Our friends at Bear Streans continue to rate Ascend as a "Neutral" [just like Merrill Lynch] and slightly raised their FY99 estimate.
Here is what they had to say:
***Although Ascend appears to be rebounding from its problems in 1997 and has delivered a solid Q1, we are maintaining our Neutral rating on the stock mainly based on valuation - ASND shares are trading at 34x our 1998 and 27x our 1999 EPS estimates respectively (compared to the company's long-term growth rate of 25%). In addition, we are also negatively surprised by a mere 1% sequential growth in the company's WAN switching business, which has generated significant excitement from inventors over the past couple months and has likely been the reason for the recent strength of ASND shares. However, we are seeing improving fundamentals including an 8% sequential growth in the company's remote access concentrator business (driven by strong demand in North America), prudent expense control and a stabilizing pricing environment in remote access. The worst for Ascend is behind us, we believe. Consequently, we will revisit our rating on the stock should ASND shares retreat to low 30s (at 22-23x our 1999 EPS estimate) on possible profit-taking from investors.
***Ascend reported Q1 EPS of $0.26 vs. $0.31, up 7.5% sequentially but down 15.5% year over year, beat our estimate by $0.01, on revenues of $305 million vs. $293 million, up 4.3% sequentially and 4.2% year over year, right in line with our expectation. The company reported a gross margin of 64.0%, unchanged from Q4 and slightly better than our forecast of 63.7% owing to stable pricing environment in the remote access concentrator business. At the same time, management continued to do an excellent job in keeping operating expenses flat (in absolute terms) from Q4. Operating expenses as a percentage of revenues declined to 38.8% from 40.4% in Q4.
***Geographically, domestic sales (74.2% of revenues) increased 5.6% sequentially, and international sales (25.8% of revenues) were up 0.8% sequentially from Q4. Japan (10% of business, up from 5% in Q4) was strong, but mostly as a result of one contract win. Surprisingly, Europe (10% of business) was weak, but we believe it was a company-specific issue and does not change our bullish European outlook, as evidenced by strong results in the region reported by almost all other leading networking vendors. Ascend has experienced challenges in its remote access concentrator business in Europe since the second half of 1997 and it appears that it will take the company one more quarter to regain momentum in the region. Overall book-to-bill ratio was above 1.0, while Accounts Receivable DSO was flat at 73 days.
***Among major product segments, remote access concentrator business (44.2% of revenues) - MAX/TNT - increased by 7.8% sequentially primarily thanks to strong demand in North America. In addition, enterprise access division (9.9% of revenues) - Multiband and Pipeline - was up 7.6% sequentially in Q1. However, the company reported a mere 1.1% sequential increase in its WAN switching business (frame relay and ATM WAN switching, and IP router GRF) in Q1. (However, in Q4, the company registered a 75% sequential growth in WAN ATM largely due to the fulfillment of a part of the AT&T contract, in our view, making the sequential comparison difficult.) We believe both frame relay and WAN ATM were up only slightly while the GRF IP router experienced a sequential decline due to continued difficulty to penetrate Cisco's installed base. While the modest growth is partly seasonally related, we believe competition from industry leaders in WAN switching - Newbridge and Cisco - continued to be very intense. At the same time, the company appears well positioned with its new CBX 550 multiservice WAN switching platform.
***Given management's apparent progress engineering company's in its turnaround, we are more confident with our 1998 EPS estimate which we are leaving unchanged. We are also slightly raising our 1999 EPS estimate to $1.45 from $1.35. However, at 34x our 1998 and 27x our 1999 EPS estimates respectively, ASND shares seem fully valued for a company with long-term growth rate of 25%. [wonder what their opinion of Cisco's 51 Pe is?]
***Consequently, we are maintaining our Neutral rating on ASND shares at this level.
GOOD TURNAROUND PROGRESS IN Q1
Solid Growth In Remote Access Concentrators. Ascend appears to be rebounding from its problems in remote access in 1997 and has delivered a solid Q1 in that business segment. Remote access concentrator business - MAX/TNT - grew 7.8% sequentially driven by strong growth in North America. We believe this was a result of strong demand for remote access ports - Interent traffic continues to double every four months - and a more stable pricing environment (price per port appears to have stabilized at $200-250 for large customers) as more customers demand value-added features such QoS (Quality of Service), Class of Service, and VPN (Virtual Private Networks).
Moreover, Ascend appears to have stopped its slide in remote access concentrator market share. While its market share (measured in revenues - an attribute which matters the most to investors, in our view) dropped from 35-37% at the beginning of 1997 to 24% in Q3 1997, it rebounded to 27% in Q4, according to Dataquest.
Improving Operating Model. Management appears to have stabilized the operating model, with higher-than-expected gross margin and flat operating expenses, which should serve as solid foundation for the company's sustainable turnaround. In Q1, the company successfully held gross margin stable at 64%, while improved its operating margin to 25.2% from 23.6% in Q4. We are modeling a gradual decline of gross margin to 63% exiting 1998 and a stable operating margin at 25% on our belief that the company will continue to exercise prudent expense control.
INVESTMENT OUTLOOK
Opportunities In WAN switching. While Ascend's WAN switching business was essentially flat (up 1% sequentially) in Q1, we still believe it will be the growth driver for the company over the next couple years. It seems that carriers have stepped up their spending in the buildout of ATM networks, which will benefit Ascend's WAN ATM business. With a new multiservice module for the CBX 500 (ATM and Frame Relay in one single box) and the ramped-up shipments of the high-density GX 550 ATM core switch, Ascend should be a beneficiary of a market which we believe will grow in excess of 40% over the next 3 years, despite strong market positions of Cisco and Newbridge. Ascend has landed a major contract for its WAN switches from Williams Communications - worth $100-150 million over the next several years, we estimate. Also, the recent GTE win appears worth $20-30 million. (We believe Cisco's strategic alliance with GTE remains intact and think GTE is merely using Ascend as a second source vendor). [I think somebody likes Cisco]
Maintain Neutral Rating Based On Valuation. We are maintaining our Neutral rating on the stock mainly based on valuation - ASND shares are trading at 34x our 1998 and 27x our 1999 EPS estimates, respectively (compared to the company's long-term growth rate of 25%). However, we are seeing improving fundamentals including an 8% sequential growth in the company's remote access concentrator business (driven by strong demand in North America), prudent expense control and a stabilizing pricing environment in remote access ports. The worst for Ascend is behind us, we believe. Consequently, we will revisit our rating on the stock should ASND shares retreat to low 30s (at 22-23x our 1999 EPS estimate) on possible profit-taking from investors. [I assume that guidance to a higher EPS estimate would also cause them to re-think their estimate. Let's hope for good Core Switching business.]
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Interesting comments about Cisco in this report. I read it as we can successfully compete with them in our niche.
Dennis
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