Our Verdict on This Key Cloud Industry Player

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Our Verdict on This Key Cloud Industry Player

Welcome to another round of C.H.A.O.S.!

Before we get started, if you missed my last column, my C.H.A.O.S. Strategy finally uncovered its first 85-pointer with haptic technology firm, Immersion Corp. (IMMR).

If you didn’t miss it, I hope you took advantage, as shares are up around 4% since last Friday’s close.

If you don’t know what C.H.A.O.S. is, you can get up to speed here.

But here’s the short version: It’s my no-holds-barred strategy for evaluating the fastest-growing, most disruptive technologies and tech companies.

I assess a company’s investment merit on five critical metrics. Each category is ranked out of 20, resulting in an overall maximum of 100 on the C.H.A.O.S. Meter.

Anytime a company scores 85 or better, it signals an immediate “Buy.”

So does today’s company make the grade?

Cloudy . . . With a Chance of Profits

It’s been a busy week for the cloud computing industry.

Data storage firm, Rackspace Hosting, Inc. (RAX), smashed a homerun on its earnings report, sending the stock up 15%.

And JP Morgan Chase (JPM) reiterated its “Buy” rating on cloud-based digital advertising firm, Criteo (CRTO). JPM also set a $44 price target, sending Criteo shares towards the company’s October 2013 IPO launch price.

Speaking of IPOs . . .   tomorrow marks another big moment for the cloud industry when on-demand customer service provider, Zendesk, goes public.

It will be the first Bay Area IPO in over a month, as weak investor sentiment has delayed several new launches recently, including cloud storage firm, Box.

While it’s obviously too soon for Zendesk, I’m feeding off the industry buzz this week by running fellow cloud firm, Polycom, Inc. (PLCM), through C.H.A.O.S.

Based in San Jose, Polycom is an under-the-radar, cloud service provider that facilitates solutions for voice, video and content-sharing for mobile apps, teleconferences, video conferencing and office-based platforms like Microsoft Lync.

Let’s see how it holds up . . .

~Cash

Polycom had a mixed first quarter. At the end of March, the company reported earnings of $0.18 per share, beating the consensus estimates by $0.03.

However, compared with Q1 2013, its revenue saw a small decline. And with its costs nudging slightly higher, net income dropped by 2%.

On the bright side, though, Polycom’s current quick ratio is 2.11. Remember, the quick ratio measures a company’s short-term liquidity by evaluating its liquid assets against liabilities. When a company has a quick ratio of 1.0, its liquid assets-to-debt ratio is 1:1. Meaning, both are equal. So the company can cover its debt, but won’t have any money left over. The higher the ratio, the better – and 2.1 is pretty healthy.

As you can see, Polycom’s revenue and profits rise steadily until 2012 and 2013, when revenue inches down and profits fall considerably.

So what’s up?

Well, for starters, Polycom’s operating expenses have nearly doubled over the last five years. So profitability has taken a hit.

In terms of liabilities, Polycom has $247 million in outstanding loans.

Let’s put that in perspective: In 2013, Polycom generated approximately $168 million in cash flow from its operations, $84 million of which went straight to its creditors.

Now, debt is never a good thing, as it heightens a company’s vulnerability during downturns and can affect its ability to raise cash and get loans. But as I noted, Polycom can cover its liabilities twice over and has proved that it can manage its debt.

It has a solid history of beating earnings, too – with 13 wins versus three losses over the last four years. And its consensus guidance is up through 2017 – to similar levels when the company’s shares were around $30.

If it can beat those higher estimates, the stock could currently be very undervalued.

C.H.A.O.S. Meter: 15/20

~High Impact

Polycom is a global communications leader. In fact, you could say that it’s a driving force behind many of today’s “long-distance relationships,” since its technology helps connect people through audio, video and other digital content.

The company’s solutions are powered by its “RealPresence” software and application programming interfaces (APIs) that give high-definition, cloud-to-device (smartphone, desktop app, web browser, etc.) connectivity and face-to-face video conferencing in homes, offices and on the go.

Indeed, its RealPresence CloudAXIS Suite has won industry awards, such as the Network Innovation Award and the Edison Award for Innovation in Media and Visual Communication.

While Polycom doesn’t exclusively sell cloud-based products, its recent strategy has focused around cloud-related products and services. Its core technology is defined as “enablement technology,” which makes teleconferencing through cloud networks possible.

While Polycom’s “video-as-a-service” (VaaS) solution might not be a game changer in the consumer marketplace, with applications like FaceTime and Skype dominating, it does leave an impression in the enterprise market . . .

For example, like Microsoft Office’s 365 cloud services do, it quickly connects people over multiple platforms. It helps save customers money, too, since they’d otherwise have to build their own cloud infrastructure.

Outside of its comprehensive “CloudAXIS Suite,” Polycom also integrates its video conferencing solution within other popular instant communication programs like Microsoft Lync.

C.H.A.O.S. Meter: 15/20

~ Acceleration

Polycom’s future acceleration is haunted by previous indiscretions . . .

