RAymond James
" " We are initiating coverage of Ascend Communications with an ACCUMULATE (2) rating based upon superior earnings growth potential combined with an above average valuation comparison.
" " Ascend is a market leader in two fast growing sectors of the WAN data networking market, remote access servers and frame relay switches. Moreover, only modest market share gains in routers and ATM switches are required to induce significant added upside earnings potential over the next two years.
" " The stock is trading at a 20% discount to its growth rate whereas comparable companies in the sector are normally priced at P/E ratios equal to, or greater than, their projected growth rates. Accordingly, our 12-month price target of $64 implies a 20% appreciation potential. An upgrade to a BUY (1) rating could be justified at a lower stock price or with the materialization of a proven growth record in the company's nascent router and ATM business segments.INVESTMENT SUMMARY
We believe that Ascend Communications holds promise to become a "core" portfolio stock holding in the data networking industry. As the industry consolidates, it is becoming increasingly evident that the leading equipment vendors will need to offer a full line of products and services. The steady diet of acquisitions at Cisco Systems together with the merger of U.S. Robotics and 3Com document the trend. Among the smaller industry constituents, we believe that Ascend is one of the most favorably positioned to emerge from the group and become a future industry leader for the following reasons:
1. Ascend is concentrated in the wide area network (WAN) which is the fastest growing segment of the data networking industry.
2. The company is already the leading supplier of one of the fastest growing products in the WAN sector where it has a 40% market share in the market for Remote Access Servers (RASs).
3. The recently completed merger with Cascade Communications puts Ascend on equal footing with Cisco in the frame relay switch business where the two competitors have comparable market share. It also provides Ascend with the technical capabilities to become a leading factor in the emerging markets for ATM switches and high speed routers.
4. We believe that Ascend's proven experience and focus on the WAN market will prove to be an advantage relative to its traditional data networking competitors like Cisco and Bay Networks, who have historically concentrated in the more mature local area network (LAN) sector, as the typical network user increasingly focuses on integrating the LAN with the WAN.
Contrary to the earlier expectation of some outside observers, Ascend's management now indicates that the Cascade acquisition will not be dilutive beyond the current quarter. Accordingly, the shares appear to be attractive for purchase now, and we are initiating coverage with an ACCUMULATE (2) rating..
Future Industry Landscape
Conventional Viewpoint. The increasing dominance of the "Wintel" duopoly within the PC industry has become obvious to nearly everyone. Within the context of the computer networking industry, the conventional wisdom suggests that a third partner is emerging to stand on more or less equal footing with Intel and Microsoft. In part this reflects a growing awareness that there is a secular trend emerging; eventually it will become difficult to distinguish between a computing device and a communications device. The functions are mutating on convergent paths that suggest they ultimately will become seamlessly integrated. The accepted viewpoint is that Cisco Systems is the favorite to enter the winner's circle, thereby changing the Wintel duopoly into a Wincistel triopoly.
As the largest factor in the networking industry, Cisco Systems is widely regarded as the logical candidate to make a space for itself in the golden circle of tomorrow's prosperous computing/communicating giants. This is especially true given Cisco's historic popularity among corporate network administrators. In this view, Cisco is supposed to dominate the networking equipment industry by establishing its equipment as an industry standard that is optimized to work efficiently with the Wintel products. This would effectively restrict the future prosperity and growth of Cisco's competitors.
Our Hypothesis. While it would be foolish to minimize Cisco's overall strengths, we believe the company is not likely to be as dominant as its most zealous proponents might think. We believe thatAscend Communications can become a serious challenger to Cisco, if not for the top spot, then for a prosperous number two or three position.
