OPINION
Raising Price Target On Long-Term Outlook –We Believe Investors In Next-
Generation Telecom Equipment Should Have Exposure To Sonus Networks
We are reiterating our Buy rating and raising our price target on Sonus Networks to $9 from
$7.10. The new price target is based on a multiple of 34x CY 2008 EPS. While this multiple
may appear rich at first glance we expect Sonus to consistently grow EPS at about a 30%
clip over the next 5-years, making the PEG ratio on our price target only about 1.1x. Viewed
on this basis, the targeted PEG of 1.1x actually places Sonus at a discount to the current
trading range of its telecom equipment peer group, which is 0.7x-2.3x with a mean PEG of
1.7x.
While there are near-term risks to the Sonus story including long revenue recognition cycles,
order seasonality and lumpiness, customer concentration, and ongoing stock option related
restatements, we believe long-term investors in next-generation telecom equipment should
have exposure to these shares. We believe service provider networks, including wireline,
wireless, and cable, are about 6 years into a 20-year VoIP conversion cycle with the steep
part of the ramp still ahead. In our view, Sonus is the clear technology and strategic vision
leader in the industry, and the company has already established a strong track record in
competing against larger incumbent vendors. Sonus has a strong presence in some of the
largest networks in the world and has an addressable market opportunity growing in excess
of 25% per year. With VoIP marching strongly ahead and Sonus in the driver’s seat, we
would not bet against the long-term prospects of this company or this stock.
VOIP Has Moved Into The Mainstream But Is Still In The Early Stages Of Adoption
The most developed of the various segments of the carrier VoIP market is the Core
Trunking or Class-4 replacement market and Sonus is a leader in this market with the most
scalable and reliable solutions available today, in our view. This market segment initially
developed as a greenfield opportunity for emerging inter-exchange carriers like Level 3 as
well as the new long distance operations of the U.S. RBOCs, such as Verizon, gained under
271 Relief. Outside North America, Sonus has found particular success in Japan where it is
the defacto standard among major service providers. Currently Sonus is migrating the entire
LD network of KDDI to VoIP. Overall, we believe about 20% of all LD traffic globally is
carried on IP networks and expect this to grow to 100% over the next 10-years. While
trunking is the most developed of the VoIP markets, it still has significant growth ahead.
The largest potential carrier VoIP segment, but the least developed to date is the Access or
Class-5 replacement market. The reason this segment is the least developed is that it
requires slower moving incumbent carriers to decommission existing voice switches.
However, the overall major changes in access network architectures driven by FTTx are now
beginning to drive Class-5 replacement projects. We are looking to late 2007/early 2008 for
the critical mass of FTTx deployments required to jump-start the Access VoIP market in a
larger way. Some of Sonus’more recent wins in Europe, such as CarphoneWarehouse and
Opal Telecom involve Class-5 primary-line residential services architectures.
Wireless is another important carrier VoIP segment and Sonus has major buildouts underway
with wireless carriers in the U.S., such as Cingular, and Japan, such asWillcom. The IMS
architecture for wireline-wireless convergence is another opportunity for Sonus. We believe
that about 75% of all Sonus customer deployments to date are “IMS ready” and we also
think that from a technology perspective Sonus is the leader in IMS technology. From the
beginning, Sonus’VoIP signaling has been based on the SIP protocol, in contrast with Nortel,
Lucent, Alcatel, and Ericsson, which are all using SIP for the first time in their new IMS
products. While we believe Sonus has a technology lead in IMS we recognize that the larger
vendors have an advantage when it comes to long standing customer relationships with Tier
1 carriers and service and support capabilities. However, we believe Sonus is closing this
gap. At DT’s T-Systems division, for example, Sonus is currently acting as the VoIP
integrator in the network which speaks to its expertise in next-generation networks and
enhanced service and support capacity.
We believe it is useful to highlight two key findings from a recent Heavy Reading report
entitled “IMS & the Future of Softswitches in Next-Gen Networks.” Over 50% of the more
than 150 service providers surveyed do not expect their networks to be more than 75% VoIP
until 2009 and another 25% do not expect to reach this milestone until 2011. This bodes
well for the market, in our opinion, as it provides visibility to the TDM to VoIP migration
process for at least the next 5 years.
Secondly, according to Heavy Reading, carriers are not favoring their TDM switch suppliers
when evaluating softswitch deployments. While operators are interested in exploring
migration paths from existing TDM equipment and want future migration paths to IMS
available for the softswitches, overall continuity with their existing TDM switch vendor was
considered the least important factor of the eight presented in the Heavy Reading survey. In
our view, this is positive for a pure-play next-generation supplier like Sonus. In addition, we
believe Sonus has a unique opportunity currently to gain share as competitors like Alcatel
Lucent and Nokia Siemens are more focused on internal integration at the expense of
outward customer facing activities.
Raising Estimates
We are making changes to 2007 and 2008 estimates. For 2007 we are raising our revenue
forecast to $306.2 million from $290.0 million. The new estimate is only a 15% annual
growth rate due to the above market 37% growth expected in 2006 as well as the difficulty in
forecasting reported revenues for the company. We expect the order rate to increase at least
25% Y-Y with the difference between orders and reported revenues to be reflected in
deferred revenues and backlog. We are not changing our 2007 EPS estimate, which remains
$0.21.
We are raising our 2008 revenue estimate to $371.5 million from $341.1 million. We are
now at a 21% revenue growth rate for the year. We are increasing our EPS estimate to $0.27
from $0.25.
VALUATION
We are raising our price target for Sonus to $9.00 from $7.10. Our new target is based on a
PEG ratio of 1.1x on CY 2008 EPS or 34x our new CY 2008 EPS estimate. Previously we
had based our target on 25x CY 2007 EPS. With 2007 fast approaching we are now looking
to 2008 as the forward year. We are also basing the target on a PEG analysis rather than a
straight P/E analysis. We believe a PEG analysis is preferable to a simple P/E because PEG
puts the valuation in context of the growth potential of the company. For this reason, we
consider our new valuation technique to be superior to our previous valuation.
We expect Sonus to grow EPS by roughly 30% in both 2007 and 2008 and see 30% as the
correct 5-year EPS growth rate as well. According to our analysis, Sonus’ peer group of
service provider equipment companies closed trading on 12/8/06 within the range of 0.7x-
2.3x with a mean PEG of 1.7x. Within the context of this group, we find a 1.1x valuation to
be highly defensible, if not downright conservative, for a fast growing company like Sonus
that is a pure-play in an attractive next-generation market space. |
