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Small-Cap Spotlight: Ceragon

Frank and Larsen take sides on this wireless infrastructure play.

This week, Larsen and Frank take a look at Ceragon Networks (CRNT) - Get Ceragon Networks Ltd Report, a small-cap company that has staked its claim in the fastest-growing area of wireless infrastructure.

Over the past six months, shares of Ceragon rocketed to over $20 from $6, but have pulled back recently to around $16.50. It is unclear whether the pullback has created an opportunity to buy or signals a longer decline.

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When analysts stop pumping this stock, it'll be an opportunity for long-term investors

High-growth names are always volatile. Whether you're investing in

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, it's important to not lose sight of the potential in a good company with strong growth and significant long-term opportunities.

Israel-based Ceragon is another high-growth name that provides some of the key equipment that goes into wireless infrastructure, creating long-term potential based on the continuing growth of next-generation wireless networks.

Even though Ceragon is a small company, with a market cap of under $600 million, it has surprising global reach, with 34% of revenue coming from North America, 28% from Asia Pacific/Latin America, and 38% from operations in Europe, the Middle East and Africa. This gives the company the opportunity to provide equipment for capacity upgrades in developed markets as well as new network construction throughout emerging markets.

In particular, India represents a huge opportunity for the company. Ceragon's relationship with its largest customer,


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affords the company access to the country's rapidly increasing wireless subscriber growth. In early July, Nokia made a major push into India as its joint venture with



scored a big win by securing a $900 million contract from Bharti Airtel, India's largest wireless operator. Nokia is one of Ceragon's biggest customers, accounting for 17% of revenues in 2006.

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Until recently, Ceragon flew under the radar screens of most investors due to its small size and limited expectations for wireless infrastructure spending. But the market has started to realize the company's huge potential based on its work in an area of wireless known as "backhaul," which is the specific portion of a wireless network where data is transferred from a cellular base station to the switching stations that direct the data traffic onto the larger network.

The advent of next-generation wireless networks has increased the speed at which users can send and receive data to the point where existing networks require additional backhaul capacity to function smoothly. As a result, Ceragon's recent financial results have been impressive.

The company logged 47% revenue growth in 2006. Sales are expected to grow another 40% in 2007, according to mean analyst estimates, with earnings almost doubling to 46 cents a share from 24 cents. Going forward, revenue growth is expected to moderate (not at all unusual for the fast-growing companies we look at), but management comments over the summer indicate that Ceragon's addressable market should grow 25% each year through 2010.

Seasoned investors know that market sentiment often plays a major role in the movements of a high-growth, speculative stock like Ceragon. Not surprisingly, shares surged from April to early this month as waves of bullish reports on the company came from investment banks and research firms.

While many companies of similar size have a couple of analysts who issue a report every month, Ceragon had no fewer than seven firms providing positive updates on an almost-weekly basis. With sentiment seemingly at an all-time high every week during this period, investors face some difficulty in finding a good entry point. The opportunity has finally arrived, as three research firms downgraded Ceragon in the past week, leading to a 25% decline in the share price since the Oct. 2 close of $21.78.

The reasoning behind the downgrades is understandable -- the company announced a proposal for a secondary offering of 6 million to 6.9 million shares, which is generally a negative for a company due to its dilutive effect on earnings per share. However, for a small company, a secondary has its bright side in that it raises money, giving the company more financial flexibility going forward. Ceragon's balance sheet is very solid, with no debt and more than 86 cents a share in cash and equivalents, according to its most recent 10-Q filing.

Another issue that caught analysts off guard (and in case you're not aware, analysts


surprises) was the revelation that competitor


is alleging that Ceragon has been using its intellectual property. Although Ceragon does not believe it violated NEC's patents, the company offered $450,000 to NEC and the opportunity to cross-license a patent that Ceragon has applied for.

Because NEC is much larger than Ceragon, this move may be nothing more than the litigious version of playground bullying. Nevertheless, this issue creates an overhang for the stock that will not lift until the two companies resolve their differences.

In the end, investors need to evaluate each situation based on a combination of the risk/reward profile and current expectations in the market. For Ceragon, the stock's decline over the past week indicates a strong shift in sentiment, but also serves as a buying opportunity for investors focused on the long-term picture. WiMax and other next-generation wireless technologies will continue to proliferate worldwide, in part due to the more attractive cost profile vs. laying fiber-optic cable, especially outside of major urban areas, and Ceragon will benefit.

Curzio: Unfavorable Risk/Reward

Ceragon has been a great performer for investors -- up 200% on the year -- due to favorable business trends in the global backhaul market. As Larsen mentioned, financial results have been impressive, but the company faces headwinds that could pressure the stock going forward.

Breaking down revenue, 14% of Ceragon's first-half 2007 sales are from Nokia Siemens Networks (NSN), the 50-50 joint venture formed in June 2006 between Siemens AG and Nokia's network business group. Siemens is a direct competitor of Ceragon's, and channel checks by analysts suggest that NSN could begin to manufacture products in-house, which would be a severe blow to Ceragon.

Also, while I agree that its partnerships with Nokia strengthened Ceragon's sales channels, as was evident in the strong guidance management offered last quarter, it has come at the expense of margins. In its latest quarter, the company's gross margins were 36%, lower than the 40% average rate that the company reported from 2003 to 2005.

As Larsen mentions, the company has seen numerous downgrades over the past week, mostly due to the proposed share offering, which will increase shares outstanding by 6.9 million and decrease shareholder value. But more important, Ceragon is asking for shareholders' approval to increase its share count to 60 million from 40 million.

Today, the company has only 28.7 million shares outstanding, so we could see a follow-up to the follow-up offering of 6.9 million (6.9 million plus 28 million) just to get to the 40 million. Also, the company has not announced its intentions on what it will do with the cash, creating additional uncertainty.

Last, Ceragon's possible intellectual property infringement against NEC is another risk that can't be overlooked. It seems that cases like this get filed by or against tech companies on a weekly basis, but the fact that Ceragon is making an offer to pay NEC raises a red flag. NEC is still reviewing the proposed offer, but common sense suggests that a first offer is rarely accepted and some kind of royalty arrangement may be required.

Looking at valuation, the company is projecting long-term earnings growth of 25%. While this is considered a respectable rate of growth, shares are trading at 31 times 2008 EPS estimates, according to Capital IQ. This does not include dilution from the 6.9 million offering mentioned above. Analysts speculate the dilution could reduce EPS by as much as 10 cents a share, which would essentially drive the price over earnings north of 40 times.

Ceragon has done a great job establishing itself as key player in the WiMax industry, but most of this is already reflected in the stock price. With the numerous headwinds mentioned above, I would use the opportunity to take profits in this winner. The reward does not justify the risk.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Ceragon Networks to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.