Emulex Earnings

Date network hardware manufacturer Emulex beat estimates, but in a recurring theme in this reporting season, Emulex gave guidance which was below the top end of analyst forecasts. For the last few quarters investors have got used to companies beating and estimates may well be above potential outcomes. Nonetheless, these results are good from Emulex.

Emulex reported Q2 results of

• Revenues of $114m vs. market forecast of $113.4m
• EPS of 15cents vs. market forecast of 13cents

For Q3 Emulex guided towards

• Revenues of $108-112m vs. market forecast of $110.5m
• EPS of 8-11cents vs. market forecast of 11cents

The results were disappointing in the context of the excellent numbers that IBM (their largest single customer) gave last week. Moreover, rival company QLogic upgraded guidance recently and there were a lot of hopes that Emulex would too.

Listening to the conference call, the management was upbeat about prospects and in particular, the upgrade cycle towards 10GB Ethernet based net revenues.  Emulex top brass talked of ‘meaningful’ growth in the June quarter (Q4 fiscal) which was later referred to as ‘high single digit’ revenue growth. This is traditionally a weak quarter for them.

Host Server Products (HSP) makes up the bulk of revenues (81%) and this is where the growth is coming from. Embedded Server Products (ESP) is still in decline but they are seen as providing easy comparatives going forward. Emulex still feels that HSP will be the growth driver going forward. The senior management discussed 18-20% calendar year growth but it is hard to see them achieving that. If I assume that 8% is the ‘high single digit’ growth for June and Mar is predicted at $110m (midpoint) this gives $110+(103.1*1.08)=221m and 500m would be the target. This means the second calendar half has to do around 279m.

This looks to be a rather decent ‘ask’. Nonetheless, these numbers don’t suggest any slowdown in data center or internet hardware spending. Instead, it looks like analyst forecasts have been too exuberant.

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.

Fortinet A Fast Growing Network Security Play

Fortinet is an interesting stock to research because it is a good way to play the growing computer network security market. There are a few options to investing in stocks focused on network security, but I think Fortinet is one of the best options. Fortinet is the worldwide leader in Unified Threat Management (UTM), which is a grandiose way of saying that their network security solution covers all the core security requirements of an enterprise’s connection to the internet. As such, this encompasses firewalls, virtual private networks, intrusion detection and prevention and, anti malware.

The UTM market is primarily targeted at the small to medium size enterprise (SME) and Fortinet is the leading player in this market. Competitors like Cisco are focused on large enterprise solutions, whilst similarly for Check Point Software their UTM offering is only part of their product range. IBM is a competitor but has recently been seen as a potential purchaser of Fortinet due to their tardiness in establishing market share. Fortinet is attractive to IBM because they possess a proprietary technology. Fortinet do not resell other companies products.


Fortinet's Growth Prospects

 I think Fortinet has good growth prospects and I see their key share price drivers

• Growth in the economy seeing an expansion in SME market and a willingness to free up IT spending
• Growth in internet functionality of SME market
• Benefit of a UTM ‘One-Stop-Shop’ solution for SME’s in securing inbound and outbound traffic through one appliance
• Growth in cyber crime raising awareness of security needs
• Growth in Fortinet’s top line leading to operating margins that are closer to, say, Check Point Software
• Takeover potential. IBM are strongly rumored to be looking at them

I think the first point two points are contingent upon your view of the economy. However, should the economy grow next year I think that SME IT spending has the capacity to expand in excess of GDP growth due to the fact that companies have cash on their balance sheets. Moreover, most of the surveys are indicating a loosening of the purse strings in this regard.

The increasing importance of E-commerce and the utilization of internet portals to increase globalization of trade, should drive SME’s to increase their internet functionality. In addition, there will be more emphasis placed on monitoring internet (internal and external) based threats, given the inexorable rise in cyber crime. Similarly, corporations may seek to reduce energy and personnel cost by adopting a one-stop-shop solution with a UTM system. Whilst, this is not seen as an option for a larger enterprise, an SME will have different priorities.

However, I think the key driver for Fortinet’s share price will be top line growth and its effect on their key margin metrics. If we look at the last three years we see a nice trend developing in Fortinet's numbers. I've included Check Point's metrics to 2009 by way of comparison.

Fortinet 2008 2009 Rolling to Q3 2010 CheckPoint 2009 Revenue 211791 252115 301808 791,147 Gross Mgn 71.10% 74.93% 72.87% 85.58% SG&AMgn 49.27% 45.55% 43.02% 30.00% R & D Mgn 17.49% 16.74% 15.90% 9.71% Op Mgin 2.33% 10.05% 13.95% 44.89% FCF Mgn 16.47% 22.76% 28.14% 59.82%
source: fortinet,check point software, earnings view
The last column of Fortinet numbers are the rolling four quarters to the third quarter of 2010. The drop in gross margin is explained by the fact that Q4 is normally a large quarter. Indeed, analysts have revenue forecasts of $86.57m for 2010 Q4 vs. $70.71m last year. Gross Margins for Fortinet have increased every quarter this year.  I would also caution that Q4 2010 included a tax gain of $32m which somewhat flatters the free cash flow margins in the last two Fortinet columns. However, excluding that quarter-by calculating free cash flow margin for first three quarters of 2010- still shows they are translating 30% of revenue into free cash flow. Fortinet Margin Expansion Clearly, these numbers indicate that Fortinet has room to expand margins and cash flow generation as they grow their revenue numbers. I have included Check Point Software as a benchmark for Fortinet. However, I think it worth noting that Check Point is likely to have lower SG&A margins because they sell a lot of their product range into larger enterprises (fewer customers, bigger ticker values). In spite of this, I think there is plenty of potential for Fortinet to grow and for these catalysts to be realized in the share price. Fortinet Evaluation Fortinet trades at a price of $31.35 and a market cap of $2.31bn with $290m in net cash. On a back of envolope assumption of 30% FCFMargin and analyst forecasts of $370m in revenue for 2011 I would say that a forward FCFYield of 4.8% is cheap for a business growing revenues, earnings and cash flow at mid teens plus rate. You won't get this kind of growth by buying a 10 year note! I picked some up.