Individual Investor
Two 'Net Stocks Cisco Could Have Had
Alexander Yakirevich (5/8/00)
Networking giant Cisco Systems (NASDAQ: CSCO - Quotes, News, Boards) took yet another step in broadening its already diversified portfolio of communications technologies when it announced last Friday that it would acquire Acton, Mass.-based ArrowPoint Communications (NASDAQ: ARPT - Quotes, News, Boards) for $5.7 billion.
It's fair to ask what could have persuaded Cisco, arguably the savviest acquirer of young tech firms around, to pay a price that values ArrowPoint at several times more than the value set at its initial public offering a month ago.
For investors, a better question is: What does this deal do for the emerging segment of Internet traffic management systems. ArrowPoint, with a market share of 16.1%, is the third largest competitor in the market, and its acquisition by Cisco offers a good opportunity to look at two larger rivals, Alteon Websystems (NASDAQ: ATON - Quotes, News, Boards), which has roughly 35.7% of the market and F5 Networks (NASDAQ: FFIV - Quotes, News, Boards), which has approximately 30%, according to Robertson Stephens.
Alteon went public in September 1999, and it supplies switches, WebICs (application specific integrated circuits used to expand switch capacity) and Web traffic management software. The company's customers include such blue chip technology companies as IBM (NYSE: IBM - Quotes, News, Boards), Concentric Network, (NASDAQ: CNCX - Quotes, News, Boards), and Hewlett Packard (NYSE: HWP - Quotes, News, Boards) .
The principal function of the systems sold by ArrowPoint, Alteon and F5 is to monitor servers and so-called server farms, or collections of servers, and identify weak links vulnerable to failures and pinpoint the servers with the best response time. As requests come in from network routers, a switch sends traffic to a server that is able to process the signal in the most expedient manner.
Robertson Stephens says the Internet traffic management market is expected to reach approximately $1 billion within three years, although judging by the size of the ArrowPoint transaction, this forecast could be too conservative.
Judging from Alteon's latest quarter, the demand for the technology is clearly growing. The March 31 quarter was the third of the company's 2000 fiscal year, and revenue grew 65% sequentially over the December quarter to $28.2 million. The company also added 350 new customers during the quarter.
The strong revenue growth and a 170 basis-point sequential improvement in the gross margin helped cut the operating losses to $3.6 million in the third quarter from the $5.1 million posted in the December quarter.
Shares of Alteon dropped 6%, to $67, following Cisco's announcement, as investors doubted sustainability of Alteon's market leadership. However, we think that the sell off may be overdone.
"Cisco's entry into the Web traffic management space validates the market," says Mark Edelen of Thomas Weisel Partners. He also thinks that the opportunity will be large enough to accommodate several vendors.
Ara Mizrakjian, an analyst with Robertson Stephens, notes that Cisco will initially distribute ArrowPoint's products. However, it remains unclear when the company will be able to fully integrate ArrowPoint's technology to offer a bundled solution. As a result, Mizrakjian sees no "near-term market share erosion" for Alteon.
At 41 times trailing-twelve-month sales of $66 million, shares of Alteon look like a bargain compared with the multiple of 270 times Cisco offered for ArrowPoint.
One thing that F5 Networks shares with Alteon is that it is also well positioned within the Web traffic management sector. That's underscored by the company's client list, which includes MCI Worldcom (NASDAQ: WCOM - Quotes, News, Boards), Exodus Communications (NASDAQ: EXDS - Quotes, News, Boards), and PSINet (NASDAQ: PSIX - Quotes, News, Boards) . Besides Web traffic management, F5 also sells Web content synchronization technology, which allows enterprises with multiple locations to synchronize Internet content across the network.
F5 shares another trait with Alteon, in that demand for its products is also growing rapidly. In the March quarter, the top line expanded 527%, to $23.6 million, compared with last year and 23% sequentially.
Thanks to the stringent overhead cost control, the company posted operating income of $3.3 million in the quarter compared with the loss of $3 million registered in the same quarter last year. In the year ago quarter, F5 lost $0.45 per share.
The company generated net income of $0.18 per share in both the December and March quarters.
Shares of F5 also declined in the aftermath of the ArrowPoint acquisition, for the same reason that Alteon sold off. The stock fell 14%, to around $34. At 11 times trailing 12 month sales, we believe that the stock is attractively valued relative to ArrowPoint.
In the first hour of trading on Monday morning, Cisco, ArrowPoint, Alteon and F5 were all down, but the session began with negative impact of a cover story Barron's printed over the weekend that questioned Cisco's ability to maintain its growth and high market capitalization.
Alteon lost $2.25 to $64.75, while F5 fell $0.50 to $33.44. Cisco was off $3.25 to $64.50, and ArrowPoint was down $7.19 to $133.
Bottom Line:
Cisco's offer to acquire ArrowPoint certainly raised the profile of the Internet traffic management market, and it set a high price for technological know-how in the sector. Given their strong market shares and current operating momentum, Alteon and F5 should not be ignored for long.
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