Telco Spending Outlook for 2014

Last year was difficult for companies exposed to telco spending, but will 2014 bring better conditions? There are countless questions regarding this issue, but for the sake of brevity, this article will focus on demand trends coming from Tier 1 service providers like AT&T  and Verizon  and touch on prospects from emerging markets. The type of solutions being bought by AT&T and Verizon will dictate selling opportunities for companies like Cisco  and Ciena  as well as many others in the telco space.

AT&T and Verizon
The issue facing service providers in the developed world is that average revenue per user is falling because technological advancements have reduced the importance of fixed and mobile voice usage. As a consequence, carriers like AT&T and Verizon are trying to reduce capital expenditures as a share of revenue, even while revenue growth is slowing. Verizon's capital expenditure of $16.1 billion in 2012 is approximately $930 million less than it spent in 2006. Conversely, AT&T's have been rising, but this is largely due to the roll out of its 4G/LTE network later than Verizon.

Source: company presentations.

In addition, both companies have given lackluster capital spending forecasts. AT&T's management stated, "we would expect the CapEx for this year to be in $21 billion range and for '14 and '15 to be in the $20 billion range."These figures are below what AT&T has spent in previous years. Meanwhile, Verizon argued that "As far as CapEx goes, I have been pretty consistent here. You should consider us improving our CapEx-to-revenue ratio going forward."

Smartphone penetration driving growth
However, the reality is that service providers will still have to invest, just in different ways. The trend carrying over from 2013 is that Verizon and AT&T have been surprised by the strength in the increase of smartphone penetration, while seeing disappointments at the lower end. On AT&T's recent conference call, management outlined:

We now have 75% of our postpaid phone base on smartphones. We expect that percentage to keep growing. These are the premium subscribers in our business. They have twice the ARPU of non-smartphone subscribers and much lower churn.

Meanwhile, the company saw "some pressure" with its "subscribers on low-end 2G feature phones." Verizon told a similar tale of increasing smartphone penetration to 67%. Verizon is also seeing strong growth in 4G take-up, with 38% of its retail postpaid customers on 4G, versus 33% in the previous quarter and only 17% last year.

These trends are likely to make carriers in the developed world focus on purchasing higher-end networking solutions, rather than investing in maintaining older networks. This might hurt a company like Cisco, but it will benefit Ciena with its next-generation technology. Ciena is particularly strong in 40G and 100G ethernet networking and optical transport networks. As for Cisco, service providers make up around 31% of its revenue. They matter a lot to the company, but Cisco is only expecting 0%-1% growth in switching and routing over the next 3-5 years.

Emerging market opportunities for Cisco and Ciena
The great imponderable for 2014 will be emerging market telco spending. Cisco's outlook for emerging markets was extremely weak, and if taken at face value, it's hard not to be cautious. On the other hand, if emerging markets follow developed market trends, expect smart phone penetration and data usage to increase strongly in 2014.

Moreover, many emerging market countries have the opportunity to jump to next-generation technologies like 4G/LTE, rather than invest in 3G or maintaining legacy infrastructure. Again, this might play to the strengths of Ciena rather than Cisco. However, Cisco has set the bar so low with regard its emerging market prospects that any upside surprise is likely to be well-received.

The bottom line
It's hard to get too excited by overall North American spending because AT&T and Verizon have made it clear that they are not planning a major ramp up in spending. However, the type of spending taking place means there will be winners and losers in the process. As for emerging markets, much will depend on the macro-economic climate. However, with most forecasters predicting stronger economic growth this year, it's reasonable to expect a better year overall. But, the investment focus should still be on niche players like Ciena, rather than larger all-purpose telco suppliers.

F5 Networks Offers Confusing Guidance

It's been an unusually volatile year for technology companies, and the fun isn't over yet. The latest tech company to give varied results and guidance is application delivery controller provider F5 Networks (NASDAQ: FFIV  ) . In short, the company pleased the market by getting back to product sales growth, but its guidance and outlook were somewhat disappointing.

F5 Networks' volatile year

 F5 ends its financial year in September, and its fourth quarter results told a tale of two varying halves. Moreover, its guidance left more questions than answers.

• Fourth-quarter revenues of $395.3 million vs. guidance of $378 million to $388 million

• Non-GAAP EPS of $1.26 vs. internal guidance of $1.17 to $1.20

• First-quarter 2014 revenue guidance of $390 million to $400 million

• First-quarter non-GAAP EPS guidance of $1.17 to $1.20

While the fourth-quarter results were a handsome beat, the guidance is either excessively conservative or hints at some potential disappointment in future. The following chart demonstrates the welcome return to product sales growth (something that F5 previously highlighted as its “No. 1 priority”). It also shows the growth deceleration in the first half vs. a recovery in the second.

Source: Company presentations, Author's analysis.

Service growth slowing in 2014 for F5 Networks?

 As the chart suggests, services growth tends to lag product sales growth (which is why the latter is so important) and you need to put this into the context of F5's guidance for the next quarter. I have a few points on this issue.

First, at the mid-point F5 is guiding toward revenue of $395 million, however its management stated this on the conference call:

We would expect to see product revenue growth year-on-year each quarter next year.

