Citi: FDRY: Continues To Have High Visibility And Strong Biz Momentum
BUY (1)
High Risk (H)
Mkt Cap: $2,374 mil.
April 20, 2006 SUMMARY
* Foundry reported 1Q sales slightly above street expecations with EPS a penny below the street due largely to some one-time in nature OPEX items.
* Foundry continues to demonstrate strong business momentum with a high degree of visibility and should its shares trade off tomorrow, we advise investors to buy on the weakness.
* Positive catalysts on the horizon include the N+I and GlobalCom trade shows in which Foundry will likely announce significant feature extensions to its SuperX, RX and XMR product lines.
* We are retaining all our forward revenue and EPS estimates.
* We continue to believe Foundry's new product pipline, sales force hires and overall business momentum will enable the company to out-perform street's estimates, fueling share price appreciation.
* We reiterate our Buy rating on Foundry and $19.25 target price.
FUNDAMENTALS
P/E (12/06E) 28.5x
P/E (12/07E) 23.4x
TEV/EBITDA (12/06E) 14.2x
TEV/EBITDA (12/07E) 10.9x
Book Value/Share (12/06E) $6.17
Price/Book Value 2.8x
Revenue (12/06E) $502.0 mil.
Proj. Long-Term EPS Growth 20%
ROE (12/06E) 10.4%
Long-Term Debt to Capital(a) 0.0%
(a) Data as of most recent quarter
SHARE DATA . RECOMMENDATION
Price (4/20/06) $17.06
Rating (Cur/Prev) 1H/1H
52-Week Range $18.16-$8.12
Target Price (Cur/Prev) $19.25/$19.25
Shares Outstanding(a) 139.2 mil.
Expected Share Price Return 12.8%
Div(E) (Cur/Prev) $0.00/$0.00
Expected Dividend Yield 0.0%
Expected Total Return 12.8%
OPINION
Business Momentum And Visibility Evident. Tradeshows And New Product
Introductions Should Provide For Positive Catalysts -- Reiterate Buy Rating.
Foundry reported 1Q sales of $114 million, slightly above street expecations of
$113.2 million, with EPS a penny below the street ($0.13 vs. $0.12) due largely
to some one-time in nature OPEX items. These include $700k in charges for
headquarters' relocation, $500,000 in excess legal fees and roughly $3 million
in payroll expenses associated with the excersise of options by employees in
the quarter resulting in an increase in payroll taxes. These expenses should
fall out sequentially. Adusting out these items essentially results in an in-
line quarter for Foundry with lots of business momentum heading into the
seasonally stronger June quarter. Foundry continues to have a high degree of
visibility and should its shares trade off tomorrow, we advise investors to buy
on the weakness. Positive catalysts on the horizon include the N+I and
GlobalCom trade shows in which Foundry will likely announce extensions to its
SuperX, RX and XMR product lines. Our estimates on Foundry essentially remain
unchanged, as does our stance. We continue to believe Foundry's new product
pipline, sales force hires and overall business momentum will enable the
company to out-perform street's estimates, fueling share price appreciation.
We reiterate our Buy rating on Foundry and $19.25 target price.
We Have Strong Expectations For 2Q And See Solid Upside To Our Forecasts. We
are modeling a conservative 6% reveneu increase into 2Q but think there is
solid upside potential as the company shifts from the seasoanlly weak 1Q period
into the seasoanlly strong 2Q period. One of the primary drivers of our
investment thesis on Foundry is that the substantial salesforce expansion
executed over the last year should drive improved productivity as the year
progresses. In 1Q, most enterprises are not executing against new projects and
business tends to be repeat business from the existing customer base. In 2Q
and into the second half the complexion of business shifts to new customers and
new RFP activity where the sales force expansion plays a much bigger role. We
believe this could drive a surprising acceleration in the results over the next
several quarters. As the sales force productivity coincides with the new
product ramp, the stage is set for upside to revenue and earnings estimates and
share price appreciation.
