CoSine Communications (BUY)
INITIATING COVERAGE - ADDING LIFE TO THE CLOUD; 12-MONTH
PRICE TARGET $75
SUMMARY
CoSine Communications has created the first platform for delivering a
complete suite of IP-based services from within a Service Provider’s network.
Internet Protocol (IP) services provisioned from the network greatly simplify
the deployment of and reduce the cost of services for both the Service
Provider and the enterprise, services such as firewalls, traffic encryption and
intrusion detection for IP Virtual Private Networks (VPN). Customer Premise
Equipment solutions prove to be difficult to implement, manage and scale.
Relative to other network-based solutions, in our opinion, CoSine possesses
a significant technological lead by being the first to market with an
architecture purposefully designed for delivering value-added services to a
large number of users from the edge of the network. Carriers that have
deployed the CoSine platform include Qwest, Aduronet, Broadband Office,
and Internet Initiative of Japan (IIJ), with testing active at a number of other
carriers.
The company is well positioned to capitalize on a rapidly growing market. All businesses seek to harness
the productivity and efficiency benefits of data communications, and more specifically, the Internet, as
evidenced by forecasts for traffic growth and numbers of connected enterprises. However, corporations’
security requirements combine with service providers’ need to offer services beyond basic Internet
connectivity to set the stage for a transformation in how businesses transmit data securely. Emergence of
these powerful drivers coincides with the commoditization of bandwidth at the core of the network,
prompting carriers to increasingly spend their valuable capital in areas that will yield the greatest return on
investment. Thus, capital expenditures are increasingly migrating to the access portion of the network, a
market where carriers have the opportunity to offer value added services, differentiate themselves, and thus
achieve a competitive advantage that goes beyond just price. CoSine is positioned at the epicenter of this
market, which is estimated to grow to $7 billion by 2004.
We expect CoSine to achieve better than 100% compound annual growth through 2002. CoSine had its first
quarter of recognized revenues in March of this year, recording $3.5 million in sales. We are forecasting
$36.4 million for 2000, growing to $85.6 million in 2001, and $152 million in 2002. Longer term, we expect
CoSine to achieve gross margins and operating margins in the 60% and 20% range, respectively. For 2000,
we are estimating gross margin of 50%, expanding to 60% by 2002. The current break-even time frame is
Q1 2003, however we would anticipate this target to come forward should customer acceptance of CoSine’s
platform accelerate and the company subsequently exceed our revenue growth forecasts.
We rate CoSine a buy with a twelve month price target of $75 representing 60% appreciation potential. This
represents a multiple of 51 times 2001 revenues. While this is at the high end of the 20-60 range in which
its peers trade, we believe the company’s significant revenue ramp will allow it to grow into its valuation.
CoSine brings a new technology to a new market, thus making it difficult to assess the premium investors
will be willing to pay for CoSine shares. However, CoSine’s IPO performed well, pricing at $23 and closing
on its first day at $63 but has since been caught in the general tech sell-off. Leading technology in a rapidly
growing market however, should drive further appreciation and sustain a premium valuation. Furthermore,
given the recent weakness in CoSine shares, we believe this is a good entry point for investors.
INVESTMENT THESIS
Capitalizing on a growing market.
As bandwidth in the core of the network becomes increasingly commoditized with the emergence of IP as a
low cost protocol, carriers are looking to spend their valuable capex dollars in areas that will yield the
greatest return on investment. Thus, spending is increasingly migrating to the access portion of the
network, a market where carriers have the opportunity to offer value added services, differentiate
themselves, and thus achieve a competitive advantage that goes beyond just price. CoSine is positioned at
the epicenter of this market which is estimated to grow to $7 billion by 20004.
Compelling economics: a new model for service delivery.
The CoSine solution revolutionizes the way IP services are delivered by being the first to market with a
platform that moves deployment from the customer site and into the Service Provider’s network. This model
offers significant cost and efficiency benefits both to the Service Provider and as the enterprise. CoSine’s
IPSX 9000 replaces, and thus removes the costs associated with, the numerous pieces of CPE that are
currently required to deploy IP services. Network topology for the enterprise as well as the Service Provider
is greatly simplified, reducing management costs and improving network efficiency. Finally, the CoSine
solution was designed as an open platform, stimulating the creation of new services by third parties and
thus removing the risk of being trapped in a proprietary prison.
Ahead of the competition.
CoSine’s solution integrates super-computing processing power, routing functionality, and an open software
architecture to create a platform from which a service provider may deliver value-added services to enterprise
customers. Most vendor solutions for IP VPN service delivery still rely on CPE, and those that claim to offer
a service provider-based solution still lag CoSine in terms of functionality and breadth of available services,
and rely on proprietary applications. We believe that this early lead will allow the company to establish a
strong foothold in the IP services market.
Strong management team.
The five-person team has more than 70 years of combined experience in the telecommunications space in
areas such as ASIC development, super computer architecture, and data networking. Each has held senior
positions at firms such as Ascend Communications, Silicon Graphics (SGI/$4.38/Market Performer), IBM
(IBM/$94.75/BUY), and Nortel Networks (NT/$68.31/BUY).
EARNINGS OUTLOOK
We expect CoSine to achieve better than 100% compound annual growth through 2002. CoSine had its first
quarter of recognized revenues in March of this year, recording $3.5 million in sales. We are forecasting
$36.4 million for 2000, growing to $85.6 million in 2001, and $152 million in 2002.
We expect the near term revenue stream to come mainly from the IPSX 9000. Longer term however, we
believe a greater percentage of total revenues will come from the sale of new processing and interface line
cards, as well as revenues from either in-house or third party applications and services sold by service
providers to enterprises.
Longer term, we expect CoSine to achieve gross margins and operating margins in the 60% and 20% range
respectively. For 2000 we are estimating gross margin of 50%, expanding to 60% by 2002. The current
break-even time frame is Q1 ’03 but we expect this target to come forward as the company exceeds our
conservative revenue growth forecasts.
We expect significant upside to our conservative 2000 and 2001 estimates. CoSine has already secured a
backlog of $18.3 million from Qwest and $20.6 million from Aduronet, as well as undisclosed amounts from
Broadband Office and Internet Initiative of Japan (IIJ). Customers in the sales/evaluation phase include PSI
Net, Flashcom, RCN, and Yipes for the U.S. Internationally customers testing CoSine’s solution include
Telenordia, Cegetel, and France Telecom (FTE/$89.13/Market Performer) in Europe and NTT
(9613.T/Market Underperformer), Nissho, and Singtel in Asia. The insatiable need for value-added data
services and the subsequent drive toward access build-out should generate healthy demand in the data
services and equipment market, a market in which we believe CoSine has secured a leading position.
(J.P. Morgan Securities Inc. acted as co- or lead-manager in an offering of securities for COSN, IBM, and
NT within the past three years. The analyst or research associate who covers IBM holds a position in that
stock.) |
