Switch Wars (At An Interop Near You)

This week the networking industry will attend the annual Interop trade show in Las Vegas.   While Software Defined Networking (SDN) and its potential disruption or new growth driver to the networking industry continues to be the main hot topic in the industry, the Data Center Ethernet Switch market remains a vibrant, good growth market in the near/intermediate future.  SDN will clearly be a major force in the networking industry over the next several years, but winning Ethernet Switching Data Center customers and footprint today will only enhance a networking company’s chance of being relevant and driving the transition to SDN.

In the past week, Data Center switch vendors Arista, Brocade and HP all announced new Data Center Ethernet Switch products.  In addition, Juniper announced its new Data Center switch about a month ago.  These and other competitors such as Extreme, Dell, and Huawei are all aiming to be of significant size and the number two Data Center Switch vendor after Cisco, which clearly dominates this market with over 65% market share.  In looking at all the recent Data Center switching product announcements, it seems to me that Arista with its new 7500E continues to stay ahead of the Cisco challengers when looking at a variety of key metrics such as latency, scalability (i.e. supports up to 100,000 servers in a two-tier design) and interface port flexibility (i.e. single line card for 10/40/100GbE).  While these hardware metrics suggest Arista continues to stay ahead of its peers, Arista also was early in developing an open based operating system based on Linux, which positioned the company’s Data Center switch products on the SDN path well before SDN was a hot topic in the networking industry.   In simplest terms, Arista seems to be given the networking industry what it wants, namely, a strong technical product line that offers both best in class hardware metrics and an open and easy to use operating system.

While the battle for number two after Cisco in the Data Center switch market is far from over, especially given the larger resources some of Arista’s competitors possess in terms of R&D, distribution and product breadth beyond switching, Arista seems to me as the one to beat.  I also think Arista’s technology product momentum is making them the likely company to beat in the high profile NYSE Data Center Switching “jump ball” that has been ongoing on for several months.   From a stock perspective, if Arista (currently a private company) can continue to leverage its technical advantages in the Data Center Switch Market through increasing market share, its success will likely take away a key potential stock catalyst for its publicly traded competitors.   While Cisco will always be the number one in Data Center Switching, a strong, rapidly growing number two could make for a good investment opportunity.  Right now, Arista is making that challenging for its publicly traded peers.

Disclosure: I do not currently own shares of any company mentioned in this blog post.  NT Advisors LLC may solicit any company mentioned in this blog post for consulting services.

What To Do With ALU?

In prior blog posts over the past few months I have been positive on technology stocks for 2013 given low relative valuations to the overall market and my view that IT and telecom capital spending will recover in 2013.  In particular, I have liked Alcatel-Lucent and Ericsson as a play on telecom capital spending and increased concern over Huawei as a security threat in the US (and some other markets), and recently Hewlett Packard given extreme negative sentiment, favorable cash flow and a low valuation, which was amplified by the Dell LBO valuation metrics.

While I remain positive on technology to outperform this year, Alcatel-Lucent has become a bit more challenging of a stock in my view.  I think the stock could still work over the course of the remainder of 2013, the next 2-3 months could be volatile and the stock could decline until after 1Q13 results are reported.  I base this on the new dynamics that have become public since the company reported 4Q12 results on February 7th, namely:

–       A new CEO was announced and he will not take over until April 1st, thus, potentially distracting the company during this interim period in 1Q13 as well as the new CEO potentially resetting expectations lower given new CEOs often seek to “lower the bar” when they take over a struggling company

–       Press reports about a potential combination with competitor Nokia Siemens Networks (NSN), which in theory could be positive but in reality may be very difficult to implement and execute

–       Press reports that the French government may take a stake in ALU to help secure the future of the company and its patent portfolio, which I think would not be in the best interest of shareholders

Positive on New Executive Announcements

I think the new CEO selection of Michel Combes seems like a good one given his background in the telecommunications industry at Vodafone and France Telecom and more importantly his reputation as a cost cutter, which is what ALU needs the most right now.  I think it is also positive that a new CEO was selected quickly, rather than long drawn out process.  I believe he will be well received by investors when he takes over the company on April 1st.  In addition, I strongly favor the selection of Jean Monty for the new role of Vice Chairman of the Board of Directors. When I was a Wall Street analyst, I found Jean Monty as an excellent CEO as he led the turnaround of Nortel in the 1990s after Nortel had underinvested in R&D and was suffering market share loss and degrading customer relationships.