Its product revenue growth in the last quarter was 1.2%, and if you assume it’s the same again in the next quarter its product revenues will be $207.2 million. This implies that its service revenues will be around $187.8 million, meaning that its service revenue growth will slow to 16.9% in the first quarter. Visualize that on the chart above to see the deceleration.

Second, the estimate for first quarter revenue growth of 8.1% looks reasonable in the chart above. However, you need to put into the context of sequential growth. In fact, the sequential guidance for the first quarter is the weakest for the last seven years excluding the 2009 recession.

Source: Company presentations, Author's analysis.

Frankly, either the guidance is excessively conservative or F5's second-half momentum is going to slow going into 2014.

Citrix Systems, Radware and Cisco

Overall it's been a disappointing year for F5, particularly as it started the year with three key tailwinds. First, it's starting to see traction with its data center security solutions, disclosing that 30% of its product sales last year were made with a security solution included. Second, Cisco (NASDAQ: CSCO) announced last year that it would cease new investment in its application delivery controller product called ACE. Instead, it intended to work with F5's chief rival Citrix Systems (NASDAQ: CTXS) and recommend Citrix's NetScaler product.

F5 obviously has an opportunity to replace legacy ACE systems. Indeed, it announced that it won over 900 ACE replacement projects in its financial year, and argued that the ACE market represented a 'two to three year market' opportunity.

The third tailwind was the launch of what F5 called its “largest appliance product refresh ever.” Unfortunately, sometimes when technology companies launch new products it can cause some short-term purchasing delays. Customers may want to hold off purchasing the older products, yet wait to assess the new products. In fact, F5 argued that this was partly the cause of the slowdown in the first half. However, if this is the case then why is the sequential guidance for the next quarter so weak?

Furthermore, Citrix just reported that for its ADC NetScaler:

The cloud and Internet segment was slower than expected due to the timing of large orders and coming off such a strong growth quarter in June.

Another ADC company Radware has been arguing that there has been a reset of pricing at the low end of the ADC market in recent quarters, even while it confirmed that it continued 'to see activities of customers replacing Cisco ACE'.

Where next for F5 Networks?

 In summary, despite the three tailwinds for F5 discussed above, there is evidence that its market conditions got tougher this year. Indeed, the company forecast a possible 50 to 100 basis point drop in gross margins next year, due to the need to invest in lower margin consulting services. Although, this doesn't imply a drop in product sales margins, all investors will really care about is the impact on its bottom line.

All told, F5 is an attractive stock if you think the guidance is too conservative. It may well turn out to be, but there are enough question marks to cause a bit of discretion over the stock.

Polycom Offers Big Risk but also Big Rewards

Unified communications specialist Polycom (NASDAQ: PLCM  ) is one of the most interesting high risk/reward situations in the market place today. It's not a stock for widows and orphans, but if you looking for a speculative investment with a lot of upside then Polycom might fit the bill.

High risk...

 There are three key concerns with Polycom. The first is that it is a small company (around $1.75 billion) competing against a giant in the tech world, namely Cisco Systems (NASDAQ: CSCO  ) . The latter can easily subsidize an aggressive market share grab, so Polycom is likely to be forced into constantly innovating in order to retain its position.

The second is that unified communication systems are seen as part of discretionary IT spending. In other words, corporations tend to invest in these video-conferencing systems when they are in growth mode, rather than in the current cautious spending environment. Indeed, you can see this by looking at the recent growth in Polycom's sales and Cisco's collaboration segment revenue.

source: Company accounts

 

While the first two risks are considerable, they can also be opportunities if Polycom gets product innovation right and if the macro-environment improves. However, the third risk comes with a more significant long-term threat.

Simply put, Polycom and Cisco's collaboration segment may be operating within a market in a structural decline.

• Current trends in IT spending are in favor of outsourcing and virtualizing IT infrastructure into the cloud, rather than purchasing dedicated hardware solutions

• Corporate IT departments are getting used to using open platforms, and the desirability of being tied to one solution provider for video conferencing is questionable

• Mobility has been one of key buzzwords of IT spending this year, and investing in a solution that may require a fixed location is not really in line with this trend

The shift to cloud and mobility based solutions doesn't look like it is slowing anytime soon, and the question for Cisco and Polycom is whether they can continue to attract purchasers to their dedicated video-conferencing systems?

...and high reward

 The arguments above present existentialist dangers to the long-term viability of its business, but investors should not lose sight of the potential reward in buying the share. Arguably the stock is being priced with the assumption of long-term revenue and cash flow declines in mind.

 Indeed, the company has been keen to point out how cheap it is. For example in its second quarter results it highlighted how it ended the quarter with cash and investments equivalent to $4 a share, and generated trailing operating cash flow of $195 million.

In other words, given its current price of ~$11.00, the stock has nearly 39% of its market cap in cash and investments. Similarly, the trailing free cash flow of around $135 million means it has just generated around 11.8% of its enterprise value in free cash flow. This stock is cheap.

