ssb: fdry: Bad Quarter But Stock Too Cheap To Sell, Reiterate Buy Rating
BUY (1)
High Risk (H)
Mkt Cap: $1,311 mil.
April 21, 2005 SUMMARY
* Foundry reported 1Q05 results of $0.07 EPS on $84.6MM in revenue, in line with its pre-announced guidance.
* Revenue declined due to weakness in the Federal gov't vertical, which represented 17% of sales in the Q, down from 23% last Q and 28% in Sept.
* U.S. enterprise was also weak, down 14% seq. Japan however, was strong, up 17% seq. Def rev was down but B-B, surprisingly, was above 1.0 in the quarter.
* Due to a lack of business visibility, particularly into the gov't vertical, management ceased to provide guidance.
* Despite the disappointing qtr and lack of biz visibility, we believe shares of FDRY are now trading at deep discount valuations.
* With $4.63 in cash in its BS and given the stock has already traded much of the way back from its pre-announcement lows of $8.70, we think the stock has support at these levels with solid pot. for positive news flow going forward.
FUNDAMENTALS
P/E (12/05E) 28.1x
P/E (12/06E) 22.6x
TEV/EBITDA (12/05E) 10.6x
TEV/EBITDA (12/06E) 7.6x
Book Value/Share (12/05E) $4.88
Price/Book Value 1.9x
Revenue (12/05E) $364.1 mil.
Proj. Long-Term EPS Growth 20%
ROE (12/05E) 6.7%
Long-Term Debt to Capital(a) NA
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (4/20/05) $9.27
Rating (Cur/Prev) 1H/1H
52-Week Range $16.44-$8.50
Target Price (Cur/Prev) $11.00/$11.00
Shares Outstanding(a) 141.5 mil.
Expected Share Price Return 18.7%
Div(E) (Cur/Prev) $0.00/$0.00
Expected Dividend Yield 0.0%
Expected Total Return 18.7%
OPINION
Foundry Reported Earnings In-Line With Its Pre-Announced Guidance But Declined
To Give Guidance Due To Lack Of Biz Visibility. We Are Reiterating Our Buy
Rating On This Name Given Its Cheap Valuation And Potential For A Recovery In
2H05.
With the weakness in its end markets, which first became apparent in our
February and March quarter U.S. VAD/VAR surveys, and the further decline in
spending by the federal government, as it continues to divert funds towards the
war in Iraq, Foundry reported March quarter revenue down 19% sequentially, in
line with its pre-announced guidance. Deferred revenue declined by $2 million,
although book-to-bill was above 1.0 in the quarter. Additionally, due to a
lack of business visibility, particularly into the federal government vertical,
management declined to issue June quarter guidance. To reflect the company's
lack of business visibility, we trimmed our top-line and EPS estimates on the
stock. Despite the disappointing quarter however, we believe Foundry remains a
Buy rated stock, for four main reasons:
* It clearly has technical support at these levels, in our view. Prior to its
March quarter dour pre-announcement in which the company disclosed it would
miss numbers by a wide margin, Foundry traded at $9.45 (April 12th).
Subsequently, the stock traded down to $8.70. Since then however, in a short
time, the stock has rebounded nicely to over $9.00, indicating to us that
this remains a support level for this name. With $4.63 in net cash on its
balance sheet, representing more than half of its market valuation, we think
the downside risk to this name is limited.
* Potential positive catalysts on the horizon. On the conference call,
management explicitly stated it would be introducing new products over the
next three months at upcoming conferences; N+I (Las Vegas), SuperComm, N+I
Tokyo. One of the knocks on the Foundry story is the lack of new products in
the market place. With these trade show new product announcements, in
aggregate, two thirds of the company's core layer 3 switching strategy will
be introduced into the market, providing substantial new product into the
marketplace, serving as a catalyst for growth.
* End markets should recover, if not in the June quarter, then 2H05. While
Foundry's end markets were slow in the March quarter, both management, and
the feedback we received from our VAD/VAR field checks indicate that this
slowdown is likely a short-term phenomenon with a rebound taking place in
2H05. Should this take place, the convergence of a rebound in the macro
environment coupled with Foundry's new product introductions could lead to
some earnings surprises.
* Federal war budget to be put in place soon. The federal government exhausted
its war budget in the summer of last year. As a result, to fund the war, the
government has been taking funds from other portions of its overall budget,
including IT, which has hurt much of the data networking industry, especially
foundry with its 28% of revenue exposure to this vertical. With a new war
budget on the table, should it pass in the next two to three months as is
widely believed, this will provide the government with the necessary funds
for the war effort and reduce its need to divert funds from other areas of
its budget such as IT, which would bode well for Foundry.