While I am positive on the two new executive announcements, this first quarter could be a very challenging one for ALU.  The new CEO does not take over until April 1st.  The company could lack focus on trying to deliver the best financial results as possible given uncertainty on what the new CEO will do when he takes over on April 1st.  In addition, the first quarter of every year tends to be the most challenging for ALU and in the industry as a whole.  Thus, there could be some pressure on ALU shares until 1Q13 results are behind the company in my view given these transitory issues.

 Merger With NSN Good Theory, But Probably Difficult in Reality

The press has reported that ALU may be seeking a merger, investment or some other partnership with European competitor NSN. In theory, a merger with NSN might look attractive given both ALU and NSN are competing against much larger wireless infrastructure suppliers Ericsson and Huawei.  Combining forces would reduce competitive pricing pressure and provide more scale to compete against these two larger companies.  In reality, however, merger of equals in the telecom infrastructure usually results in 2+2=3, not 4 or 5.  The reason is that rationalizing duplicative product lines (wireless infrastructure in this case) is not easy, as customers do not typically accept products to be discontinued due to a merger. Thus, duplicative products and associated costs linger much longer than anticipated.  The other main issue in merger of equals is the cultural clashes of the two companies and political infighting that take place post the merger.  In fact, both NSN and ALU experienced these issues when each entity was formed in prior mergers (i.e. Alcatel merging with Lucent and Nokia Networks merging with Siemens infrastructure).

In addition to the challenge of achieving synergies being difficult in a merger between ALU and NSN, the appetite of NSN to go through such a restructuring effort after it is far along on its own restructuring plan would seem low to me.  NSN is well along in its restructuring into a primarily wireless infrastructure company after selling most of its other businesses and downsizing the company’s workforce by close to 25% (e.g. Access business sold to Adtran, Optical business sold to Marlin Equity Partners, Microwave Transport to DragonWave and Business Support Systems to Redknee etc.).  These restructuring efforts have paid off for NSN as it has reported solid financial results in 2012.  Merging with ALU would require a long merger process followed by another couple of years of new restructuring.

Another problem in merging NSN and ALU is that NSN is not a public company and does not have its own stock.   It seems to me that NSN, if public, would have a higher valuation than ALU and be more of the potential acquirer or investor into ALU than ALU being the acquirer or investor into NSN.  NSN is much further along than ALU in its restructuring, and as a result is much more profitable than ALU with full year 2012 operating margin of 5.6% and 4Q12 operating margin of 14.4% vs. ALU full year operating margin of (1.8%) for 2012 and 2.9% for 4Q12.  In addition, NSN has been generating positive cash flow for the past several quarters while ALU burned cash in 2012.  The better profitability, cash flow generation and further restructuring progress at NSN, would likely result in a higher valuation for NSN than the current ALU valuation.  ALU currently trades at about 0.3x EV/Sales. Ericsson, the other global, large, profitable and publicly traded telecom equipment supplier, currently trades at about 1x EV/Sales. My sense is NSN would trade closer to the valuation of Ericsson rather than ALU (maybe 0.6x-0.7x EV/Sales as an estimate).

Given NSN would have the higher valuation than ALU, but does not have a public stock currency, either NSN would first have to be spun out as a stand alone company to obtain a stock currency or NSN parent companies Nokia and/or Siemens would have to put up the cash to acquire ALU.  A spinout is certainly a possibility, but that will take months to implement and it would be highly unusual for such a spinout to do a large acquisition right after the spinout.  I also think neither Nokia nor Siemens has the appetite for using their cash to acquire ALU.  In particular, I think Siemens no longer views telecom infrastructure as strategic and would be reluctant to provide any additional cash infusion to NSN so it could acquire ALU.  Siemens is more likely looking at monetizing its potential stake in NSN (e.g. about €4-€5 billion) rather than investing more into the JV to acquire ALU.  Nokia may want to maintain an ownership in NSN even post an spinout given there are some advantages in selling both mobile devices and infrastructure to telecom operators. Huawei is using this tactic more often, and I believe Nokia views NSN as a way of countering this Huawei sales approach.  There may be some other intricate financial means for NSN to acquire ALU than the two I mentioned above, but regardless of the method, it would be a challenging integration in my view.

