Jeff --
I believe the primary reason for H&Q's rating NN "market perform" is NN's inability to guide analysts' expectations more than any fundamental issue within the company.
Michael Neiberg writes:
On May 4th, the company reported that fiscal fourth quarter sales and earnings would fall below Wall Street expectations as the result of serious operational issues which prevented the company from shipping as much as C$115 million and capitalizing on quarterly orders of over C$550 million. These operational issues took both the company and the investment community by surprise. Management indicated on a conference call that as little as ten days before the pre-release they had believed that they were going to post better than expected quarterly earnings. We believe that the ability to better forecast sales and production is essential to Newbridge, and we believe this problem will take several quarters to resolve.
He goes on to discuss NN's competitive position:
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* dramatic growth in data traffic over the telecom network. According to the Yankee Group. . . NN has the largest market share, at 26%, of the WAN ATM market. Additionally, the company's mature TDM product line could see renewed strength if the emerging markets in Asia and Latin America see some renewed economic strength.
* well positioned to sell products directly to the North American incumbents. The company, through their relationship with Siemens, has been successful selling into Europe and Asia. The company has not capitalized on the emerging carrier space as well as some of their main competitors (Cisco, Ascend) and is currently working on building channels to the CLECs and ISPs. There has been tremendous consolidation in the WAN switch vendor marketplace, and there is the risk that some of the company's competitors bundle competitive switch products into systems level solutions (Alcatel, Lucent, Cisco).
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Clearly, written before Cisco announced it was cancelling its core ATM switch development.
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* While we have no real revenue expectations for the 36190 Core ATM switch developed in conjunction with Siemens, we do believe it is imperative that the companies increase the speed of the backplane of the 36170 up towards 50 gigabits. NN is also in the process of entering the IP switching space, either as a service offered out of the 36170, or through the development or acquisition of a high-speed router. Based on a strong Book to Bill ratio in the WAN packet segment, we believe that over the next several quarters, growth from this segment could be in excess of 10% sequentially.
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NN has already announced its 50/320 gig products, with the 50Gig in labs this fall and the 320 following shortly thereafter. No credit given for Ironbridge, NN's affiliate developing an IP router. Neiberg has underestimated WAN packet growth, a conservative stance based on recent operations difficulties.
* The company has a number of investments in start-ups, known as the Newbridge affiliates. The technologies that these companies focus on range from Network Management to communications components to IP. We estimate the value of these investments approach $4 per share. Over the past year, the company as divested of several of these affiliates including ACC and Cambrian, raising the company's overall cash balance to approximately $700 million (US). Going forward, we expect to see continued divesting of the affiliates and seeing Newbridge focus more directly on their own core WAN market. This obviously includes bringing a bigger presence on IP switching into the company.
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He notes the high valuations of IP start-ups and yet doesn't include these inflated values when referring to NN's IP affiliates, most notably those they'll bring in-house.
COMPETITION
On the ATM side of the business, as a result of acquisition, the company is now competing with large systems companies including Lucent/Ascend, Cisco/Stratacom and Alcatel/Xylan. Additionally, depending on the success at the carriers of the Terabit/Gigabit routing companies, there may be a new breed of competition including Avici Systems & Nexabit. The TDM market is now mature and is not intensely competitive on a market share basis, however, Network Equipmetn Technologies does remain a viable competitor.
Cisco's out. Alcatel/Xylan isn't a competitor, in fact Alcatel could use NN to combat LU and NT. LU/ASND is real, but they're losing out at BEL and NN's gaining strength with several of their Next Generation service providers.
RISKS
* Internal controls --- . . . until these issues have been resolved, it will prove to be exceedingly difficult to forecast quarterly EPS. . . .
Forecasting is an analyst problem, not a corporate problem. If I had to choose between disappointing analysts and the problems associated with knocking the socks off product growth, I'd choose the latter.
* Siemens Relationship --- [Alliance and distribution channel] Over the past several years, this relationship has been beneficial for NN, but not without some difficulties, the most noticeable has been the failure of the consortium to develop the Next Generation 36190 Core ATM switching platform. The risks associated with this relationship are twofold. First, over the past several quarters, Siemens has made several Data Switching related acquisitions (Argon Networks and Castle Networks). At this current time, the acquisitions appear to be complimentary, but over time this could change. Additionally, the presence of Siemens at approximately 18% of sales does make NN a tougher acquisition target in this rapidly consolidating industry.
The alliance isn't developing the 190, Siemens is. NN recognized the lack of progress nearly a year ago and under Brian Jervis's direction has surpassed the 190 with the 50/320. Argon and Castle are totally unproven start-ups (NN passed on Argon and later hired their CTO) and are not considered threats by anyone I've talked to.
* Rapid conversion to IP --- . . . NN is in the process of getting a new IP strategy to meet the demands of these new customers and the ISPs. We believe that demand for carrier ATM switches will continue to be robust and complementary to growth in IP, however, if IP were to replace ATM at the core of carrier networks, this would pose a competitive threat to NN.
In the Robertson Stephens NN report dated June 25, 1998, Paul Silverstein discusses NN's IP development at Ironbridge, TimeStep and Bridgewater, indicating some analysts have understood NN's IP plans far longer than others. Perhaps Neiberg should beat the bushes a little harder.
* Dilutive Acquisition --- The company, which has historically been adverse to acquisitions, may make an IP related purchase of a technology start-up to enter the high speed routing sector. Given the valuation that several of the companies in this sector have received, any acquisition would almost certainly prove to be dilutive,at least in the near term.
If you own 30% of the company being acquired, it changes the equation. I've been told any acquisitions will not be dilutive.
