CLFD - Clearfield: Nestor Cables Causing A Problem

2023-04-14 06:09:33 ET

Summary

• Clearfield's growth rates are slowing down. And on top of this, management will now be removing its backlog figures.
• With significant uncertainty over the sustainable go-forward growth rates, investors are passing up on the stock.
• Clearfield's profitability doesn't inspire much optimism either.

Investment Thesis

Clearfield ( CLFD ), the fiber optic company, is expected to see its growth rates slow down. Furthermore, Clearfield's dropping its backlog figures is causing investors to eschew this stock.

The core issue here is that investors are struggling to figure out what's the sustainable growth rate for Clearfield.

Then, on top of that, Clearfield recently diluted shareholders to bolster its cash reserves.

Altogether, this poses a problem for the stock.

Why Clearfield? Why Now?

Clearfield provides fiber protection, management, and delivery solutions to the broadband sector. Essentially, Clearfield is a hardware company.

Clearfield saw explosive growth that culminated with the pandemic period of low-interest rates and cheap money. At the time, investors were not overly concerned about underlying profitability, as investors become obsessed with growth stories.

Today, as conditions normalize, the market is more discerning and more inclined to ask difficult questions. The times of buy first and ask questions later are gone. So, what does Clearfield now offer investors?

Revenue Growth Rates Are Slowing Down

There are two main considerations to keep in mind. In the first instance, it's abundantly clear that the revenue growth rates that Clearfield reported last year are meaningfully higher than this year. Put another way, there's a significant deceleration in its growth rates.

This means that it doesn't matter as much whether or not Clearfield reports 40% y/y growth in fiscal 2023. What matters here is what is the exit rate from fiscal Q4 2023 (quarter ending September) will be.

Secondly, investors are trying to figure out what's the sustainable growth rate of this business. Simply put, a company that just ended fiscal 2022 growing at 92% y/y and now is expected to grow in fiscal 2023 by around 40% y/y and then, looking ahead to the next fiscal year, starting October 2023, the company could be growing at 20% y/y, that's the growth profile of 3 very different companies.

Along these lines, President and CEO Cheri Beranek stated on the call :

As people are, as our customers align their inventory positions and their forecasts positions in regard to product alongside the labor conditions, we are seeing a bit of a bubble or perhaps even an inventory swell at this point in the market.

And so we think it is very much a - it is not a softening of the market and that demand is very high. It is an alignment of what is actually available with labor.

Essentially, Clearfield's end customers have too much inventory and they need to work through that excess inventory in the first instance before they return to purchasing more from Clearfield's Nestor Cables unit.

Profitability Profile Leaves Much to be Desired

In last year's fiscal Q1 2022, Clearfield's gross profit margins were very close to 50%. This time around, its gross margins dropped by over 1,400 basis points to just below 36%.

When asked on the earnings call, it was evident that Clearfield's recent acquisition of Nestor Cables was the main culprit for this deceleration. Management declared that Nestor Cables' gross margins in the current quarter were around 2.5%. But in time, by the summer months, Nestor Cables' gross margins will probably expand to the mid-teens.

And even though Clearfield reports very compelling GAAP profitability, nearly all of its profitability gets used up on building its inventory, which means that the business doesn't actually report any positive free cash flows, either in fiscal 2022 , or fiscal Q1 2023 .

The Bottom Line

The biggest problem with Clearfield is the uncertainty over the business. You have to form a very strong view of what the sustainable growth rate of the business is likely to be.

Then, you must have a view of when the business starts to report positive free cash flows.

All that being said, on a positive note, paying 2x forward sales for the business isn't that expensive, and with the share price already down more than 60% from its highs, I believe that a lot of this bad news is already factored in.

Nevertheless, allow me to state from experience, that cheap stocks can get a lot cheaper. Particularly once management starts removing their guiding metrics, such as disclosing their future backlog figures.

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