French Government Involvement Not Likely In Shareholders’ Interest

Press reports also suggest the French government may seek to invest directly in ALU via the government’s Strategic Investment Fund.  This fund was used in the past to invest in other French based companies (e.g. Gemalto and Nexans SA) that the government viewed as critical to French competitiveness. I am not positive on a French government investment in ALU.  I think a key motivation of the French government to invest in ALU would be for job preservation in France (ALU employees about 9,000 in France), which would oppose the whole idea around cost reduction for ALU and not be in the best interests of shareholders.  For shareholders, I think it would better to see ALU go through a restructuring program much like NSN did over the past two years, rather than take an investment from the French government to preserve French and other European jobs.   As I mentioned in prior blog posts, ALU cannot remain in all aspects of telecom infrastructure, but should follow the path of NSN and focus where the company has scale and competitive advantage. Namely, I think ALU should focus on Access, IP Routing and Optical.

Disclosure: I currently own shares of Alcatel-Lucent, Ericsson and HP although I may look to sell my ALU position in the very near term given points I mentioned in this blog.  NT Advisors LLC may currently or in the future solicit any company mentioned in this blog post for consulting services.

Return of the Telecom Jedi?

I continue to be positive on large telecom equipment suppliers Ericsson and Alcatel-Lucent.  The main premise behind my positive view is the telecom infrastructure industry is a cyclical industry, and we are likely to see a recovery of capital spending by telecom operators in 2013. This recovery in telecom spending, combined with relatively low valuations for equipment companies like Ericsson and Alcatel-Lucent, should allow these stocks to have good relative performance in 1H 2013.

In addition to this primary thesis on these stocks, I also point to two other recent data points.  First, the strong recent operating results and profits by the telecom equipment infrastructure business at Nokia Siemens Networks (NSN).  As mentioned on a prior blog post, NSN has reported better than expected profit margins in the past three quarters and seems to be executing well on its restructuring plan.  Secondly, I believe the momentum of Chinese based equipment suppliers Huawei and ZTE is diminishing (at least for now), which should bode well for Alcatel-Lucent, Ericsson and others.  This is an important point as Huawei and ZTE have been massive market share gainers and price setters in the telecom infrastructure market over the past decade, which negatively impacted the entire sector.

Both Huawei and ZTE provided financial updates on their 2012 results in the past couple of weeks, which showed slowing momentum in terms of further market share gains and achieving their respective 2012 revenue targets.  According to the Financial Times, Huawei announced in January revenues of about $35 billion for 2012, but that was below the Huawei target of $38.7 billion it was discussing as late as September of 2012.   Over the past couple of years, Huawei has been seeking to achieve its long-term growth targets by entering the new markets of Enterprise Networking and Mobile Devices.  While the company seems to be doing well in Mobile Devices at the low end of the market, Huawei does not seem to be hitting its targets in the Enterprise Networking market.  These new efforts are also spreading the company thin in my view and puts Huawei on a multi-front competitive battle with Cisco and HP in enterprise networking, Samsung in mobile devices in addition to traditional competitors like Alcatel-Lucent, Ericsson and NSN in telecom infrastructure.

As for ZTE, the company pre-announced lower than expected results for 4Q12 last week.  Not only were the results lower than expected, but also some equity research analysts now believe ZTE’s market share gains in the international telecom equipment market have stalled.  Below is an exert from a research report on this topic from UBS Investment Research:

“After large-scale staff layoffs and the closure of a few representative offices in

overseas markets, we believe ZTE’s growth in the overseas equipment segment

will slow significantly. Our channel checks suggest the pipeline for new

contracts is limited. In the longer term, we believe ZTE’s withdrawal from some

developed markets means the prospect of ZTE gaining a top-three role as a

global equipment vendor by overtaking Nokia Siemens Networks (NSN) and

Alcatel-Lucent has become quite slim.”

Source: UBS Investment Research Report Dated 1/28/13

 

Disclosure:  I currently own shares of Alcatel-Lucent, Ericsson, HP and Cisco all of which are mentioned in this report.  I also may solicit any company mentioned in this report as a potential consulting client for NT Advisors LLC.