Despite its strengths, Cisco has weaknesses. First, it is traditionally oriented toward the "enterprise" data networking market. Until recently the "enterprise" market for data networking within the confines of a corporate enterprise was the largest and most vigorously growing. However, the advent of the Internet and growing popularity of Wide Area Networks (WANs) based upon the services of outside vendors such as Internet Service Providers (ISPs), Competitive Local Exchange Carriers (CLECs), other "bypass" services, and the Public Switched Telephone Network (PSTN) have led to a de-emphasis on private, leased-line WANs. In combination, these organizations compose the "public provider" market for data networking services and it is the growth of this sector that has become the major focus of the data networking industry. This is where Ascend has important strengths. As network administrators turn to the public providers for WAN services, we believe that Ascend's proven track record in meeting the needs of the public market will enable it to gain market share.
In the context of the emerging WAN/LAN integration trend, Cisco generally approaches the network administrator from a position of historical strength in the LAN whereas the biggest future needs are in the WAN. In the WAN Ascend has about 40% of the Remote Access Server (RAS) market and 30% of the frame relay market, whereas Cisco has virtually no presence in the RAS segment and ranks about equal to Ascend in the frame relay market. While it must also be acknowledged that Cisco is ahead of Ascend with multimedia ATM switches, our point remains that Ascend is able to approach some of the most important sectors of the emerging data networking landscape from positions of strength relative to Cisco. Ascend also has vigorous product development efforts in the ATM product line that are only now getting into the market.
Networking Equipment
Dominant Trends. The networking industry provides the hardware and software permitting data to be quickly and accurately transmitted over existing communications lines. In our accompanying industry analysis, Media Convergence and Network Ubiquity, we document a number of important trends. Several thought to be particularly important to Ascend in the years ahead are the following:
1. The historic architecture of a typical corporate Wide Area Network (WAN) is changing. In the past, WAN connections between Local Area Networks (LANs) were typically provided by a leased telephone line. In the years ahead, we believe that such traffic will increasingly be carried over the Internet backbones of public Internet Service Providers (ISPs) and other bypass carriers.
2. Corporate LANs are mutating into Intranets, which operate very much like a mini Internet since they use networking equipment, a web browser, and allow access to the public Internet as well as company files. Separation of the Internet from the user's perspective is accomplished wholly through a security firewall that keeps unwanted visitors from accessing particular files (it can also limit access to the public network by company employees).
These two trends are important because the historical boundary between LAN and WAN environments is becoming less focused. Equipment that previously was intended for one environment or the other now serves both. We believe the changing landscape will induce a particularly sharp increase in demand for hardware in the WAN marketplace, including switches for the backbone, but also RASs for local access high speed routers at the ISP LAN. Further, we believe that these trends indicate the rising predominance of public backbone providers at the expense of the previous standard, corporate leased line service.Another important trend affecting this industry is the move toward "end-to-end" service. This essentially means that network service providers and other customers of networking companies are tending to prefer vendors with a full range of products. This is being driven by a number of factors, including consolidation in the ISP industry and the desire for "one-stop shopping."
Finally it should be recognized that workers are becoming increasingly mobile. The population of "road warriors," home-office workers, and telecommuters is growing rapidly. For instance, International Data Corporation forecasts that portable PCs as a percentage of total PC shipments will increase from 18% today to 24% in 2001.
Taken together, the above ideas strongly suggest the qualities of the successful data networking equipment vendor include market leadership in backbone switches and remote access servers, tested relationships with public network service providers like ISPs, and a full line of networking products. We strongly believe that Ascend meets all three of these criteria.
Before presenting our analysis of Ascend's product profile, some readers may find it helpful to examine the structure of a typical data network and become familiar with its component parts.
General Structure. A data network is typically configured from a vast number of components. Our discussion is simplified and we are focused primarily on those components most germane to Ascend. For purposes of clarity, we attempt our explanation by way of illustration, which at times may be oversimplified, but we trust that the technical omissions facilitate a working understanding for the average reader.
Consider a hypothetical telecommuter named Paula and follow the data flow path through each network component resulting from her traffic in Figure 1. Paula works at home where she needs access to her employer's LAN and the Internet. Consider that she is first accessing the Internet and the data flow is directed from her terminal on the right into the network "cloud" on the left. |
