citi: FDRY: Expecting Strong 4Q, Meaningfully Ahead Of Consensus
BUY (1)
High Risk (H)
Mkt Cap: $1,980 mil.
B.Alexander Henderson
b.alex.henderson@citigroup.com
Nigel Frankson
nigel.frankson@citigroup.com
Michael Genovese
michael.genovese@citigroup.com
January 17, 2006 SUMMARY
* Foundry is scheduled to report 4Q earnings on Thursday, January 26.
* We think Foundry will grow its top-line by at least 5% sequentially to $111.8MM, versus consensus which is calling for a seq. growth of 3% to $110.0MM. Our EPS est. is a penny higher than consensus at $0.12 due to the higher revenue estimate.
* Foundry did not issue 4Q guidance, which may be the reason for what we believe to be conservative Street forecasts.
* We think Foundry's strong biz momentum exiting the 3rd qtr, in which its top-line grew 11% q-q, with a B-B over 1.0, the seasonal strength of the 4th qtr for the overall industry, strong end mkt conditions as evidenced by our VAD/VAR field survey and Foundry's new prod release will enable FDRY to meet our ests.
* We note this is a seasonally weak period for the federal gov't (~20% of rev) and we expect Foundry will see this biz decline ~10% q-q.
FUNDAMENTALS
P/E (12/05E) 38.9x
P/E (12/06E) 27.5x
TEV/EBITDA (12/05E) 20.1x
TEV/EBITDA (12/06E) 12.6x
Book Value/Share (12/05E) $5.61
Price/Book Value 2.5x
Revenue (12/05E) $399.6 mil.
Proj. Long-Term EPS Growth 20%
ROE (12/05E) 6.9%
Long-Term Debt to Capital(a) 0.0%
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (1/17/06) $14.23
Rating (Cur/Prev) 1H/1H
52-Week Range $14.61-$8.12
Target Price (Cur/Prev) $16.00/$16.00
Shares Outstanding(a) 139.2 mil.
Expected Share Price Return 12.4%
Div(E) (Cur/Prev) $0.00/$0.00
Expected Dividend Yield 0.0%
Expected Total Return 12.4%
OPINION
Strong Biz Momentum & End Markets, High Visibility Via New Product Launches
And A Low Set Bar Leads Us To Believe Foundry Will Outperform 4Q Expectations.
We believe Foundry followed up a strong September quarter, in which revenue
grew sequentially at a double-digit clip, with a solid December quarter in the
face of low Street expectations. Consensus is calling for Foundry's top-line
to grow only 2% sequentially in its seasonally strongest quarter of the year
(December). We think the company grew at least 5% this quarter given the
strong business momentum it had exiting the third quarter, strong end market
conditions according to our recent VAD/VAR surveys, and its new product
introductions, many of which likely began kicking in, in a meaningful way, as a
driver of its top-line results this quarter. We believe the combination of its
new product introductions, and our expectation of a strong start to 2006 for
the industry's end market conditions, will lead to either solid 1Q06 guidance,
or at the least a bullish tone to the company's 4Q05 conference call. Foundry
remains one of our picks for 2006, given its exceptional visibility and strong
growth profile, and we would be buyers of the stock at these levels.
3Q Business Momentum Evident -- Revenue Up About 11% Q-Q With A Book To Bill
Above 1. Business Was Strong In U.S., Federal Rebounded Strongly. Foundry
reported 3Q revenues of $107.1 million, representing an 11% sequential
increase, following a strong 2Q in which revenue there increased 14%.
Foundry's top-line came in ahead of our above-consensus estimate of $100
million. U.S. enterprise business was strong, up 9% despite the seasonal
weakness that typifies the September quarter. Federal government grew from 15%
of revenue last quarter to 22% of revenue in the quarter as revenue here
rebounded from their depressed 2Q level. The Street is currently only modeling
for Foundry to grow its revenue 2% since management declined to issue any
guidance. We think this bar is set unreasonably low given this is the
company's strongest quarter, seasonally.