 

 

 

 

Cisco Wants To Be #1 – Déjà Vu All Over Again

Cisco held its annual financial conference on December 7th and as expected, the company outlined its new plan to become more of a software and services company. I wrote about this twist on Cisco’s strategy on my blog “Cisco Pulling an IBM?” on November 19th.   While Cisco spent a good part of its analyst day talking about how it is best positioned to implement this new strategy, CEO John Chambers also put out the goal for Cisco to be the number one IT company in the world in the future.  What I found interesting about this statement is that Cisco first put this target out in the 2006-2007 timeframe in a prior financial analyst meeting.  At that time, Cisco had its “secret” spin-in Nuova developing the UCS blade server allowing Cisco to expand its addressable market within the IT industry from networking to also servers.  Cisco was also at that time initiating its entry into the consumer IT segment, which it later shutdown in 2011 post the failed 2009 acquisition of Flip maker Pure Digital.

Cisco backed off its aim to the be the number one IT company when the 2008/2009 recession led to a decline in Cisco revenues and earnings, and concern that HP was going to commoditize its traditional networking business hit the stock in 2010/2011.   Well now that the great recession is over and HP is viewed less likely to be a challenger to Cisco given the numerous problem the company is experiencing, John Chambers has re-launched the bold target to be number one.  In 2006/2007, Cisco had the expansion into servers and the data center market as its launch pad for being more than just a networking company.  Today, Cisco is using a more aggressive entry into software and services as the next frontiers for being number one.  Storage seems to remain an area of partnerships rather an acquisition for now, but that could change depending on what EMC decides to do in the future with regard to any broader efforts in the networking market.

In my view, Cisco is better positioned in the networking industry than it was a couple of years ago as primary large competitors HP, Huawei and Juniper are less of a threat.  HP has had many corporate issues and a failed overall strategy to date, Huawei’s success in entering the Enterprise market has shown little progress outside of China and Juniper is spread thin and faces niche competitors in addition to Cisco in areas such as security and switching.  The improved competitive standpoint in networking and a much stronger commitment to capital returns to shareholders via a higher dividend yield than the past has make Cisco stock a safer place to be these days than the past three years.

While Cisco stock may be safer today than in the past three years, I think its still a long shot for Cisco to fulfill the number one IT company goal given IBM is basically already the de-facto number one IT company today with a strong suite of software and services, trust by corporate CIOs and a very focused and consistent strategy.  I don’t see IBM bowing to Cisco’s new goal to be number one.  In addition, other large traditional IT companies like Oracle and EMC and new challengers to the traditional IT model like Amazon, Apple and Google are all aiming to capture a larger share of corporate IT spending.  So until proven otherwise, Cisco’s claim that it wants to be number one in IT sounds like déjà vu all over again to me.  Given John Chambers is likely to retire within the next 3-4 years, the ultimate outcome of this goal is not even likely to be known when he departs after a long and successful role as CEO since 1995.

 

Marlin Attempts A Roll-Up Strategy In the Optical Market – Good Luck!

It appears Marlin Equity Partners, a private equity firm, is attempting to create a new Optical Systems roll-up company. Specifically, the company announced today that it was acquiring the Optical Systems business of Nokia Siemens Networks (NSN). This follows the announcement in October of the acquisition of optical switching company Sycamore Networks.  Marlin is quoted in the press as saying it wants to act as a consolidator in the optical market and buy more assets.  Thus, it is likely they will look to acquire more optical in assets in the future.

Strategy Will Be Challenging

My take on this strategy is that a successful outcome will be difficult for Marlin. While the long-term historical growth rate in the optical systems industry is fairly robust at 6%-7%, actual annual growth rates are very volatile around the average.  In addition, gross margins in the optical systems market have remained in the 35%-45% range for over 20 years with high R&D costs required to maintain innovation limiting overall net profit margins.  This has led to very few optical systems companies showing consistent profitability and free cash flow generation over time.  Finally, Marlin will only have a combined global market share of about 4% with NSN and Sycamore.  With Chinese competitors Huawei and ZTE of both having materially higher share of about 20% and 12% respectively and technology leaders Alcatel-Lucent and Ciena having shares of about 16% and 10% respectively, Marlin will be very challenged to obtain scale in the business.