Foundry's Federal Business Is Resilient In The Quarter Despite Weakness
Experienced By Others---We Think This Reflects Their Focus On The Military And
VHA. Weakness in the Federal markets have hurt a number of companies in the
quarter and have been an issue for Foundry in the past. This quarter Foundry's
Federal business declined only $2 million sequentially which is a relatively
solid performance. We think the bias to Foundry's Federal business is giving
them better insulation to the spending variations experienced by others.
Foundry has a bigger share exposure to the VHA and defense arenas.
Excluding The $2 Million Decline In Federal, Overall Foundry Enterprise
Business Came In Flat-Given Seasonality We Think This Is A Solid Performance.
Management was very optimistic as to this business' prospects. Taking it a
step further, management even went on to point out it increased its Federal
sales force in anticipation of its stronger performance, later in the year.
While management did cite that the quarter to quarter fluctuations in this
business will always be a factor, it was adamant in stating that its Federal
pipeline of business remains strong.
REVIEW OF THE QUARTER
Revenue Declined About 2% Q-Q With A Book To Bill Above 1. Federal Was Weak
But Japan Was Strong. Foundry reported 1Q revenues of $114 million,
representing a 2% sequential decline, following a seasonally strong 4Q in which
revenue increased 8% and a strong 3Q in which revenue increased 11%. Foundry's
top-line came in ahead of consensus estimate of $113 million. U.S. enterprise
business was flattish, down less than 1% in the seasonally weak March quarter.
Federal government declined 9% sequentially. Despite a weaker than expected
performance here, management was optimistic about its business here going
forward, citing it has even added to its sales force here. Federal essentially
accounted for all of Foundry's $2 million decline in sales from last quarter.
Overall, U.S. sales accounted for 68% of revenue with international accounting
for 32%. Sales in the quarter to enterprises accounted for 80% of sales with
sales to carriers accounting for the remaining 20%. Stackables accounted for
29% of sales, down from 31% in the December quarter with Chassis based sales
accounting for 71%. 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 Declined Due To Higher OPEX, $3MM Of Which Was One-Time
In Nature. Adjusting Out This $3MM, Operating Margin Was Down 230 Basis Points
Instead Of 490. Total gross margins for Foundry increased 20 basis points from
61.3% in the fourth quarter to 61.5% this quarter. A shift to new product sales
caused the modest expansion. Operating expenses increased $5 million in the
quarter, as Foundry grew its headcount by 22 in the quarter, in order to
support its new products and the subsequent business it anticipates from that.
Also, about $3 million of this $5 million increase was quasi one-time in
nature, surrounding higher compensation costs. R&D increased to $14.1 million
(12.4% of sales) up from last quarter in which R&D was $12.2 million (10.5% of
sales). Sales and marketing expenses came in at $26.6 million (23.3% of sales)
down from last quarter in which sales and marketing was $25.2 million (21.7% of
sales). G&A came in at $8.8 million (7.7% of sales) versus last quarter's $7.0
million (6.1% 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
$790 million in cash and short-term investments. Cash flow generation (CFFO)
came in at about $15 million in the quarter. The effect of exchange rate
changes was about ($82k). Receivables increased by ~$6 million during the
quarter, while deferred revenue increased by about $8.4 million. DSOs
increased to 67 days from 62 days in the December quarter. Finally, inventory
turns declined from 5.6x to 4.9x.
Estimates Go Unchanged. With the exception of our full year 2006 EPS estimates
going from $0.63 to $0.60 due to rounding error and the lower-than-expected 1Q
performance, we are not changing any of our top-line or EPS estimates,
meaningfully, on Foundry.
VALUATION
With $5.10 per share in net cash on its balance sheet, we think Foundry has
some downside protection. Foundry is currently trading at 21x 2007 P/E
estimates of 0.56 (excludes interest from cash). 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 at 2.8x 2007 estimates versus a peer group
average that we find is 2.2x. 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 26x 2007 estimate, excluding cash, well above the mean of its peers' range
is appropriate.
We support this using an enterprise value to sales multiple of 3.4x, also at
the high end of the range, which we view as 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.
I, {Alex Henderson}, research analyst and the author of this report, hereby
certify ... |
