SSB FDRY: Negative Pre-Announcement Not altogether Surprising
BUY (1)
High Risk (H)
Mkt Cap: $1,239 mil.
April 12, 2005 SUMMARY
* Foundry preannounced its 1Q05 earnings citing rev will fall short of its guided range of $100MM to $110MM, coming in at about $84MM with EPS in the $0.06 to $0.07 range. We were modeling EPS to be $0.11 on $105MM in rev.
* Foundry's comments on the shortfall fall in line with the commentary we received in our most recent VAD/VAR field checks.
* Mgmt is blaming the shortfall on continued softness in sales to the Federal government, and a general slowdown in the North American market.
* We think June Q strengthens; we are not throwing in the towel on the sector.
* We are modeling Foundry's 2Q05 revenue to rebound and be up 9% seq.
* We are lowering our TP to $11.00 to reflect relatively stable target multiples on lower '06 ests. Currently trades in aftermarket at $8.76, for an ETR of 25.6%.
* FDRY generated $39MM in cash in the Q. With $4.33/shr in cash on its BS, its P/E excl cash is about 8-9X CY 05 earnings even after the earnings shortfall.
FUNDAMENTALS
P/E (12/05E) 25.0x
P/E (12/06E) 16.2x
TEV/EBITDA (12/05E) 9.7x
TEV/EBITDA (12/06E) 6.0x
Book Value/Share (12/05E) $4.91
Price/Book Value 1.8x
Revenue (12/05E) $372.3 mil.
Proj. Long-Term EPS Growth 20%
ROE (12/05E) 7.3%
Long-Term Debt to Capital(a) NA
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (4/12/05) $8.76
Rating (Cur/Prev) 1H/1H
52-Week Range $18.35-$8.50
Target Price (Cur/Prev) $11.00/$14.00
Shares Outstanding(a) 141.5 mil.
Expected Share Price Return 25.6%
Div(E) (Cur/Prev) $0.00/$0.00
Expected Dividend Yield 0.0%
Expected Total Return 25.6%
OPINION
Pre-Announcement Not Altogether Surprising Given Our VAD/VAR Field Checks
Results. We Think End Mkt Slowdown Is Temp However And Expect June To Be
Solid.
Foundry announced it will miss its guided range for 1Q05 revenue to be $100
million to $110 million. The company said it now expects revenue to be $84
million with EPS of $0.06 to $0.07. Management is blaming the shortfall on the
persistent slowdown in business from the federal government vertical and a
general softness in North American.
This commentary foots almost exactly with the commentary we received in our
recent U.S. VAD/VAR field surveys, which cited a slowing end market in the
months of February and March. We initially called out Enterasys and Foundry as
two of the companies which could have more seasonally normal CY1Q results vs.
the strength that was forecasted, based on the slowdown we were seeing. For
Foundry specifically, the lack of a new product cycle, their orientation to the
bread and butter segments of the networking market and underexposure to the
hottest areas enterprise spending; Layer 4-7 switching and Security made them
particularly vulnerable to the slowdown. To be clear, we believe this sluggish
end market conditions in the U.S. is temporary and we are not throwing in the
towel on the space. We think the general market will strengthen in the June
quarter, and as a result, we are modeling Foundry to rebound by its top-line by
9% sequentially, however, this seems a small consolation after the sharp 20%-
25% decline in product sales in the current quarter.
Mgmt Commentary Falls In-Line With Commentary From Our Latest VAD/VAR
Field Checks Which Indicated U.S. Data Networking Closures Did Not Accelerate
As Much As Expected In March. In our last round of extensive field interviews
with U.S. data networking Value-Added Dealers & Resellers (VAD/VARs) we were
unable to confirm the positive comments on demand made by some of the
networking chip suppliers and contract manufacturers. With roughly 50% of the
quarter typically closed in the month of March, the softer conditions, which
became evident in February, and appear to have continued in March. In the
latest round of conversations, our contacts generally voiced frustration with
the continued strong activity rates but closure rates below previous
expectations. In aggregate, it appears March closures did accelerate over
February, but more in the 5%-10% range than in the 10%-20+% range that was
expected. As a result, we believe the VAD/VARs had a sequentially slightly
down rather than slightly up quarter as previously anticipated. Coming into
the quarter, the VAD/VARs were looking for quarterly revenues to be flat to up
5% and they were still calling for this at the end of February, but by the end
of March we were hearing expectations of flat to down 5%.
