UBS synopsis: ASND: SOLID FIRST QUARTER; INCREASING ESTIMATES; UPGRADING TO BUY
SUMMARY
ASND reported 1Q98 EPS of $0.26 which exceeded our estimate and the consensus estimate of $0.25. The slight upside was due to better than expected operating margin. Both Remote Access Concentrators (RAC) and Core Switching were up sequentially at 8% and 1% respectively. The balance sheet trends were good as AR DSOs of 73 days remained flat. Increasing 1998 and 1999 EPS estimates to $1.19 and $1.50 from $1.15 and $1.35 respectively. Upgrading stock to Buy from Hold given improving visibility in Core Switching, better outlook on operating margins and stable pricing on RAC market. Our year end target is $45, although we believe stock could exceed our target if takeover speculation increases.
Here are the highlights of the UBS report:
* ASND reported 1Q98 EPS of $0.26 which exceeded our estimate and the
consensus estimate of $0.25. The slight upside was due to better than expected operating margin of 25.2% vs. our estimate of 23.5%.
* The $0.26 result was up from the $0.24 reported in 4Q97 and down from $0.33 reported in 1Q97.
* Revenues of $305M were slightly lower than our estimate of $308M but met the consensus estimate. Both Remote Access Concentrators (RAC) and Core Switching were up sequentially at 8% and 1% respectively. RAC slightly exceeded our estimate while Core Switching fell slightly below our estimate.
* The balance sheet trends were good as AR DSOs of 73 days remained flat, Inventory Turns of 4.3 were up from 4.2 and cash improved to $605M from $475M respectively on a sequential basis.
* Increasing 1998 and 1999 estimates to $1.19 and $1.50 from $1.15 and $1.35 respectively primarily due to higher confidence in Core Switching sales and in better operating margins than prior estimates.
* Upgrading stock to Buy from Hold given improving visibility in Core Switching, better outlook on operating margins and stable pricing on RAC market.
* Our year end target of $45 based on 30x 1999 estimate of $1.50 although we believe stock could exceed our target in 1999 if takeover speculation increases towards the end of the year.
[Is this a possible reference to LU? - The next six months should be interesting]
Here is UBS's analysis:
Ascend Reports Another Solid Quarter - Company Turnaround Continues
After the close on Thursday of last week, Ascend reported 1Q98 EPS of $0.26 which slightly exceeded our estimate and the consensus estimate of $0.25. The $0.26 result compared to $0.24 reported in 4Q97 and $0.33 reported in 1Q97.
The slightly better than expected result was due to a better operating margin of 25.2% vs. our estimate of 23.5%. The better operating margin was achieved from lower operating expenses in both R&D and SG&A than we expected. [Interesting. If the operating margin HAD been lower, I still think we would have seen $0.26 on slightly higher revenues] Revenues of $305M were actually a bit below our estimate of $308M but in-line with the consensus average. More importantly, the company showed sequential growth in both Remote Access Concentrators (RAC) and Core Switching product lines which were up 8% and 1% respectively. Overall, revenues were up 4% sequentially and year over year. The company saw strength in the ISP channel which was up 86% sequentially while both the Carrier and Reseller channel were down sequentially at 15% and 23% respectively. We believe this strong growth in the ISP channel combined with an 8% growth rate in RAC was due to continued customer acceptance of the TNT product in North America. Also, both International and Domestic revenues were up sequentially at 1% and 6% respectively. There was only one customer that exceeded 10% of sales (probably between 10%-13% of sales) which we believe to be UUNET although the company did not identify the customer. UBS includes a nice table:
1Q98 Revenues % of Sales Up Sequentially Up YOY
Channel
ISP $125 41% 86% 16%
Reseller $ 64 21% -16% 2%
Carrier $110 36% -23% 1%
Direct $ 6 2% 4% -54%
Geography
International $ 77 25% 1% -14%
Domestic $229 75% 6% 12%
Asia (ex. Japan) $ 12 4% -30% -20%
Europe $ 34 11% -18% -27%
Japan $ 29 10% 98% 32%
Other $ 2 NA NA NA
Product Line
RAC $135 44% 8% -22%
Core Switching $125 41% 1% 41%
Enterprise Access $ 30 10% 6% 40%
Service $15 5% -7% 41%
TOTAL $305 4% 4%
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UBS says that the outlook On Core Switching Is Solid.
