A reference to MRVC in a BEST report on BAY's earnings. Also note the discussion of New Oak which MRVC will now compete with with the Xyplex RAS product that they felt was better than New Oak. The references to Accelar is from BAY's Rapid City acquisition - a GE company. MRVC is also a direct competitor here (and will beat their butts when competing for new business, IMO. BAY should have a big edge with existing customers)
BEAR, STEARNS & CO. INC.
EQUITY RESEARCH
Bay Networks, Inc. (BAY - 24) - Attractive
Q3 Below Expectations; Lowering Estimates;
Maintaining Attractive Rating On Medium-Term Outlook
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***While Bay's shortfall in Q3 turned out to be greater than
expected, we continue to believe it was primarily caused by
product transition issues coupled with a seasonal weakness in the
industry and the technology sector, and the company should work
out transition issues and resume growth over the next few
quarters as the industry comes out of seasonal weakness . We are
encouraged by the positive reviews we are hearing from customers
on Bay's new product lineup, particularly the Accelar routing
switch, which appears to be enjoying good demand in the
marketplace. There is also a potential for a new product cycle
from Bay's New Oak extranet router, which should be shipping in
volume in 2H1998.
***Bay reported Q3FY98 EPS of $0.04 (excluding non-recurring
items) vs. $0.10, down 84% sequentially and 57% year over year,
well below our revised estimate of $0.12, on revenues of $547
million vs. $513 million, down 15% sequentially but up 7% year
over year, below our revised estimate of $580 million. The
results were worse than Bay's guidance on March 17 when the
company pre-announced disappointing Q3 results.
***Due to product transitions and a weaker-than-seasonal Q3, Bay
experienced weakness in almost all product lines and geographies.
In addition, gross margin came in lower than expected at 46.8%,
below our assumption of 49.5% and was down from 51.5% in Q2, due
to lower revenues, aggressive pricing environment in the low end
(BayStack 350T), and unfavorable product mix. However, we
believe gross margin will trend up quite materially over the next
several quarters based on new product offerings in Layer 3
switching (Accelar) and extranet routing (New Oak), both of which
carry higher margins. [I wouldn't be as confident of this as BEST is. MRVC can price aggressively here too, and still do well, but which would continue to hurt BAY. Remember, we have all those Xyplex sales people selling domestically, which should give BAY much more competition going forward]
***Geographically, international sales accounted for 37% of total
revenues with strength in Europe but weakness in Asia, while
domestic sales represented 63% of total revenues. As expected,
DSO increased to 55 days from 44 days in Q2, while book-to-bill
was slightly below one at 0.92 in Q3. Meanwhile, management
continued to exercise sound financial control with flat operating
expenses from Q2.
***Due to product transitions and seasonal weakness, Bay
experienced weakness in all product categories. Switching (31%
of revenues) decreased by 20% sequentially, while shared-media
(26% of revenues) experienced a 24% sequential decline. Router
sales (23% of revenues) were down 11% sequentially and remote
access business (6% of revenues) declined by 15% sequentially.
***Despite Bay's problems in Q3, we remain optimistic about the
company's medium-term outlook given the company's strong product
offerings, a large installed base of enterprise customers, which
could position the company well as an alternative to Cisco in the
enterprise market. In the near term, however, the company's
financial performance will greatly hinge on the success of
Accelar, which in turns depends upon how quickly enterprise
customers begin to deploy layer 3 switches on a large scale. We
are taking a conservative view in our estimates for Q4, but
believe Bay can regain good growth momentum beginning fiscal 1999
(which starts in July) when new products (such as the Accelar
routing switches and potentially the New Oak extranet routers)
become the growth drivers of the company.
***We are lowering our FY98 and FY99 EPS estimates to $0.62 and
$1.05, from $0.81 and $1.25 respectively. With potential selloff
today (4/17), BAY shares are trading at 15-16x our calendar 1999
EPS estimate of $1.35, well below its long-term growth rate of
20%. Consequently, we believe long-term investors should enjoy
attractive return on BAY shares
over the next 12-18 months.
