valuation gap of 44.2%. Further, the group’s performance was decent, given the challenges arose because of COIVD-19 pandemic, with a strong balance sheet and solid liquidity to pass through the challenging times. EXFO develops smarter test, monitoring and analytics solutions in the global communications industry, and we expect the demand for the group’s offerings to increase as 5G deployment is likely to go on.

• Shares Traded Above Crucial Long-term Support Level: At the last traded price of CAD 5.21 (on August 11, 2020 market close), shares of EXF traded well above the crucial long-term support level of 200-day SMA of CAD 4.70. The price to 200-day SMA ratio stood at 1.11x, which implies that shares have traded approximately 11% away from its 200-day support level. A higher positive spread between 200-day SMA and Price is typically considered as a strong uptrend in the stock. Also, 200-day SMA is rising, which is another positive signal. Further, at the last closing price, EXF shares also traded above the short-term strong support level of 50-day and 30-day SMA, which is again supporting the long-term uptrend in the stock. Short-term moving averages have also increased significantly since late June and still soaring higher, which makes the momentum in the stocks stronger.

Moving Averages vs Price Performance. Source: Refinitiv (Thomson Reuters)

• Momentum Indicators reflect EXF Shares are hovering in a neutral Zone: Bollinger Band and RSI technical tools, which have been developed to generate overbought and oversold signals show that shares of EXF are hovering in a neutral zone. At the last traded price of CAD 5.21 (on August 11, 2020 market close), EXF shares traded near the middle band, which is a 20-day simple moving average price. Further, the Bollinger band is also squeezing; it happens when volatility falls to low levels and the band narrows. A volatility contraction or narrowing of the bands can foreshadow a significant advance or decline. Also, the leading indicator, 14-period daily RSI, hovers in a neutral region since the last 5 trading sessions.

Source: Refinitiv (Thomson Reuters)

• Risk Associated to Investments: The second wave of COVID-19 may hamper the demand of the product and supply chain of the group, which would affect the financial performance adversely. Further, the company is exposed to currency risk as a result of its export sales of products manufactured in Canada, China, France and Finland, the majority of which are denominated in US dollars and euros. 

3Q Financial Highlights

Source: Company Presentation (Q3FY20)

In the third quarter of fiscal 2020, sales narrowed by 10.1% on a YoY basis, driven by sales reduction of test and measurement (T&M) product line by US$4.1 million, or 7.5% year-over-year, mainly due to the global impact of the outbreak of the coronavirus. In particular, sales were negatively impacted in the Americas and the APAC regions for optical test and high-speed optical transport solutions, as ongoing constraints and preventive measures affected the group’s ability to ship the products and deliver services. The company also witnessed a pause in large-scale fibre installations with communications service providers mainly focusing on maintenance work during the peak of the pandemic. Sales of T&M product line were, to some extent, negatively affected by currency fluctuations on a YoY basis. However, the company made strong progress in China for the advanced equipment for labs and network equipment manufacturers (NEMs), mainly for 5G deployments, as China was the first region to re-open after the lockdown, and received large orders for copper test solutions in the EMEA region, which partially offset the overall year-over-year decrease in T&M sales in the third quarter of fiscal 2020.

During the quarter under review, sales of the company’s Service Assurance, Systems and Services (SASS) product line decreased by US$3.1 million, or 16.0% on a YoY basis. The YoY decrease in SASS sales is mainly due to the coronavirus outbreak as preventive, and lockdown measures worldwide prevented the group from closing a certain number of deals and from delivering products and services to customers during the quarter. In addition, sales of the company’s SaSS product line were, to some extent, impacted by currency fluctuations year-over-year.

In the third quarter of FY20, the group’s booking diminished by 15% on a YoY basis, driven by 7% slump in T&M Product line bookings and 33.9% slump in the bookings of the SASS product line.

Adjusted EBITDA came in at US$10.7 million, or 16.1% of sales, in the third quarter of fiscal 2020, compared to US$7.9 million, or 10.7% of sales for the same period last year.

Source: Company filings

Stock Performance

At the closing (on August 11, 2020), shares of EXF traded 0.95% lower against the previous trading session at CAD 5.21. Over the last year, its shares have tested a 52W high price of CAD 6.50 on January 07, 2020 and a 52W low price of CAD 2.91 on March 17, 2020 and at the last closing price, EXF shares have traded approximately 79.04% above from its 52W low price level and traded approximately 20% below its 52W high price level. This reflects that the stock is more tilted towards its 52W High price level.

1-year price performance (as on August 11^th, 2020, after the market close). Source: Refinitiv (Thomson Reuters)

Over the past three months, EXF shares have bagged approximately 54.14% and significantly outperformed the benchmark index by 41.12%. In a month over time, its shares added approximately 8.09% and outperformed the benchmark index by 3%. Also, on a YoY basis, the stock is posing a positive price return of 2.56%. These reflect a relative price strength in the EXF shares against the broader market.

Top-10 Shareholders

The top 10 shareholders have been highlighted in the table, which together forms around 42.08% of the total shareholding. Lamonde (Germain) and Fidelity Investments Canada ULC hold the maximum interests in the company at 15.27% and 5.46%, respectively. Further, four out of top-10 shareholders have increased their stake in the company over the last three months, with Fidelity Investments Canada ULC and 22NW, LP are among the top investors in the company that have increased their stakes by 1.18 million and 0.31 million, respectively. The institutional ownership in the SRX stood at 29.54%, and ownership of the strategic entities stood at 18.88% respectively

Source: Refinitiv (Thomson Reuters)

Valuation Methodology (Illustrative): EV/EBITDA Based Valuation Metrics

Note: All forecasted figures have been taken from Refinitiv (Thomson Reuters) 

Stock Recommendation

In the third quarter of FY20, the company made a strong progress in China for its advanced equipment for labs and network equipment manufacturers (NEMs), mainly for 5G deployments, as China was the first region to re-open after the lock-down, and received large orders for copper test solutions in the EMEA region. Further, despite challenging time the company had forecasted adjusted EBITDA of US$33 million for fiscal 2020 and set an adjusted EBITDA margin target of 15% of sales by the end of fiscal 2021.

EXFO develops smarter test, monitoring and analytics solutions in the global communications industry. Since most of the countries have started easing the restrictions and 5G deployment is likely to go on, we expect the demand for the group’s offerings to increase.

However, COVID-19 pandemic has been imposing ongoing constraints and preventive measures that have affected and are still affecting the global economy. Although constraints and preventive measures are progressively being relaxed in many countries, the breadth and duration of this pandemic are unknown and raise uncertainties that may impact the group’s sales and operating results, as well as the measurement of assets and liabilities in future periods.

Further, the technical trends are also  indicating a strong uptrend in the stock, as its shares traded above the short-term as well as long-term crucial support levels of 30-day, 50-day and 200-day and SMAs and moving averages are also edging higher, which is another positive trend in the stocks.

Therefore, given the above rationale, we have given a “Speculative Buy” recommendation at the closing price of CAD 5.21 (as on August 11^th, 2020), with lower double digit upside potential, based on the NTM Peer’s Average EV/EBITDA multiple of 10.30x on the FY2E EBITDA. We have considered Netscout Systems Inc, Anritsu Corp and Viavi Solutions Inc as a peer group for the comparison purpose.

*Recommendation is valid at August 12, 2020 price as well.

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