citi: FDRY: Raising TP To $19.25 Following Call/Mgnt; Biz Visibility Strong
BUY (1)
High Risk (H)
Mkt Cap: $2,206 mil.
March 14, 2006 SUMMARY
* A call with mgmt highlights Foundry's strong product portfolio, sales force expansion and improving visibility. We are increasing our target price to reflect this improving visibility.
* With about 2/3rds of the March qtr's biz complete, mgnt continues to term its Feder'l biz as "stable" and its Japanese biz as being "flat to up" as it's not seeing any issues in its NTT biz, dousing two sources of investor near term concern.
* Longer term, we think operating margin upside is limited with respect to 4Q levels, as a result, we view Foundry purely as a growth story fueled by a new product cycle, product line expansion and signficant sales force growth.
* As the 30% plus sales force increase over the past 18 months becomes productive, Foundry continues to hire targeting. 13% increase in force in 2006.
* We think estimates for 2Q and 2H look overly conservative with roughly 1/3rd of the estimates looking for flat to down results or only very slight growth.
FUNDAMENTALS
P/E (12/06E) 25.3x
P/E (12/07E) 21.6x
TEV/EBITDA (12/06E) 12.2x
TEV/EBITDA (12/07E) 10.2x
Book Value/Share (12/06E) $5.40
Price/Book Value 2.9x
Revenue (12/06E) $502.4 mil.
Proj. Long-Term EPS Growth 20%
ROE (12/06E) 11.7%
Long-Term Debt to Capital(a) 0.0%
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (3/14/06) $15.85
Rating (Cur/Prev) 1H/1H
52-Week Range $15.34-$8.12
Target Price (Cur/Prev) $19.25/$16.00
Shares Outstanding(a) 139.2 mil.
Expected Share Price Return 21.5%
Div(E) (Cur/Prev) $0.00/$0.00
Expected Dividend Yield 0.0%
Expected Total Return 21.5%
OPINION
Following Our Discussion With Mgnt, We Are Convinced Street Ests Are Too Low.
We Stand Behind Our Buy Rating And Above Consensus Ests And Are Raising Our
T.P.
Despite being above consensus, we continue to see solid upside potential to our
forecasts. We recently held a discussion with management in which it became
clear to us that many of the street's concerns regarding Foundry's near term
story appear unfounded, even as the visibility to growth and new market
penetration continue to improve. Foundry and Cisco seem to be reacting to
similar world views as both companies are aggressively deploying new products
and building substantial new distribution footprint. Both companies are seeing
an accelerated demand for networking products, deeper penetration into the
service provider arena, increasing need for security, an aging installed base
of equipment and the need for network upgrades to facilitate VoIP, real time
services and webified applications. Foundry added roughly 30% to its sales
force last year and expects to continue to ramp its sales force this year with
at least a 13% addition. If the strength in operating results which is
gradually appearing continues, management is likely to further accelerate this
spending and sales ramp rate. Foundry's new products all seem to be doing
well, according to management, as they continue to gaining traction in the
market. As a result, we now have more conviction in our above consensus
revenue and EPS estimates and in fact see upside to our forecasts, and we
believe the street's estimates are simply too low. We are now raising our
target price on Foundry from $16.00 to $19.25, as we award the stock higher
valuation multiples, on unchanged estimates, to reflect this dynamic.
Like Cisco, 2005 And 2006 Sales Force Additions Introduce Significant
Visibility Into Foundry's 2006 And Beyond Business. Foundry has increased its
sales force by over 30% in the last eighteen months, with the bulk of these
additions taking place in the second half of 2004 and the first half of 2005.
Of the 90 sales people added in the eighteen months prior to yearend 2005,
about two thirds were added in the basic enterprise markets with about fifteen
of the remaining 30 new hires allocated to the layer 4-7 arena and the
remainder dedicated to the service provider markets. About two thirds of all
sales people hired were hired for the North American geography with the
remaining one third split between Europe and Japan. Many of these sales
people, particularly those peddling the more complex higher end products, will
be just now hitting their stride in the first half of 2006. Additionally,
management intends to continue to increase the sales force by at least 13%, at
the rate of fifteen heads or more per quarter, in 2006 in order to take
advantage of what management believes to be a strong end market. Sales force
quotas for the existing sales force has also been increased in the 5% to 10%
range, depending on the geography, according to management. The bottom line
here is we think Foundry is seeing a significant growth opportunity in front
of it and is voting with its dollars on substantial 2006 and 2007 growth.