While Ascend only reported a 1% sequential increase in Core Switching sales in the quarter, we believe the outlook is solid. [UBS sees the bigger picture, not just what was reported.] Orders for both Frame Relay and ATM WAN switches were up sequentially from 4Q97. Ascend has announced many contracts in the past few months, primarily in the US market, which we believe provides good visibility in the Core Switching business. These contracts, potential new contracts and existing supply agreements with leading US operators suggest that Ascend is a market leader in the US WAN switching market.
In addition, Ascend is increasing its business overseas with contracts with new operators in Europe. We believe these improving fundamentals in the Core Switching business should allow Ascend to show quarterly sequential increases in revenues throughout 1998. We should point out that Ascend did not recognize any revenue from its new GX 550 ATM switch in 1Q98. Some of the WAN Switching contracts that Ascend has announced or is close to winning include:
1) A contract with GTE Internetworking for 24 GX 550 ATM switches, CBX 500 ATM switches and B-STDX 9000 Frame Relay switches. Ascend will ship against this contract in 1H98. We also believe that Ascend will win a much larger contract with GTE for its CLEC network. We believe this contract entails the purchase of 200 WAN switches including the GX-550, CBX 500 and the B-STDX 9000 switches. Ascend is also an existing supplier to GTE's ILEC frame relay and ATM network.
2) A contract with Williams Company for WAN switches valued at $150M over three years. This contract was announce several months ago, but the buildout is expected to accelerate in the remainder of 1998.
We also believe Ascend may emerge as an ATM supplier to other new IP centric carriers besides Williams in the US. While these new IP centric carriers favor pure IP networks that rely on high speed routers riding over SONET and DWDM networks, our research suggests that such carriers believe IP over SONET technology is not yet mature and will utilize ATM in the initial build-out of these new networks. [This is interesting - we just discussed this on the thread last night] We believe Ascend is well positioned to win its fair share of these ATM opportunities. Longer term, however, Ascend will need to enhance its WAN portfolio to capture the larger opportunity of IP switching products with these new IP centric carriers. [Interesting, more features or possible acquisitions?]
3) A contract to build out Bell Atlantic's ATM network across both Bell Atlantic North and South. Our research shows that Bell Atlantic will increase its purchases of Ascend equipment in the future once it is allowed to offer inter-lata data services. Also, we believe in the future, Bell Atlantic will seek to use ATM switches to carry voice traffic as well in a traditional tandem switch operation. [This is new to me!]
4) Ascend has not yet formally announced any contract with AT&T although the company has been shipping WAN switching products to AT&T since at least 4Q97. Specifically, we expect AT&T to deploy 120 CBX 500 and 90 B-STDX 9000 WAN switches by the end of 1998 in its IP network. We also believe Ascend is pursuing other opportunities within the AT&T account outside of the IP network.
5) Ascend is also winning WAN switching contracts in the international market. The company has already won WAN switching deals with new operators in Europe such as o.tel.o of Germany and Cegetel of France.
Remote Access Concentrators Still A Tough Market But Stabilizing For Ascend
The 8% sequential increase in Ascend's RAC business exceeded our estimate of 6% growth. This is the first quarter since 1Q97 that Ascend showed a sequential improvement in RAC products. Sales increased sequentially in North America but were down sequentially in Europe and Asia as expected. We believe the improvement was due to customers accepting shipment of the TNT and other MAX products due to improving stability in Ascend's RAC software. In addition, we believe that RAC pricing has stabilized after a dramatic round of price decreases in 1997. Finally, an agreement in the industry on a single standard for 56 kb/s modems has taken some concern out of the market.
Ascend will ship a software upgrade to comply with the V.90 56 kb/s standard in May. While we believe that the outlook for RAC is not as certain for Ascend as its Core Switching business, we believe sequential improvements throughout 1998 are now more likely due to the following key points:
1) Stable Pricing: RAC pricing has stabilized in the $200 (low end) to $300 (high end) range. This level of pricing has now remained since the beginning of 1998. While new rounds of price reductions are always possible, there do not appear to be any signs of such reductions in the immediate near term.
