Monday, January 17, 2011

Blue Coat Ready to Take on Riverbed in WAN Optimization?

Optimizing IT Performance






Blue Coat Systems International $BCSI is an interesting stock that is focused on some high growth areas in technology spending. The co is well positioned in  providing Wide Area Network Optimisation Controllers (WOCs) , Secure Web Gateway and Application Performance Monitoring. These are set to be high growth areas in future, thanks to the explosion in bandwidth usage and mission critical nature of the Internet and cloud computing.

In summary, Blue Coat is an interesting value type of play. I argue that Blue Coat is in the 'value' category of stock because Blue Coat have some restructuring issues following disappointing European sales in 2010. The company has increased margins over the years with cost cutting by moving workers to Bangalore, however, earnings growth in future will be guided by a resumption to top line growth. If Blue Coat achieve this, than I would argue that they present good value.


Wide Area Network Optimization the Key Growth Driver

The WAN  industry is growing strongly as bandwidth usage expands exponentially. In addition, WAN optimisation provides a relatively short return on investment and can generate growth even in slower economic times. Bandwidth isn't the only issue as the usage of business applications over the WAN isn't linear. In other words, WAN resources might be needed at unexpected times.

The leader in this space is Riverbed Technology and $RVBD appear to offer a superior solution to Blue Coat in terms of WAN optimization. However, Blue Coat's solutions offer an integrated approach which can incorporate security and performance measurement in 'one box'. If a customer wants an integrated approach, he will favour Blue Coat. For pure WAN optimisation, he is likely to turn to Riverbed. It is incontestable that Riverbed has outperformed Blue Coat this year, but if Blue Coat can turnaround execution difficulties the company should have enough of a differentiated offering in order to grow revenues.

The likes of Cisco, Citrix Systems and F5 Networks all play in this market but they tend to offer specific or expensive large enterprise or data center solutions.

As stated in their Q2 results announcement, WAN optimization-rather than Network Security-appears to be their growth focus

'growth in the traditional enterprise portion of the Secure Web Gateway market has slowed. At the same time, we have been too dependent on selling into the company’s substantial installed base and in fact, we are very effective at lining that installed base last year'
 Blue Coat already has a strong market share in Secure Web Gateway with large enterprises and growth is slowing.


Blue Coat European Troubles in 2010

Blue Coat gave a horrible trading statement in May at the final results. Blue Coat's year end is in April.The essence of the problem lies within European sales

 
Region
Q2 09
Q3 09
Q4 09
Q1 10
Q2 10
Q3 10
Q4 10
Q1 11
Q2 11
Americas
61,295
44,110
52,663
53,305
55,255
53,561
58,344
54,612
56,937
EMEA
37,586
43,905
39,731
41,753
44,952
50,531
47,924
42,207
40,889
APAC
20,143
21,581
21,228
20,931
20,229
23,024
26,325
25,661
23,221
Total
119,024
109,596
113,622
115,989
120,436
127,116
132,596
122,480
121,047

 source: Blue Coat

I've put the European sales numbers in red to highlight when growth turned negative on a quarter to quarter basis. Initially, the company blamed the macro economic environment, however after closer inspection it became clear that executive and operational changes needed to be made.

Whilst Riverbed, in Europe, had focused on direct contact with key accounts in Northern Europe, Blue Coat had taken a different approach. Blue Coat Europe is supposed to run their global model of a blend of one and two-tier distribution approaches. Unfortunately, they seemed to be over relying on the two tier model, which caused problems when the slowdown hit. Ultimately, the sales force was focused on selling into the installed base and when their sales quotas proved too high, the sales guys were disheartened.


Restructuring Blue Coat

Blue Coat didn't stand still in dealing with the problems. Brian NeSmith was moved from CEO to Chief Product Officer and industry veteran Mike Borman was brought in as CEO. He promptly inked a two deals. One with Alcatel-Lucent in order to sell Blue Coat's CacheFlow solution to Telco's, ISPs and mobile operators.Similarly, a deal was done with Brocade to co-develop a network health monitoring solution for telco Co's. Given Borman's three decade experience with IBM, speculation is bound to ensue over closer collaboration between the two Co's. Particularly, as IBM is rumoured to be on the acquisition trail.

In addition, the European sales operation has been restructured with Borman recently stating that sales there were stabilising. Blue Coat has new products coming in the new year and this should help drive growth. The focus is on the high growth WAN optimization market, whereby they have to compete with Riverbed.

Another area of growth is Asia, whereby Blue Coat is not strongly established. The management is keen to expand in the region and in particular in China, where there are only ten employees at present.


Exposure to Public Expenditure Cutbacks?

Blue Coat like most other significant IT firms (Riverbed etc) does have exposure here. It is something that I am concerned with, as Governments (particularly the UK) have been cutting back on their IT spending budgets. This area will give Blue Coat exposure to the business cycle, however I think they may fare well due to WAN optimization offering a cost saving solution. Similarly, the network security is hardly an area that is easy for Government to cutback on. Nonetheless, a reduction in growth in public IT spending will result in a knock on effect to the likes of Blue Coat and Riverbed.


Blue Coat Growing Margins

Margins have been growing, thanks to downsizing and shifting employees out to Bangalore. However, I suspect that future growth will come from growing top line revenues as this process appears to be largely complete.


%
2009
2010
H2 2011
Non-GAAP Gross Margin
75.7
76.7
79.8
Non-GAAP Operating Margin
12
17.4
21.1
FCF Margin
6.8
15.9
18.7

source: Blue Coat, Earnings View


To put these numbers into context, the current market cap of 1.35bn with an EV of 1.14bn. Analyst forecasts are for Revenues of 498m and 535m to April 2011 and 2012 respectively. EPS forecasts are for $1.53 and $1.62.

On a free cash flow basis the stock is good value, for example if they play out the H2 FCF Margin and hit 498m forecast (I consider this forecast conservative) they will generate a FCF/EV of over 8.1%  This is cheap for a company growing earnings at double digits.

The question is, will they start to see growth get back to double digits in line with other cloud computing plays?


Blue Coat a Stock to Buy?

Frankly, I'm not sure. Whilst Riverbed looks fairly valued (analysts are starting to make a lot of long term assumptions over their earnings) I think Blue Coat still offers good recovery potential. The WAN optimization market is clearly lowly saturated and looks set for strong growth. Moreover,the restructuring looks to have been carried out in earnest and they do have good momentum in Asia.

On the downside, if Blue Coat don't get back to generating growth, than Blue Coat will have to erode margins in future by rethinking the business. I would look for confirmation of a turnaround in Europe in the next results. Furthermore, the  core business of Secure Web Gateway has slowed and I suspect this is the major cash generator. They are trying to move into the mid-level security market, but this has proved problematic for Websense recently.

I will monitor results.