U.S. Field Conditions Look Strong, As Is Seasonally Normal. When reporting the
CY 3Q numbers, many of the data networking companies gave atypically
conservative guidance for the December/January quarter, artificially
suppressing expectations for the quarter. Cisco guided for only flat to up 1%
sequential sales growth, while smaller networking vendors more comparable to
Foundry in scale and scope, like Extreme, guided for flat to up 5% sales. We
believe some of this conservatism was likely due to uncertainty about the
effects of the hurricanes as well as macroeconomic concerns related to interest
rates and energy prices, as well as continued uncertain demand out of Europe.
In addition, we expect the Federal vertical to be down only 10%-15%
sequentially in December since it is FY1Q and the seasonally weakest quarter
for this vertical. We note that Federal makes up about ~20% of Foundry's
business. Overall, we think Foundry can grow its top-line in the December
quarter by at least 5%.
The Outlook For 2006 Is Solid/Strong -- VAD/VARs Are Generally Confident With
The Visibility -- Backdrop Supportive Of A Strong 1Q For Foundry. Among our
U.S. contacts, confidence in the 2006 outlook remains solid, with the VAD/VARs
expecting another year similar to 2005. Almost without exception, our contacts
characterized their pipelines of new business as "strong." In the latest round
of checks, the individual VAD/VARs generally told us they expect 2006 orders to
come in up in the 10%-20% range with a few outlying data points to the upside.
This represents a slight shift upwards from the November survey, when the range
of expectations both for CY 2005 and CY 2006 was primarily in the 10%-17% band.
The individual contacts were strikingly consistent in voicing the expectation
that the 2006 growth rate would mirror the 2005 growth rate. In other words,
if a contact told us their 2005 order growth was 15% it was very likely they
would set their 2006 expectation at 15%. This indicates to us that Foundry,
with a newly launched product line throughout most of its portfolio, is well
positioned to take full advantage of this backdrop. As a result, while the
company will likely to stick to its 'no guidance issuance' policy, we believe
management's tone and forward looking commentary will be bullish on its
December earnings call.
On Our Mid-December Bus Tour, Foundry Was The Most Positive Of The Company's
We Visited, Maintaining Its View 2006 And 2007 Should Be Strong For The
Company. We held a mid-December Silicon Valley data networking bus tour. Of
all the companies we met with, Foundry was easily the most bullish on its
outlook. The information gleaned from our meeting with them affirmed our
belief that Foundry should be our top pick among the companies in our small cap
data networking universe. Management speaks in terms of expecting a strong
next two years, with a completely refreshed product portfolio. In anticipation
of this business, the company continues to hire more sales people, building in
operating leverage for 2006 and beyond. Over the last year, as of September
quarter-end, the company has increased its sales force from 280 to 350, and has
hired more sales people since then. Management anticipates it taking about six
to nine months for a sales person to achieve full productivity, implying a
steady and positive rolling effect on the business as recent hires get trained
and gain experience. From a product standpoint, driving numbers in the near
term are the recent launches of its layer 3 core and wiring closet offerings,
with business slowly rolling on from its new router products over the next nine
months or so as these product pass testing trials and gain acceptance into
customer accounts. Management remains confident that end market conditions
will remain strong.
With Legal Costs Rolling Off, G&A As % Of Rev Should Decline, Fueling Operating
Margin Expansion -- Otherwise, Margins Look To Be Fairly Stable. Foundry has
completed much of its investment in its operating structure in preparation for
its new product ramp up, although the company will likely continue to add to
its headcount at a measured pace. As a result, we expect its margins to be
fairly stable this quarter. The largest delta between this quarter's OPEX
lines and last quarter's will likely come from the G&A line. Due to certain
one time legal expenses last quarter, we believe G&A will decrease from 9% of
sales to 6% of sales. We believe gross margins and R&D will stay roughly in
line with last quarter as a percentage of revenue, while continued additions to
the sale force will likely increase sales and marketing as a percentage of
revenue. Overall, we see operating margins improving to 18.7% from 17.2% last
quarter.