***We are maintaining our Attractive rating on Bay.
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MARKET CAPITALIZATION $5.5 billion
SHARE COUNT 227.2 million
EARNINGS Q1 Q2 Q3 Q4
Sep Dec Mar Jun Year P/E
Current 1997 $0.25A $0.10A $0.10A $0.14A $0.58A 41.4x
Current 1998 $0.22A $0.27A $0.04A $0.10E $0.62E 38.7x
Previous 1998 $0.22A $0.27A $0.12E $0.20E $0.81E 29.6x
Current 1999 $1.05E 22.9x
Previous 1999 $1.25E 19.2x
***Excludes non-recurring items.
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FACTORS CONTRIBUTING TO SHORTFALL
1. A seasonally weak March quarter (Q3). While Q3 is typically
weak as it follows seasonally strong calendar year-end Q2, we had
originally expected that the company could buck the trend this
time as a result of a strong product cycle in switching. As it
is turning out, due to aggressive pricing environment in the low-
end and multiple transitions in the industry, the company
couldn't overcome this phenomenon.
2. Technology and product transition could have negatively
impacted core business. We think that a number of technology
transitions could have negatively impacted the company's core
business as Bay's installed base of customers evaluate their
technology options for backbone equipment. We believe we are at
the beginning of a potentially significant transition from
routing to Layer 3 switching in the backbone. Bay's Accelar
routing switch (Layer 3) appears to be enjoying good acceptance
particularly among its own installed base of customers, many of
whom are evaluating the product. Although we believe demand for
Layer 2 switches (such as Bay's System 5000 switching platform)
and standalone routers (Bay's Backbone Node) will remain solid
for a period of time despite the emergence of Layer 3 switches
(because different networks run optimally with different
technologies based on their specific network designs), it appears
that some of Bay's installed base of customers delayed their
purchase decisions for routers and Layer 2 switches while they
evaluated the Accelar routing switch.
WHY WE STILL LIKE THE STOCK?
However, we believe Bay's problem is short-term and the company
should bounce back over the next several quarters based on the
following rationale:
1. Strong Demand For Accelar Bodes Well For Revenues Going
Forward. We believe the Accelar routing switch is enjoying good
acceptance and demand and the company should be able to recognize
significantly higher revenues from the product line in Q4 and in
fiscal 1999.
The company indicated that it met its revenue target of $40-60
million for Accelar in Q3.
2. New Oak's Extranet Router Should Start Contributing to
Revenues in 2H1998. We think Bay's extranet routers (NOC
2000/4000 acquired from New Oak) have at least a six-month time
to market advantage in addressing the Virtual Private Network
(VPN) market ($1 billion market by the year 2000 according to
Forrester Research) and should start contributing to revenues
materially in the second half of calendar 1998.
3. Seasonally Strongest Quarter Ahead. Bay is entering a
seasonally strong Q4 with customer budgets fully established and
the force strongly motivated by the year-end bonus opportunities.
4. Core Business Should Pick-Up Following Evaluation of Layer 3
Switching Technology. As Bay's customers complete their
evaluation of different technologies in their LAN backbone, they
will begin deployment of Bay's products regardless of which
technology they choose (Layer 2 + Router vs. Layer 3).
Consequently, the negative impact on Bay's core business that we
are seeing should abate over the next several months.
5. Severe Price Erosion in Low-End Switching Could Decrease.
Finally, Bay indicated that it believes pricing actions in the
10/100 switching segment over the next 6-9 months will be more
benign than the price cut Bay started in January. As the leader
in the 10/100 segment in both price and market share (40%), Bay,
in our view, should set the tone for a more stable pricing
environment in the 10/100 segment, which should benefit Bay
itself and other players in the segment such as 3Com and MRV
Communications. [This would be nice to see, indeed]
BUT WE CANNOT UNDERESTIMATE LAYER 3 SWITCHING RISK.
At the same time, although revenue opportunities from Layer 3
switching products could be significant (as we have already seen
with Bay's Accelar), we think product transition risks cannot be
underestimated. Layer 3 switching introduces a new, more
efficient way of building next generation networks. Even though
we are somewhat skeptical of the marketing claims that the new
products will provide ten times the performance at one tenth the
price of the traditional routers, the price/performance
improvement is nevertheless likely to be very significant.
Hence, it is possible that customers will delay purchase
decisions while they evaluate the new Layer 3 switching products
such as Bay Networks' Rapid City (Accelar) and Cabletron's Yago.
The resulting pause could delay Bay's recovery.
Companies Mentioned:
Bay Networks
Cisco Systems
MRV Communications
3Com Corp. |