In July 2013, then-CEO, Andrew Miller, was forced to resign over accounting irregularities. Because of his actions, Polycom faces:

• An SEC Investigation: Following Miller’s departure, the SEC investigated Miller’s expenses. It’s still ongoing, and Polycom is cooperating.

• Lawsuits: In July 2013, a shareholder filed a class-action suit against Polycom and some of its current and former officers, alleging that Polycom issued false and/or misleading financial statements. Polycom is also dealing with derivative lawsuits against its current and former executives. One was dropped in February, but the company is still battling another one, which alleges breach of fiduciary duty, failure to maintain adequate internal controls, and the authorization of false and misleading statements.

In addition, no insiders have bought shares in over a year, yet plenty have sold.

However, among Polycom’s institutional holders, George Soros recently picked up 9.4 million shares.

And under new CEO, Peter Leav, the company is charting a new course. Leav has strong leadership experience, having previously worked at Cisco (CSCO) and Motorola (MSI). Polycom also just hired a new Executive Vice President of Worldwide Engineering.

So it’s out with the old (and shady), and in with the new. Investors are taking notice, too…

Since the end of July 2013, shares are up over 29%. And with that, analysts’ price targets on Polycom are also rising . . .

• UBS (UBS) and BMO Capital Markets both boosted their target prices to $13 – up 5.7% from today’s price.

• SunTrust (STI) and Zacks have set a $15 price target – a rise of 22%.

• Citigroup (C) upgraded Polycom from “Neutral” to “Buy,” with a price target of $16 – up 30%.

• Goldman Sachs (GS) bounced Polycom’s valuation to $17 – 38% higher than today.

This is positive news, but the ongoing lawsuits are concerning. Management has an “unspecified amount” allocated for damages, but it can’t yet determine the potential hit if the judgments go against the company.

And while Polycom does have $530 million in cash, this is a troubling potential obstacle.

C.H.A.O.S. Meter: 12/20

~Orders

Polycom gets its orders from a host of household-name partners. First, through service providers like Microsoft (MSFT), IBM (IBM), BroadSoft (BSFT) and Cisco, among others.

Many of these companies have their own communication products and services, into which Polycom combines its video conferencing technology.

It also has a global network of distribution partners, like AT&T (T), Digital China Holdings (DCHIY), ScanSource Communications (SCSC), Dimension Data Holdings and NETXUSA.

Although Polycom is a global firm – and therefore has a diversified revenue stream – its order-acquisition strategy is still sensitive in many ways.

For example, it relies too heavily on revenue from some of its partners. Like ScanSource.

In 2013, ScanSource made up 16% of Polycom’s total net revenue. If it lost this business, Polycom would take a big hit.

Factor in that this is a highly competitive, constantly evolving space, and the risk is heightened. Partnerships come and go all the time. In fact, it’s happening right now…

For example, Polycom recently reported that Cisco will no longer sell Polycom’s IP conference phones, reducing 2014 revenue by around $40 million, compared to 2013.

Also, 57% of Polycom’s 2013 revenue came from overseas markets. So currency fluctuations could affect revenue and growth expectations.

However, Polycom is finding creative ways of generating business . . .

It recently established “Polycom Capital,” which offers financing options to its partners to help increase the lifespan of business deals.

This strategy should help boost quarterly numbers . . .  or at least help even them out.

C.H.A.O.S. Meter: 13/20

~Scalability

To scale its business, Polycom will need to focus on the following growth drivers . . .

• Cloud Security: As the online universe continues to be at risk from hackers, identity thieves and government agencies, Polycom can grow tremendously by making its cloud network communications ultra-secure… both now and in the future.

• “Work From Home” Market: This is a huge market – and following one of the worst job markets since the Great Depression, a market that’s growing every year. Polycom is looking to expand into it (and many government telecommuters, too).

• On-Demand Services: In our on-demand, instant gratification society, Polycom stands to benefit by incorporating its technology for companies looking to increase engagement with their audiences.

As mobile devices continue to proliferate – especially in emerging markets – and video communication evolves as the method of choice for both consumers and enterprises, Polycom is at the forefront of this trend.

With over 290 U.S. patents and 290 non-U.S. patents (plus 120 pending U.S. applications and 220 foreign applications), Polycom is serious about maintaining its advantage.

C.H.A.O.S. Meter: 17/20

OVERALL C.H.A.O.S. RANKING: 72/100

Final Verdict: While Polycom’s former CEO and other executives did the crime (allegedly), its stock and shareholders have done the time.

But the company is bouncing back. Shares are up 30% over the past year, and my research indicates that shares are headed higher still. A host of analysts and George Soros think so, too.

But keep in mind, Polycom’s full recovery isn’t going to happen overnight. And the company isn’t going to wreak chaos, either.

However, there are plenty of positives ahead, thanks to its impressive technology that’s used around the world and integrated into products from trusted names like Microsoft, IBM and Cisco.

Plus, it’s at the forefront of a proven growth trend (cloud computing), that’s only going to grow from here.

Consider grabbing a few shares on any weakness and treat it as a long-term play.

Your eyes in the Pipeline,

Marty Biancuzzo

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