Our 4Q05 Estimates:
* Revenues. We are forecasting the company to report revenues of $111.8
million, which would represent a 5% sequential increase. Management did not
issue guidance, which we believe went a long way towards suppressing the
street's expectations. Our VAD/VAR survey, the seasonal strength of 4Q, the
company's new product introductions and its strong 3Q business momentum lead
us to believe FDRY will outperform consensus.
* Gross Margin. Last quarter Foundry produced gross margins of 62.0%, up 110
bps sequentially with its new product inventory buildups finally easing some.
We are modeling for gross margins to stay roughly at this level for the
December quarter as the company should generate enough sales volumes to
offset any incremental additions to inventory.
* S&M. We are forecasting selling and marketing expenses to come in at $28.5
million, or roughly 25.5% of sales. This represents an increase in spending
on both an absolute and percentage of sales basis as compared to last
quarter's 24.2% of sales, or $25.8 million. We think the company will have
modest head count increases, although this process is largely completed at
this time. Over the last year, as of September quarter end, the company has
increased its sales force from 280 to 350, and has hired more sales people
since then, to date.
* R&D. With this round of new products released, this number should stabilize
for the comapny. We are modeling research and development expenses to come in
at $13.0 million, or 11.6% of sales. This compares with last quarter's $12.4
million, 11.6% of sales.
* G&A. We expect general and administrative expenses to come in at $6.7
million or 6.0% of sales, which compares to $9.6 million, or 9.0% in the
previous quarter. Foundry had some one time legal expenses last quarter that
should be rolling off this quarter.
* EPS. On a pro forma basis, we are modeling EPS of $0.12, a penny above the
First Call average due largely to our higher than consensus revenue
projection.
* Guidance. We are modeling Foundry revenue to increase 2% in the seasonally
weaker March quarter. Foundry could out-perform this figure given its new
product revenue should be kicking in. We think there is good visibility in
Foundry's ability to hit these numbers.
VALUATION
With $4.85 per share in net cash on its balance sheet, we think Foundry has
significant downside protection. Foundry is currently trading at 14.5x our
2006 EPS estimates, excluding cash, which compares to the average of its peers
at 16x with a range of 10x to 26x, based on our analysis. On an enterprise
value to sales basis, we find Foundry is also trading roughly inline with the
group average of 2.2x 2006 sales (range = 0.6x to 5.6), trading at 2.3x. With
this much cash on its balance sheet ($4.85/share) and at these valuation
levels, we think Foundry's downside, should it disappoint in the near future,
is limited. That said, given our strong outlook for its business in the longer
term (2006/2007), we think the stock should trade at the high end of the range
of its peer group for both metrics. On a PE excluding cash basis we think our
target multiple of 25x, excluding cash ($4.85/share), towards the high end of
its peers' range is appropriate. We also think an enterprise value to sales
multiple of 3.4x, also at the higher end of the range, is appropriate. Both
valuation metrics bring us to our target price of $16.00.
RISKS
We consider Foundry to be High Risk because it is a high beta technology stock
that has exhibited significant market price fluctuations. Near term revenue
risk heads our list of concerns. Management did not issue guidance for the
coming quarter and thus, where the street will place its expectations is a bit
of an "X factor" for the stock. Longer term, Foundry competes with Cisco and
Juniper and these companies are working to aggressively integrate their product
lines with security and VoIP capabilities as well as traffic management
functionality. This trend represents a challenge to the speeds and feeds
mindset of Foundry's management. 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 downplay 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 company to sustain the current level of earnings,
valuation parameters could be undermined, and the stock fail to reach our
target price.
INVESTMENT THESIS
We rate Foundry Networks 1H (Buy, High Risk). We believe Foundry's new product
line up, to be released throughout the second half of 2005, adds meaningful
visibility into Foundry's business. Foundry is setting up for a better year in
2006 on the heals of new product launches at the high end of its line and in
the service provider market and Layer 4-7 segment, in addition to the operating
leverage it is currently building into its business this year. Foundry has a
strong balance sheet with almost $5.00 per share in cash and this provides some
downside risk protection. Our concerns surrounding the risk to revenues and
earnings if the timing of product availability and the costs of ramping added
sales channels conspire to result in softer revenues and higher near term
operating expenses has meaningfully abated at this time.
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, research analyst ... |