Current trading

 In its recent results the company gave forecasts for a "very modest low single-digit growth rate" in the second half of 2013. Moreover the mid-point of its guidance for the third quarter assumes that revenues will be flat for the quarter. This means that it is forecasting a return to growth in the fourth quarter, and analyst forecasts have the company on a 3.8% revenue growth rate in 2014.

This sounds good, but readers should note that it has released a new series of products, which it claims are helping win market share from Cisco. The danger here is that the company is getting trapped into a long-term game of investing in new technologies in order to wring out any bit of growth from a market in decline. If this is the new reality then its free cash flow could start to degenerate in future years.

 On the other hand, if it hits analyst targets for 2014, and a better economy encourages some more discretionary IT spending, the stock is a great value.

Where next for Polycom?

 Ultimately, an investment decision here will boil down to your opinion on the long-term viability of Polycom's solutions. Risk seeking investors may love the proposition here, but for more cautious investors a piece-meal approach probably works best. You could always monitor the next few quarters of Polycom's results in order to see if it is hitting its targets. Meanwhile, it would be useful to see if Cisco can start to report some growth in its collaboration segment.

Polycom is an attractive stock, but it doesn't come without risk. No one said investing was easy!

Is Cisco Systems a Buy?

The market always looks to Cisco Systems'  (NASDAQ: CSCO  )  results because they are usually a good indicator of where technology is headed. The latest earnings report proved no different. Cisco discussed a slow but ongoing economic recovery that contains some notable differences in growth rates from various regions. It seems that different geographies and end markets are taking turns to outperform for one period and then disappoint in the next. It looks like the tech markets are set for more uncertainty in the second half.

Cisco reports mixed regional growth...

Cisco's 6% revenue growth in the fourth quarter was in line with its long-term targeted aim of 5% to 7%, so investors could be easily forgiven for thinking that it was just another quarter. However, the underlying story was the relative performance of each region.

Revenue from the Americas grew 7%, and Europe, the Middle East and Africa (EMEA) grew an impressive 12%, but this quarter Asia-Pacific, Japan and China (APJC) actually fell 3%. Moreover, Cisco saw noticeably varied performance within the 8% growth recorded in its emerging markets. India and Mexico recorded double-digit gains, while the Brazil and Russia were flat with China down 6 %.

...and mixed industry growth too

It wasn't just a regional issue. In terms of orders by customer, enterprise declined 2% (with particular weakness in EMEA) although commercial grew 5%, and the global public sector grew 6%. The latter is notable because three quarters saw weakness in the public sector. In addition, service-provider orders grew 6%, and this comes after whole swathes of the tech industry had reported weakness in service-provider spending in the first quarter of 2013.

Furthermore, there was even some significant variability within Cisco's sales. Starting with its core sales, switching had a good quarter as new products were released, but routing had another weak set of results. There was also some bad news with services revenue only growing at 5.6% when Cisco plans for 9% to 11% for the next three-to-five years.

Its core activities of switching, routing, and services typically make up 68% to 69% of Cisco's total sales.

Source: Company accounts

What it all means to the industry

Investors should expect more unpredictability in the tech market. Oracle's (NYSE: ORCL  ) recent results were also disappointing. In common with Cisco, it cited US and EMEA license growth in line with expectations, but saw weaker conditions in China and Brazil. The variance in emerging market performance is worrying because a lot of tech companies spent last year relying on the BRICs for their growth prospects.

 

Indeed, International Business Machines (NYSE: IBM  ) reported an overall revenue decline of 3% in its results in mid-July with growth in the BRICs being flat. IBM's results presaged what Oracle and Cisco would say about regional growth, and it also gave a cautious outlook on Brazil and China. On a more positive note, the one key theme from all three earnings reports is that the US enterprise sector is outperforming.

 

However, investors need to be cautious over expecting too much from the government sector. Austerity measures and sovereign debt issues are not going away anytime soon, and order growth could continue to be lumpy in future quarters.

 

What to do with the big three?

Frankly, if you are thinking about investing in any of these three companies, then you need to forget about expecting too much help from the macro-environment. IBM's prospects are about its internal restructuring in order to focus on higher margin sales rather than pure revenue generation. Oracle is managing a shift in its revenue to cloud-based software, while also undergoing a transition to new hardware product systems.

 

One thing that all three have in common is prodigious cash generation, and they currently trade on historically attractive free cash flow yields.

 

IBM Free Cash Flow Yield data by YCharts

In Cisco's case, you are looking at business that just generated around $11.7 billion in free cash flow, and has over $33 billion in net cash and investments. These figures represent significant percentages of Cisco's current market cap of $129 billion.

Ultimately, the case for buying Cisco remains the same as before these results. Top-line growth will be hard to generate organically (particularly from its switching and routing sales) but its cash generation and assets mean that it can make acquisitions in its non-core segments.

What Cisco needs to do

Here is a breakout of its core and non-core (collaboration, service provider video, wireless, security and data center) revenue growth.

 

Source: Company accounts

 

Cisco's challenge is to carry on making acquisitions in order to generate growth in a slow economic environment.  In this way it can also help generate growth in its service sales. As a long-term investment proposition, the stock remains compelling, but just be prepared for some short-term disappointments along the way. Global economic growth remains slow and patchy

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.