REVIEW OF THE QUARTER
Revenue Down About 19% Q-Q With A Book To Bill Of Above 1. Business Was Weak
Across The Board With The Exception Of Japan. Foundry reported 1Q revenues of
$84.6 million, representing a 19% sequential decrease, roughly in-line with our
estimate of $84.3 million, and in-line with management's pre-announced
guidance. U.S. enterprise business was weak, down 14% as Foundry was hit
particularly hard by the March quarter slowdown in enterprise spending.
Federal government fell 40% sequentially as Foundry is now feeling the effects
of the shift in governmental spending on its war efforts and away from other
areas, including data networking.
Overall, U.S. sales accounted for 67% of revenue with international accounting
for 33%. Sales in the quarter to enterprises accounted for 80% of sales with
sales to carriers accounting for the remaining 20%. Stackables accounted for
28% of sales, up from 35% in the December quarter with Chassis based sales
accounting for 72%. 85% of the company's revenue were from Layer 2/3 switching
products and Metro Routing products while the remaining 10% was derived from
its layer 4-7 gear.
Figure 1: Foundry 4Q04 Revenues By Segment
($ millions, unless 4QA 1QE 1QA Pct. Change
otherwise noted)
U.S. Federal $24.1 $20.7 $14.4 -40.3%
% of total sales 23% 27.3% 17% -600bps
U.S. Enterprise $49.2 $39.0 $42.3 -14.0%
% of total sales 47% 43.5% 50% 300bps
Japan $9.4 $7.3 $11.0 16.7%
% of total sales 9% 10.0% 13% 400bps
Other International $22.0 $17.3 $16.9 -23.0%
% of total sales 21% 19.2% 20% -100bps
TOTAL $104.8 $84.3 $84.6 -19.2%
Source: Foundry Financial Reports and Smith Barney Estimates
Margins Decreased Mostly Due To Lower Sales Volumes. Total gross margins for
Foundry decreased 210 basis points from 64.4% in the fourth quarter to 62.3%
this quarter. The decrease was primarily due to lower overall sales due to the
soft end-market conditions. Sales in Chassis represented 72% of revenue versus
stackables which came in at 28% of revenue. This compares to last quarter in
which chassis accounted for 75% of revenue and stackables 25%. Sales in
chassis declined about 26% sequentially.
Foundry's Balance Sheet Remains Strong. Foundry, despite the disappointing
quarter, ended the quarter with $657 million in cash and short-term
investments. Cash flow generation (CFFO) came in at $32 million in the
quarter. The effect of exchange rate changes was about ($130K). Receivables
decreased by $35million during the quarter, in step with deferred revenue which
was also down about 2 million. DSOs decreased to 71 days from 80 days in the
December quarter, as a result. Finally, inventory turns decreased from 3.9x to
3.1x.
Adjusting Estimates To Account For Diminished Business Visibility. With
Foundry's government business falling to 17% of revenue from 28% of revenue in
the September quarter, due to the shifting of federal budgets towards Iraqi war
efforts, according to management, we are trimming our top-line estimates and
margins assumptions. We are now modeling Foundry to do $90 million in June
quarter revenue. We think the company will do $364 million in 2005 revenue,
and $424 million in 2006 revenue. We were previously modeling June quarter
revenue to be $92 million with 2005 and 2006 revenue at $372 million and $478
million, respectively. We also adjusted our model to reflect high OPEX and
slightly lower gross margins in light of this quarter's results and the
additionally clarity we gleaned into the company's cost structure at these
depressed revenue levels. We are now looking for June quarter EPS to be $0.08
per share with 2005 and 2006 EPS estimates now at $0.33 and $0.41. This
compares to our prior expectations of $0.09 in the June quarter and $0.35 and
$0.54 in the 2005 and 2006 time frames.
VALUATION
Our price target for FDRY shares is $11 and is based a multiple of 27x our
$0.41 estimate 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 22x. Our target P/E multiple is at a modest premium to the group
average. We think Foundry deserves a higher target multiple (old target
multiple = 20x) on this metric due to the heightened potential for positive
catalysts in the near to intermediate term. These included new product
announcements, an improving macro environment for data networking, and a new
federal budget.
Our P/S analysis produces the same price target of $11.00 per share based on a
price-to 2006E sales multiple of 3.7x. 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. We think
Foundry deserves a higher target multiple (old target multiple = 3.5x) on this
metric due to the heightened potential for positive catalysts in the near to
intermediate term. These included new product announcements, an improving
macro environment for data networking, and a new federal budget.
Near-term market volatility and short-term trading patterns may cause the
Expected Total Return to become temporarily misaligned relative to the hurdle
for this stock's fundamental rating, as defined under our current system.
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, the author of this report, hereby certify that all of the
views expressed in this research |