Buying Cheap, But May Not Be Enough

The one advantage Marlin has in its strategy is that it is implementing this roll-up strategy at a time when optical system valuations are at the low end of the historical range in terms of price/sales multiples (e.g. Ciena is trading at about 0.8x sales vs. a 5 year range of 0.5x-3.5x) and my guess is they are not paying much for either NSN or Sycamore.  However, compiling 2nd/3rd tier businesses at low prices does not guarantee a great strategy.  I have yet to see a successful roll-up strategy of 2nd/3rd tier players in the communications equipment market (e.g. Zhone).   Marlin will also perhaps be challenged in quickly achieving cost reduction given a high level of European employees in the NSN transaction.  I am sure Marlin was aware of this prior to pursuing the deal, but even so, layoffs in Europe typically take a long time to implement and have high severance costs associated with them.   Look at all the issues Alcatel-Lucent is having in cutting headcount in Europe even as the company is burning cash consistently and has a troubled balance sheet.

Sign of the Times

We have also seen some recent attempts at buying assets on the cheap as part of rollup strategy this year in the sector including Adtran/NSN in the broadband access market, Calix/Ericsson in the broadband access market and Oclaro/Opnext in the optical components market.  Thus, Marlin is not alone in trying to take advantage of companies “throwing in the towel” in certain businesses and buying assets at low prices in an attempt to build scale and value over time.   I suspect this trend will continue given the ongoing slow capital spending growth in the sector and poor stock performance of equipment manufactures.  Companies like Alcatel-Lucent and Tellabs have already announced plans for layoffs, and closing/selling certain businesses within these and other companies over time is likely in my view

Adva or Fujitsu USA May Make A Good Fit For Marlin

For years as an equity research analyst there was constant speculation about private equity and other companies looking at rolling up the 2nd tier optical systems companies.  When Nortel’s optical systems business went up for sale in 2009 during the Nortel bankruptcy process, however, only Ciena and NSN (likely partnered with private equity at the time) actually bid on the assets.  The fact that no other private equity shop bid on the Nortel asset at the time and the lack of any other attempt to rollup the optical system industry since then I think is a sign that the actual implementation of such a strategy will be challenging.

Given that Marlin now appears ready to give the optical systems rollup strategy a shot, what other deals might be appealing to them?  NSN is strongest in long haul transport and Sycamore has technology in bandwidth management/switching.   Thus a metro optical company would make the most sense for Marlin. The two that come to mind here are Adva and Fujitsu’s US optical business..  Fujitsu is already partnered with NSN in the US market at AT&T.  The challenge with acquiring the Fujitsu US optical business is that the R&D is done in Japan, which will complicate the integration of both NSN and Fujitsu. Adva might be an easier integration given that the company is based in Europe, where most of the NSN R&D is centered.    It certainly will be interesting to watch….

Cisco Pulling an IBM? Reasonable Strategy But Starting Point Is Different

As noted on my Blog from October 24th “Tucci Says No to Networking; Chambers Says Yes to Software”, Cisco is becoming more serious in its pursuit to transform its business model to become less dependent on traditional networking hardware products (e.g. Ethernet Switches, Routers etc…) and more dependent on recurring revenues from higher margin software and services.  CEO John Chambers and the Cisco Board finally concluded that reinvigorating revenue growth to the glory days of Cisco’s past as a means of reversing Cisco’s declining price earnings multiple that has taken place over the prior 12 years was not going to work.  Paying a healthy dividend and improving earnings growth/visibility even during economic downturns was a better formula for shareholder returns and relative valuation metrics to other large mature technology companies.

While I agree with Cisco’s new strategy and give credit to Cisco for finally pursuing this course of action, Cisco is entering this transformation with very high gross and operating margins. Thus, while many hope Cisco can “pull and IBM” over the next several years in transforming its business to more software and services, IBM started its transformation from an easier starting point in terms of profitability margins.   This high starting ground for Cisco, reflective of still very high margins in its traditional networking hardware platforms that are subject to longer term margin pressure, will make Cisco’s transformation a lot more challenging than IBM’s in my view.  It is also likely to lead to more aggressive and larger acquisitions in the software industry in the next two years.  NDS and Meraki, the two largest software-like acquisitions in 2012 so far, are likely to be just the start of things to come at Cisco.

