here's what brought the stock down....
09:18am EST 10-Dec-97 DLJ Securities (Stephen G. Koffler)
BAY WFLT SNPX BAY NETWORKS: Lowering numbers and
rating due to product transition
[FirstCall Notes 12/10]
DLJ ****** DONALDSON, LUFKIN & JENRETTE ****** DLJ
December 10, 1997 Stephen G. Koffler (212) 892-4203
Peter Giglio (212) 892-8946
BAY NETWORKS (BAY: $27.5) #
Lowering numbers and rating due to product transition issues
Range: Earnings Per Share 1998 vs 1997 % Chg
40-15 Old New P/E Ratios F1Q $0.22 vs 0.25 -12%
(FY:June) 1999E $1.55 $1.55 17.7 F2Q 0.25 vs 0.10 +150%
1998E 1.10 1.08 25.5 F3Q 0.28 vs 0.10 +180%
1997A 0.60 45.8 F4Q 0.32 vs 0.15 +113%
Yield: % Market Cap.: $5.4 Billion 5-Yr. Growth Rate: 20%
Dividend: $ Avg. Trading Vol.(000): 2300 Book Value: $6.02
RATING: Market Perf. Change: Down From Buy 12-Mo. Target: $31
Investment Summary
We found Bay Network's management to be positive overall in our meeting with
them on Monday, but two issues did come out that cause us to be cautious about
the medium term outlook. The company faces significant product transition
situations in both the router and hub business from its continued roll-out of
switching products. Specifically, we were disappointed to learn that the
company's product strategy for 100 megabit hubs so far has not provided
incremental growth in the hub business in the December quarter. Also, the
company until recently has characterized the router market as a growth market,
but now is characterizing it as flat or low growth in calendar 1999. We think
that the company anticipates some cannibalization of routers from its recently
introduced Accelar switch which performs many of the same functions at better
price/performance. Management was also a bit cautionary about the March quarter
as corporate budgets are normally not set that early in the year for large
networking projects. To account for these issues we are trimming our EPS
estimates for this quarter and next by $0.01 each. On the positive side, the
company is seeing good early demand for Accelar, and has put the product on
allocation for this quarter and next. Also, the company is finding the component
environment to be more favorable than it expected and the scenario for improving
gross margin remains in tact. Our conclusion on Bay is that there is less upside
than we have been recently thinking to our earnings estimates for FY99 mainly
because of product transition issues. We think these issues will limit top-line
growth to about 20% in FY99 which we formerly thought was conservative. We do
not believe there is significant upside to our $1.55 for FY99 and competitor
estimates that are significantly higher (of which there are many) will
ultimately come down. We think that 20 times the forward year or one times the
top-line growth rate is a reasonable multiple to pay for the company, and
therefore limits upside to the low thirties, rather than the $50 price target we
formerly carried. Lowering rating to Market Performance from Buy.
100 Megabit strategy not kicking in for hub business. When Bay reported that
hubs grew modestly in the September quarter, we attributed this strength mainly
to low end stackables, but we were also enthusiastic about a 100 megabit
strategy that the company announced for its hub business in the summer.
Essentially, 100 Megabit hubs provide a low cost upgrade alternative to
switching for customers that prefer a more gradual migration as they up grade
their networks. We felt that the impact of this product strategy would begin to
be felt in the December quarter, but in our meeting the management reported that
with three weeks left to go, this has so far not been the case. We think that
hubs will probably be flat in the quarter, and this is one reason for our
trimming of estimates.
Some caution on March quarter and router outlook. In our conversation the
management did express some caution about the March quarter because they feel
that budgets for large networking projects are unlikely to be approved early in
the year. Also, we noticed a change in their outlook on the router market. As
recently as the December quarter routers were described as a growth category.
Now the company feels routers could show very slow growth or flatness in FY99
due to some cannibalization from Accelar, Bay's new layer 3 switch.
Accelar on allocation: Perhaps the most constructive thing we heard in our
meeting with BAY management yesterday is that early demand indications are
strong for BAY's Gigabit product, Accelar. This product is the fruit of Bay's
acquisition of Rapid City, one of the leading Gigabit ethernet start-ups which
was announced last summer. In addition to its switching capabilities scaling
from 10 Megabits to 1000 Megabits, the Accelar is also enabled to recognize and
transmit layer 3 information which allows it to take over many of the functions
of a traditional router. The fact that the product is on allocation is obviously
positive, but the prospect of cannibalization of the router business is a factor
in trimming our estimates and also making us feel there is little upside to our
$1.55 estimate for FY99.
Margin story still in tact. In discussing the long term impact to gross margins
from a variety of factors, we found no change in the company's positive stance.
While the pricing environment remains very competitive, it has not surprised the
company on the downside. On the component side, the pricing of key memory
components is actually better than the company expected when it made its budget
over six months ago. Also the company sees some margin opportunity by bringing
some of its outsourced manufacturing in-house. We continue to believe that the
company can continue to expand gross margin above the 53% level over a two year
period.
20 times forward is an appropriate multiple. We think that 20 times forward year
estimates is an acceptable multiple to pay for Bay, and may even be a bit high.
This would be roughly l times the top line growth rate. Cisco, which is the most
comparable company is trading at about 27 times our forward year estimate of
$3.25 which is actually a slight discount to the company's top line growth rate
of 30%. A 20 times multiple on our estimate of $1.55 leads to a new target price
of $31. |