Lowering Estimates To Reflect Pre-Released Numbers. We are lowering our March
quarter revenue estimate from $105 million to $84 million, in line with
management's new guidance on the quarter. We left our R&D and G&A estimates
in-line with our previous estimates and lowered our S&M estimates some,
resulting in an EPS figure of $0.06, down from $0.11. For 2005, our revenue
estimate goes from $452 million to $372 million with EPS now coming in at $0.35
as opposed to $0.51. We are also lowering our 2006 and 2007 estimates to
reflect similar growth expectations, albeit on a lower 2005 base. We now have
2006 and 2007 revenue estimates of $448 million and $535 million, respectively,
with EPS of $0.54 and $0.63. Our old revenue estimates for 2006 and 2007 were
$540 million and $647 million, respectively, with EPS of $0.63 and $0.74.
Lowering Target Price To $11.00. We are lowering our target price on Foundry
from $14.00 to $11.00. We value Foundry on a P/S and P/E basis. This
reduction in target price is due largely to our lowered sales and earnings
estimates for the company in the out years. Given our growth assumptions have
not changed much for the company, our target valuation multiples also did not
meaningfully change.
VALUATION
Foundry is selling at just under $9 per share with $4.33 per share in cash on
the balance sheet and earnings of roughly $0.35 per share. This implies
roughly an enterprise valuation of a scant 8-9X 05 earnings.
Our price target for FDRY shares is $11 and is based a multiple of 20x our
$0.54estimate for CY06. Based on our analysis, the data networking vendors
trade in the range of 10x and 35x our CY06 EPS estimates, with the mean
multiple at 20x. Our target P/E multiple is inline with the group average.
Our previous target price was $14. Our target price is now lower largely due
to our lowered EPS estimate for 2006.
Our P/S analysis produces the same price target of $11.00 per share based on a
price-to 2006E sales multiple of 3.5x. Based on our analysis, the data
networking vendors trade in the range of 0.4x and 5.6x our CY06 revenue
estimates, with the mean multiple at 3.0x. Despite our concerns with the
overall Layer 3 networking market, we still consider Foundry to be one of the
top companies in data networking, with some of the richest operating margins
and revenue per employee metrics of any of the companies in the sector, and
believe it justifies a premium valuation to the group on a P/S basis. Our old
target price on Foundry was $14. We are lowering it largely due to the lowered
sales estimate for 2006.
RISKS
We consider Foundry to be High Risk because it is a high beta technology stock
that has exhibited significant market price fluctuations. We think the most
significant near-term risks include the possibility that a pickup in U.S.
enterprise demand does not materialize, possible demand weakness in Europe and
Japan, the potential for a rollover in the company's federal government
vertical, the fact that Foundry competes against Cisco, a much larger
competitor with a broader product line, and the risk that operating margins
could continue to trend down. Foundry has significant exposure to the federal
government vertical, which tends to have lumpy order patterns. While we
believe the company's pipeline of federal business continues to be solid, the
lumpy order patterns typical of that vertical could potentially have a negative
impact on a quarter if orders were to suddenly fall off. Another risk comes
from management's history of trying to carefully manage investor expectations
and the possibility that the tone of their public communication could dampen
investor enthusiasm even as business potentially accelerates. Finally, Foundry
has recently launched a number of new product lines and there is risk that one
or more may not be accepted in the marketplace. If the impact on Foundry from
any of these factors proves to be greater than we anticipate, it may be
difficult for the stock to attain our target price.
INVESTMENT THESIS
We rate Foundry Networks 1H (Buy, High Risk). After eight quarters of strong
growth Foundry appears to have stumbled with three of the last four quarter of
disappointing revenues and earnings, coupled with a somewhat weaker economic
backdrop. The company did however provide a solid near term strategy of
building in operating scale and leverage in order to support future revenue
growth and margin expansion. We continue to believe the economic backdrop is
strengthening meaningfully, albeit slower than our original expectations, and
this should help the company going forward, especially considering its multiple
new product launches. With the stock well off its highs and trading at
historically low multiples we are recommending the shares.
COMPANY DESCRIPTION
Foundry Networks is a manufacturer of next-generation networking equipment
providing end-to-end Ethernet and intelligent traffic-management solutions.
Foundry's products include Internet routers, Layer 3 LAN switches, and Layer 4-
7 web switches with integrated Internet traffic and content management. The
company has more than 7,000 customers worldwide, including enterprises,
Internet-based businesses, Metro Area and Internet service providers,
government agencies, and other institutions.
I, Alex Henderson, |