Cisco Hitting Recent 5%-7% Growth Target, But Helped by Acquisitions

Chambers no longer talks about the 30%-50% revenue growth goal that was the Cisco growth mantra up until the tech bubble crash in 2000 or the 12%-17% growth target that followed post the tech bubble recovery in 2004 but rather a more subdued 5%-7% growth that followed post the recovery from the 2008 financial bubble collapse.  Cisco has been living up to this new target with average revenue growth of 6% in the past eight quarters.  Even this more modest goal has not been a layup for Cisco, however, as organic revenue growth excluding acquisitions in the most recent quarter and guidance for the next quarter is below 5%.

With Revenue Growth Elusive, Pursue Earnings Visibility and Dividends

With strong organic revenue growth proving to be elusive for Cisco given increased competition from niche start-ups in various product categories (e.g. F5 in Layer 4-7, Palo Alto in Security, Arista in Switching etc…), price competition from broad large IT companies like Huawei and HP and the potential for a new business model disruption to its hardware centric business from the emerging Software Defined Networking architecture, Cisco altered course to pursue an “IBM like” model of high margin recurring revenues from software and services and an increasing dividend payout.  This increasing focus on software and services was very prevalent on Cisco’s earnings call last week as evident from this quote from John Chambers:

“…we are focusing very aggressively, even though it takes a couple of years to do it, much more software, much more recurring revenue…”   

I think John is being a bit optimistic that this business model transformation will only take a couple of years, but it is certainly clear that this is the new direction for Cisco.  This software, services and recurring revenue strategy is also very evident when one looks at the acquisitions Cisco has made so far in 2012.   In 2012, Cisco has announced 8 acquisitions with only one being in classic hardware (e.g. Lightwire for development of lower cost transceiver modules within Switching and Routing platforms), while all the other companies were primarily software companies.  In particular, the two largest deals of the year, NDS Group ($5B purchase price) and Meraki ($1.2B purchase price) were predominantly software-based businesses with gross margins above Cisco’s corporate gross margin in the 60% range.

Cisco Will Be Challenged To Achieve IBM’s EPS Growth Rate and Visibility

Besides concluding that strong organic revenue growth was unlikely given failed attempts in the past decade, Cisco likely looked at the success IBM has had over the past decade in reducing its earnings volatility during downturns in the global economy and how that has led to a superior stock performance and improved valuation vs. Cisco.  In particular, IBM has shown only about 3% revenue CAGR over the past decade, but its operating income has grown at about a 30% CAGR and EPS CAGR of about 23%.   Over the same period, Cisco has shown stronger revenue CAGR of about 11%, buts much weaker operating income CAGR of 8% and EPS CAGR of 13%.  More impressively, IBM never had a down year in EPS over the past decade, even during the “great recession” of 2009.  Cisco on the other hand, had two years where earnings fell with a 20% decline in fiscal 2009 and a 14% decline in fiscal 2011.

While Cisco’s revelation that a business model around strong revenue growth was not achievable and pursuing a more stable, higher margin, recurring revenue model with higher dividends was more favorable for its shareholders there is one major difference between when IBM started its transformation and where Cisco is today.  Namely, IBM’s gross margin and operating margin a decade ago were in the high 30s and between 8%-9% respectively.  By focusing on software and services via acquisitions and organic development, IBM was able to increase its GAAP gross and operating margin to about 47% and 19% respectively.  Cisco on other hand is starting its business transformation from a very high margin structure with GAAP gross and operating margin of about 60% and 22% respectively.   Cisco still derives well over 50% of revenues from networking hardware platforms and enjoys extremely high margins of over 60% on these platforms.  The ability to transform its business model to more software and services will only be achieved if Cisco can preserve profit margins on traditional networking platforms.  This is likely to be challenging in my view as traditional networking products will likely to continue to experience margin compression over time given the ongoing trends of Software Defined Networking, increased availability of networking merchant silicon making lower cost networking platforms more prevalent and continued pricing pressure from large IT players from China like Huawei.   With such a challenging goal, I believe Cisco will seek to achieve its transformation via a more aggressive acquisition pace in the software area and a networking hardware sales approach that seeks to maximize the leverage of its installed base to delay as much as possible the likely margin pressure in traditional networking products.