Management Seems To Agree With The Result Of Our Most Recent VAD/VAR Survey
-- Business Conditions Overall Are Strong, With 1Q Shaping Up To Be Better Than
Seasonal Norms. We very recently spoke with approximately 30 U.S. VAD/VAR
contacts and they were extremely consistent in reporting 1Q order rates running
slightly ahead of their expectations going into the quarter, generally 1%-5%
ahead of plan. The contacts were fairly evenly distributed in terms of their
expectations going into the quarter between expecting sequential orders to be
slight down, flat, and slightly up. In terms of reported U.S. VAD/VAR
expectations going into the quarter, our volume weighted average estimate is
flat to slightly down, which is seasonally typically normal. With the
important month of March still ahead, conditions through the first two months
appear to be supporting an actual sequential order rate of flat to slightly up
or a little better than previously expected. As it relates to Foundry, we are
only modeling for Foundry to produce March quarter sales of down about 1%,
versus the street's overly pessimistic expectations for the company to be down
in excess of 3%.
New Products Gaining Traction With 2H 2006 Shaping Up To Be An Inflection Point
For Foundry's Router Business. Management is very pleased with the traction
Foundry's new products have been gaining in the market. Foundry's new layer 4-
7 load balancing solutions, complete with SSL line cards, are benefiting
greatly from the strength in that end market, as the company has been able to
leverage its installed base in a meaningful way here. We note that what
Foundry is selling here is a chassis based, load balancing switch, which is not
to be confused with F5's stackable traffic management solutions, and thus, they
are not directly in competition with one another. Management appeared most
excited about the prospects of its new MPLS routers, largely being sold into
the service provider markets. While doing so makes for long lead times,
management believes this product bodes well for Foundry's 2H06 business, as
much of the testing and customer acceptance issues should be resolved by then.
Average deal sizes in the service provider market for these kind of products
range in the $3 million to $5 million range, as opposed to the layer 4-7 market
where deal sizes are about $50k, or the layer three market in which the deal
sizes can be even smaller than that. Given this dynamic, it is easy to see why
management is looking forward to the success of its XMR router. Management
stated it would expect its service provider business to grow from the 15% of
total revenue that it represents today to 20% or so of 2007's revenues.
Management Reiterated Some Positive Commentary Surrounding Two Near Term
Concerns Investors Currently Have; Its Japanese And Federal Businesses. With
two thirds of the March quarter business completed, at this juncture,
management was willing to reiterate its belief that its Federal business seems
stable in the March quarter, versus last, with its Japanese business poised to
be flat to up slightly sequentially. Foundry is not seeing much in the way of
poor end markets there, as its larger rivals Juniper and Cisco have noted.
Specifically, Foundry is not experiencing any delays in its business with NTT,
boding well for its Japanese operations in the March quarter.
We Believe First Call Estimates Are Too Low -- Raising Target Price To $19.25
To Reflect Future Consensus Estimate Out-Performances. First Call consensus is
currently calling for Foundry to produce a 3% sequential decline in revenue
with EPS lower by a penny versus the December quarter. We think the street's
analysts are factoring in typical March quarter seasonality, concerns
surrounding Foundry's Federal and Japanese businesses, and a fairly aggressive
headcount increase negatively impacting the SG&A line, in coming up with these
estimates. We also think many investors are mistaking Foundry's long standing
policy of not issuing quarterly guidance as a lack of business visibility on
the company's part. We believe Foundry's business visibility is amongst the
highest in the category and think our down 1% sales forecast is already on the
conservative side. Longer term, we do not believe Foundry will have too much
trouble hitting our estimates, and should be able to show top-line growth in
excess of 20% and produce EPS of $0.61 versus consensus of $0.54. Given
Foundry's stronger than anticipated business visibility, We are raising our
target multiples on our above-consensus estimates, resulting in a new target
price of $19.25.
VALUATION
We are rolling forward our valuation parameters to reflect 2007 numbers as
opposed to 2006 numbers. With $5.10 per share in net cash on its balance
sheet, we think Foundry has some downside protection. Foundry is currently
trading at $15.71 or 23x 2006 EPS estimates, excluding cash, and 19x 2007
estimates. This compares to the average of its peers at 17x with a range of
11x to 26x. On an enterprise value to sales basis Foundry is also trading
roughly inline with the group average of 2.5x 2006 sales (range = 0.8 to 5.6,
by our analysis) at 3.0x, and trading at 2.5x 2007 estimates versus a peer
group average that we find is 2.2x. With significant cash on its balance sheet
($5.10/share) and the stock at current 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 on
both metrics. On a PE excluding cash basis we think our target multiple of
26x, excluding cash, well above the mean of its peers' range is appropriate.
This, we note, represents a raising of our target multiple from 20x 2007
estimates previously, reflecting the heightening of business visibility that we
believe company is experiencing, which became evident to us following our
recent conference call with management.
We also think an enterprise value to sales multiple of 3.4x, also at the high
end of the range, is appropriate, for the same reasons cited above. Both
valuation metrics bring us to our target price of $19.25.
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.
ANALYST CERTIFICATION APPENDIX A-1
I, {Alex Henderson}, research analyst and the author of this report, hereby
certify that all of the views .. |
