Citigroup FDRY: Good Quarter, Strong Visibility; FDRY Remains A Top Pick
January 26, 2006
B.Alexander Henderson
b.alex.henderson@citigroup.com
Nigel Frankson
nigel.frankson@citigroup.com
Michael Genovese
michael.genovese@citigroup.com
BUY (1)
High Risk (H)
Mkt Cap: $1,912 mil.
SUMMARY
* Foundry Reported 4Q05 revenue and EPS of $116MM and $0.14, well ahead of ours and consensus estimates. We were above the street with a top-line forecast of $112MM and an EPSestimate of $0.12.
* Foundry was able to demonstrate growth across all geographies, with the U.S. and Japan driving much of the strength in the quarter.
* Surprisingly, Foundry was able to show growth in its sales to the Federal government, despite this being the seasonally weakest quarter for it.
* Book-to-bill was above 1.0 in the quarter; meaningfully so, in our view.
* Foundry is achieving strong traction for its new prods, providing it with good visibility into 2006. Perhaps most telling of the company's visibility is mgmt's commentary that it will look to increase its quota carrying sales force by 35%.
* We continue to view Foundry's shares favorably and rate it among our top picks in the sector. Reiterate Buy rating.
FUNDAMENTALS
P/E (12/06E) 22.5x
P/E (12/07E) 19.7x
TEV/EBITDA (12/06E) 10.1x
TEV/EBITDA (12/07E) 8.7x
Book Value/Share (12/06E) $5.37
Price/Book Value 2.6x
Revenue (12/06E) $487.7 mil.
Proj. Long-Term EPS Growth 20%
ROE (12/06E) 11.4%
Long-Term Debt to Capital(a) 0.0%
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (1/26/06) $13.74
Rating (Cur/Prev) 1H/1H
52-Week Range $14.90-$8.12
Target Price (Cur/Prev) $16.00/$16.00
Shares Outstanding(a) 139.2 mil.
Expected Share Price Return 16.4%
Div(E) (Cur/Prev) $0.00/$0.00
Expected Dividend Yield 0.0%
Expected Total Return 16.4%
OPINION
Strong Quarter. New Products Seem To Be Ramping Nicely Providing Ample
Visibility -- Reiterate Buy.
Foundry reported earnings and EPS well ahead of our above consensus estimates.
Foundry's revenue increased 9% sequentially, or up $9.5 million. Surprisingly,
the Federal vertical saw sales increase 4% sequentially. Book-to-bill was
above one in the quarter. Perhaps the most telling sign that business momentum
and visibility for the company is strong, is management's commentary that it
will look to increase its quota carrying sales force by about 35% in 2006,
provided the company can find qualified individuals on the market. Gross
margins were flattish despite the strong top-line performance but OPEX declined
meaningfully, resulting in a 480 basis point expansion in its operating margin.
Management was very pleased with the performance of several of its new
products, particularly the BigIron RX and FastIron Super-X. Chassis sales for
the BigIron RX tripled sequentially. Foundry continues to invest in its
operating structure, as a result, we consider Foundry to be more a top-line
growth story as opposed to a margin expansion story. We do expect, however,
that Foundry will meaningfully improve its operating margin on a full year
basis, despite subsequent quarters showing only marginal improvements on 4Q's
level.
We believe the strong end market conditions we are picking up in our VAD/VAR
field work is one of the reasons why Foundry was able to post such a strong
quarter, with a plus one book-to-bill. We also think Foundry's management team
is to be rewarded for good execution. Despite the company clearly having
increased visibility going into 1Q, given its new product launches, management
chose not to issue 1Q guidance, with the exception of some OPEX commentary.
This approach is consistent with Foundry's history however and we continue to
encourage investors to be buyers of Foundry at these levels.
REVIEW OF THE QUARTER
Revenue Up About 9% Q-Q With A Book To Bill Above 1. Business Was Strong
Across The Board... Even Federal Was Up Q-Q Despite Seasonality. Foundry
reported 4Q revenues of $116 million, representing an 9% sequential increase,
following a strong 3Q in which revenue increased 11% and a strong 2Q in which
revenue increased 14%. Foundry's top-line came in ahead of our above consensus
estimate of $112 million. U.S. enterprise business was strong, relatively
speaking, up 7% in the seasonally strong December quarter. Federal government
grew 4% sequentially, which is a strong performance given this is the
seasonally weakest period for Federal spending as it is its fiscal first
quarter.