 

Matt Bross To Juniper? I Really Doubt It

Light Reading reported yesterday that Matt Bross, the CTO of Huawei, has left Huawei and is likely heading to Juniper.  The timing of such speculation is very interesting as Juniper executive Stephan Dyckerhoff, EVP of the Platforms Systems Division, announced last week he was leaving Juniper in the near future to pursue a career in venture capital.  Some have taken the Light Reading report and Stephan’s departure as perhaps endorsing the press report that Matt Bross is in-fact heading to Juniper.

I personally think Matt Bross is not going to Juniper.  I think Matt Bross would not be a good cultural fit with the Juniper culture and his joining Juniper would be more detrimental than helpful.  I also think it would be difficult for Juniper to parade around the former CTO of China based Huawei to its top customers as a new senior executive of the company.  The more I think about this speculation, the more I conclude it makes very little sense and Juniper’s management team and board will hopefully see it the same way.

Juniper Stock Seems Stuck

After reviewing Juniper’s 3Q earnings release and listening to their earnings call tonight, I came away continuing to think that Juniper’s stock is stuck in many ways.  In particular, the company seems to be bound to single digit revenue growth at slightly over $1 billion in quarterly revenues and a peak quarterly run rate of $0.20-$0.25 in pro-forma earnings per share.   In the world of technology stocks, former darling growth companies that seem stuck in terms of revenue growth and peaking earnings power suffer the ongoing melting away of their valuation multiple. Clearly Juniper has seen their valuation compress over the past several quarters, but hopes of an expanding multiple do not seem likely for now.   With earnings bound  between $0.80 and $1.00 on an annualized run rate, the stock is not likely to get over $20/share in my view anytime soon.

The key for Juniper’s valuation expansion will be acceleration of its revenue growth and margin preservation. While new products like the PTX in MPLS Core Switching and Q-Fabric in Data Center Fabrics have provided hope to the Juniper bulls on the stock over the past year or so, these products continue to ramp very slowly.  There also continues to be doubt on how successful the Q-Fabric product will be given its lack of significant revenue traction in the past few quarters, increasing competition in this segment of the market and the potential overhang that the open standards Software Defined Networking (SDN) architecture poses to the originally closed Q-Fabric offering.  Juniper mentioned on their call that SDN is a key area of focus for the company, and it is likely the company will focus its efforts in the future to make the Q-Fabric more open and less reliant on the originally planned closed Juniper Q-Fabric controller.

There also continues to be a lack of excitement in the future growth prospects of the traditional Router and Security businesses.  Both Routing and Security products have shown year over year declines for the nine-month period through the end of 3Q12.  One could argue somewhat convincingly that routers are suffering a cyclical decline and are poised to recover at some point, but even so, the future growth is likely to remain sub 10% in the future.  Security is not suffering any cyclical decline, but rather a case of niche specialized competitors gaining share (e.g. Palo Alto Networks, Fortinet etc…) as Juniper has lost competitive advantage in this market.  \ It is unlikely this business will return to a consistent growth story in the future.  The company continues to do well in the traditional enterprise Ethernet Switch market growing 20% year to date vs. last year, although this business tends to be lower in margin profile than both routing and security, thus, not likely to help the long term business model.   Even so, this is the one share gainer Juniper has going for it right now.

What Should Juniper Do?

Juniper is in a multi-front war in Service Provider Routing, Enterprise/Data Center Switching and Next Generation Security Firewalls all of which will also be challenged in some unknown way by the emergence and deployment of SDN in the next 3 years.  The status quo of investing in all of the above seems like a high risk proposition for Juniper as it will have to continue to fend off much larger companies like Cisco and Huawei and smaller product specialists like Arista Networks, Palo Alto Networks etc…  My sense is Juniper will need to focus more, get back to its roots in the Service Provider market and seek larger committed partners that can help it succeed in the Enterprise market.  Breaking up the company while likely very difficult could also be a favorable outcome for shareholders as different buyers would emerge for the Service Providing Router business and the Enterprise business.