2) Max 6000 Product: Ascend has released its Max 6000 for the enterprise market. While total RAC revenues grew sequentially in 1Q98, we believe that only the TNT product within Ascend's Max family or RAC products showed sequential revenue growth. The introduction of the Max 6000 which targets the mid-range of the RAC market and primarily the enterprise customer base should allow for some sequential improvement in the non-TNT MAX product line revenues for Ascend in the next two quarters. The Max 6000 contributed only modestly to revenues in 1Q98.
3) International Growth: The company expects RAC sales to increase to
international markets in the coming quarters. International sales of RAC products have continued to decline on a sequential basis in 1Q98 but should increase in 2Q98 given acceptance of the TNT. Also, we are starting to hear about efforts to create reduced tariff rates in Europe for Internet dial-up connections. Currently, tariff rates in Europe for Internet dial-up are metered since local phone calls are metered in Europe. In the US local phone calls (and thus Internet connections) are not metered which leads to higher Internet penetration and usage in the US than in Europe. While we do not expect Europe to go to flat rate local pricing for Internet phone calls like in the US, any reduction in Internet connections would increase Internet penetration and usage. While this may not be a factor to enhance sales of RAC equipment in 2Q98, it could impact 2H98 if such tariffs emerge.
4) New Products for 2H98: Ascend plans to introduce higher density port cards for the TNT in the coming months. Also, the company will have a third generation product released by the end of the year that will offer higher densities and more functionality than the current TNT.
The RAC market remains the main risk factor in the stock for the next two quarters in our opinion. Specifically, Lucent (LU-$70-Buy) has recently released its PM4 product which was acquired through its Livingston acquisition. While we do not believe Lucent will use price to make the PM4 a success, its marketing muscle and strong relationships with wireline and wireless carriers on a global basis poses a new competitive threat to Ascend's RAC business. In addition, Cisco (CSCO-$67-Buy) continues to seek market share gains in the RAC market and has released several new products in 1998. The competitive landscape and pricing trends in the RAC market need to be monitored closely given that Ascend still derives over 40% of revenues in the product category.
Given the solid results in 1Q98, a better outlook both Core Switching and RAC products and a more stable outlook for profit margins, we are raising our 1998 and 1999 estimates to $1.19 and $1.50 from $1.15 and $1.35 respectively. The improving fundamentals also lead us to upgrade our rating on the stock from Hold to Buy with a year end price target of $45, or 30x our 1999 estimate.
While we do not believe that the stock should get a multiple much higher than 30x estimated 1999 EPS, a case can be made that the multiple could expand slightly beyond that throughout 1998. Specifically, there is a possibility that takeover speculations may surface towards the end of 1998 that Lucent may want to acquire Ascend. Speculation along there lines has surfaced many times in the past and may resume later on in the year once Lucent is able to use the pooling method of acquisition after October 1st. While we are not suggesting that Lucent plans to acquire Ascend in October, just the potential of such an acquisition as we approach October may lead to a takeover premium in Ascend's stock whether an acquisition happens or not.
Lucent currently trades at 33x our calendar 1999 estimate. Thus, there is a possibility that Ascend's multiple could approach 33x the 1999 earnings estimate which would lead to a $50 stock price. While we are not suggesting that investors purchase Ascend on this theory, we mention it in the context of valuation since the possibility of a takeover premium may emerge as we approach October. We believe that the likelihood of such a premium is correlated to the following points:
1) Lucent's 1999 PE multiple as we approach October. Currently the multiple is 33x which is higher than Ascend's PE multiple. If Lucent's multiple does not exceed Ascend's as we approach October, then we believe a takeover premium in Ascend's stock is less likely.
2) The success or lack of success of Lucent's PM4 RAC product line and its MX-1000 ATM WAN edge switch product. We believe that the PM4 has a higher probability of success than the MX-1000 based on our industry checks at this time. The PM4 appears to be a well regarded product in the industry and should be competitive. The MX-1000 is not scheduled to be available in its first release until mid-1998 and this first release will not have a full feature set. Thus, we do not believe that this product will be as successful as the PM4 in 1998 for Lucent. Finally, we expect Lucent to continue to win contracts for its Globeview-2000 ATM core switch. The success of this product, however, we believe is not as relevant to any potential takeover of Ascend given that we view it as a complimentary product to Ascend's family of WAN switches than a competitor.
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