Overall, U.S. sales accounted for 70% of revenue with international accounting
for 30%. Sales in the quarter to enterprises accounted for 80% of sales with
sales to carriers accounting for the remaining 20%. Stackables accounted for
31% of sales, up from 30% in the September quarter with Chassis based sales
accounting for 69%. We estimate about 85% of the company's revenue were from
Layer 2/3 switching products and Metro Routing products while the remaining 15%
was derived from its layer 4-7 gear.
Operating Margins Increased Due To Higher Revenue Fueled By New Product Sales.
Gross Margins Actually Slipped A Bit. Total gross margins for Foundry declined
70 basis points from 62.0% in the third quarter to 61.3% this quarter. The
decrease was due to some building of inventory for its new products. Operating
expenses actually declined again in the quarter, despite Foundry growing its
headcount by 27 in the quarter, in order to support its new products and the
subsequent business it anticipates from that. R&D declined to $12.2 million
(10.5% of sales) down from last quarter in which R&D was $12.4 million (11.6%
of sales). Sales and marketing expenses came in at $25.2 million (21.7% of
sales) down from last quarter in which sales and marketing was $25.8 million
(24.1% of sales). G&A came in at $7.0 million (6.1% of sales) versus last
quarter's $9.6 million (8.9% of sales) with the rolling off of certain one time
legal costs that occurred last quarter.
We Find Foundry's Balance Sheet Remains Strong. Foundry ended the quarter with
$746 million in cash and short-term investments. Cash flow generation (CFFO)
came in at about $43 million in the quarter. The effect of exchange rate
changes was about ($90k). Receivables increased by ~$1.3 million during the
quarter, while deferred revenue increased by about $8.3 million. DSOs declined
to 62 days from 66 days in the September quarter. Finally, inventory turns
increased from 5.2x to 5.6x.
Adjusting Estimates To Account Company's Accelerating Business Momentum. With
Foundry's line up of new products all released in 3Q and 4Q, coupled with a
strengthening demand backdrop, we are increasing our estimates on Foundry. We
are now modeling Foundry to do $114.4 million in revenue in the March quarter.
We think the company will do $487 million in 2006 revenue, and $566 million in
2007 revenue. We were previously modeling March quarter revenue to be $113.9
million with 2006 and 2007 revenue at $486 million and $563 million,
respectively. We also adjusted our model to reflect higher OPEX and flattish
gross margins in light of this quarter's results and the additionally clarity
we gleaned into the company's cost structure given its aggressive investment
plans. We are now looking for March quarter EPS to be $0.14 per share with
2006 and 2007 EPS estimates now at $0.61 and $0.70. This compares to our prior
expectations of $0.12 in the March quarter and $0.52 and $0.62 in the 2006 and
2007 time frames.
VALUATION
With $5.10 per share in net cash on its balance sheet, we think Foundry has
significant downside protection. Foundry is currently trading at $13.74 or 14x
2006 EPS estimates, excluding cash, which compares to the average of its peers
at 16x with a range of 9x to 25x. On an enterprise value to sales basis
Foundry is also trading roughly inline with the group average of 2.1x 2006
sales (range = 0.5x to 3.6x), trading at 2.3x. With this much cash on its
balance sheet ($5.10/share) and at these valuation levels, we think Foundry's
downside, should it disappoint in the near future, is limited. That said,
given the 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
18x, excluding cash ($5.10/share), above the mean of its peers' range is
appropriate. This, we note, represents a lowering of our target multiple from
25x. Our old 25x multiple took into consideration Foundry's potential for EPS
out-performance and cash balance increases. With some of that potential now
realized, we deem it appropriate to lower our target multiple to a level only
modestly above the mean for the group.
We also think an enterprise value to sales multiple of 3.4x, also at the high
end of the range, is appropriate. Both valuation metrics bring us to our
target price of $16.00. Our modest change in sales estimates did not
meaningfully change our target valuations.
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... |