* Critical Mass --- The WAN switch market has been rapidly consolidating over the past several years with essentially all of the companies competition getting acquired by larger systems oriented vendors. While Newbridge does have global distribution and a big partner in Siemens, it is possible that the companies competitors will be able to bundle WAN switching solutions and offer financing options that are currently that Newbridge is not capable of.
This would be more of a threat if the competition had products that could be bundled.
MODEL ASSUMPTIONS
Our model assumes that the ATM business, despite the current manufacturing environment, continues to show sequential growth for the next several years. In terms of TDM, we are now assuming flat to slightly down sequential from a new base level of C$150 million. As the mix of business shifts more towards ATM, we are forecasting a slight sequential decline in gross margins from 58% in FY99 to 57% in FY00. We are looking for reasonably stable operating margins in the 17-18% range. With a stable tax rate at 30% and slightly increasing share count, we are currently projecting EPS of US$1.00 and $1.30 in FY00 and FY01, and our CYoo and CY00 EPS estimates are $0.85 and $1.20, respectively.
Conservative estimates considering the fact Alan said on the last conference call, "Go ahead and downgrade and then I'll challenge you when we report." [Indicating he'd have more to say on the next CC.]
VALUATION
Given the company's recent EPS shortfall as the result of inadequate controls, our near term EPS projections could unfortunately prove to some degree of variance. As a result, and despite our believe that the demand for the company's WAN ATM business, remains exceedingly strong, selling at 36x and 26x our CY99 and CY00 EPS estimates of $0.85 and $1.20, respectively, we are initiating coverage on Newbridge shares with a Market Perform rating. We would note that given the recent sector consolidation, we believe that there will be a scarcity value placed upon these shares, and that the sale of the company is a definite possibility. We will revisit our rating on this stock as we see proof that the company is successfully resolving its operational issues.
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Based on "sector consolidation" and the "scarcity value" of NN's technology --- clearly understood by Neiberg --- I think it's safe to say the "market perform" rating is a way of disciplining NN for its inability to guide analysts more carefully. Whether they deserved it is immaterial. What is material is the fundamentals underlying the company, overall.
On a different note, the latest Forbes (May 17, 1999) has an article on AT&T's Services division:
forbes.com
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Consulting and outsourcing contracts kept IBM alive. They might help AT&T, too.
Ma Bell at your service
By Scott Woolley
RICHARD ROSCITT WAS LISTENING to a speech by his new boss, AT&T Chief Executive C.Michael Armstrong, when he heard something that made him swallow hard. The old Ma Bell never announced specific revenue targets for its business units. Yet here Armstrong was, promising in public what Roscitt had brashly promised Armstrong weeks before—in private: that Roscitt's fledgling services division would grow sixfold, to $5 billion in sales, in five years.
Armstrong's message to Roscitt after the speech: "Now both of our asses are on the line."
Roscitt, 47, runs AT&T Solutions, which does the mundane job of managing other big companies' telecommunications networks. When Armstrong made his forecast early last year, the unit was bringing in a mere 1.5% of AT&T's $53 billion in sales. It must do more.
So far, Armstrong has spent huge sums to buy growth from elsewhere. For his second act he needs growth, preferably internal. AT&T has just completed the acquisition of cable concern Tele-Communications Inc. for $48 billion, only to make a stunning $58 billion offer late last month for a second cable property, MediaOne, which had accepted a $50 billion bid from Comcast.
"If this is a niche, then it's a niche that's growing at 30% a year and is going to swallow the world."
And while Armstrong has been successful at hacking AT&T's overgrown cost structure, helping boost the share price 45% in the past year, penny-pinching goes only so far. Its core long distance business has been stuck at $45 billion in revenue for the past two years running. A coming invasion by the local Bells could raidone-third of AT&T's 50% share of the business in a few years. Enter AT&T Solutions. It has been growing 30% a year, but Roscitt says his business can post up to 50% growth in annual revenue, the range it achieved in the most recent quarter without any major acquisitions. If he can keep it up, the business could be at $12 billion in sales in five years.
His earlier reluctance aside, Roscitt will likely hit the promised $5 billion mark two years ahead of Armstrong's schedule. AT&T just spent $5 billion to buy IBM Global Network, the phone network division of Armstrong's alma mater, IBM, where he spent the first 31 years of his career. The deal, set to close this month, includes a promise from IBM to pay AT&T Solutions $5 billion to run IBM's global telecom network over the next five years.
The swap was a watershed in the corporate outsourcing world. IBM says it got fed up trying to maintain and understand a global telecom network. Roscitt has already turned that into a sales pitch: "If IBM decides it can't keep up and needs a specialist in networking, then what should Bank of America do?" he asks.
A big push into services resurrected IBM after its mainframe business disintegrated in the early 1990s. Services posted just 9% of IBM sales in 1991 but generate 30% of revenue today. When Armstrong came to the phone company 18 months ago, it looked as if AT&T was too late to get into services. Giants like IBM, Andersen Consulting and EDS had already staked a big claim in high-tech outsourcing. Phone networks were presumed to be just another part of overall computer systems, certain to merge into corporate information-technology operations.
Well, no—and IBM's move to sell its network to AT&T was the final proof of that fallacy. Telecom technology is frightfully confusing, and fiber-optic networks can become all but obsolete by the time they are turned on. While that upheaval gives the rest of AT&T headaches, it builds business for AT&T Solutions.
Some industry analysts still dismiss AT&T Solutions as a specialty business. Roscitt counters: "If so, it's a specialty that's growing at 30% a year and is going to swallow the world." Armstrong just wants it to swallow enough business to keep his shareholders from going hungry.
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I'll be at the AEA conference in Monterey next week and will try to check in from time to time. I'll be watching for progress on the fixed wireless front, among others, and if I discover another SDLI --- found at last fall's AEA in S.D. --- I'll let you know.
Later ---
Pat |
