$38.63 / (NSCN-NASDAQ)
Overview
NetScreen has performed exceptionally well, doubling its revenue run rate, since its December 2001 Initial Public Offering. Juniper Networks recently agreed to acquire NetScreen for 127.4 million Juniper shares or 1.404 shares of Juniper for each share of NetScreen and therefore, the stock will trade inline with Juniper. Analysts believe that NetScreen has a technological advantage over its closest competitors, CheckPoint and Cisco, which it has used to take market share and maintain stable pricing. Therefore, an investment decision in NetScreen should be based on your opinion of the company’s ability to maintain its revenue momentum through a technological advantage over competitors and its ability to continue the integration of new features into its suite of products, such as Intrusion Detection & Protection technology, which NSCN acquired through OneSecure and SSL VPN through its announced acquisition of Neoteris. NetScreen has introduced a number of new products since its IPO, allowing it to maintain pricing power and grow deferred revenue. As product releases slow, NSCN’s ability to maintain pricing in a competitive market and grow deferred revenue are also critical to its attractiveness as an investment going forward.
Investment Positives: / Investment Risks:- NetScreen has technological advantage over its competitors with its proprietary system
- NetScreen is taking share in the firewall/VPN market
- Strong revenue growth has outpaced all of its competitors
- NetScreen is entering new markets with, including Intrusion Detection & Prevention, which could spur future growth.
- Pricing competition from Cisco and others could hurt growth
- Ability of security to continue growing faster than overall IT spending
- High valuation may limit the stock’s upside potential
NetScreen is a Sunnyvale, CA based supplier of high-end firewall and Virtual Private Network (VPN) solutions, which compete primarily with CheckPoint and Cisco, the company was founded in the late 1990’s and went public in December of 2001. NetScreen differentiates itself from competitors with its appliance approach that was developed with a custom ASIC and proprietary Operating System to run the software. The appliance approach offers better throughput, better price/performance and easier maintenance than simply running the software on commodity hardware. About 60% - 70% of NSCN’s revenue comes from integrated VPN/Firewall sales with the rest being pure firewall sales.
NetScreen has had solid revenue growth, growing from $85 million in FY 2001 to $138 million in FY 2002 and an estimated $239 million in FY 2003. As a result, the stock is trading at a premium to its peers, recently at 36x consensus FY 2004 estimates. Analysts that have neutral ratings on the stock are concerned that slowing revenue momentum is a risk to valuation. While most analysts believe the company will continue to take share for the foreseeable future based on its technological advantage, some are concerned that the pace of growth will slow, particularly in installations where NSCN is replacing an installed vendor. NSCN acquired a privately held company called OneSecure that is involved in Intrusion Detection & Protection (IDP). NSCN’s ability to integrate IDP functionality into its appliances should have a significant impact on its ability to grow revenue over the next 12 months.
NetScreen recently announced the acquisition of SSL VPN provider Neoteris. Although dilutive in FY 2004, analysts are positive on the acquisition as it rounds out NSCN’s product offering on the low-end. SSL VPN allows remote users to connect through a browser rather than installing software at the client end. This will allow users to access email and other corporate applications from home or on the road at a much lower cost and is therefore expected to expand the use of VPN’s.
NetScreen has been able to maintain pricing due to superior products and its limited distributor strategy, which motivates value added resellers to maintain pricing. However, price competition from Cisco has intensified and poses a risk to revenue and margins if NSCN’s innovation were to slow. NSCN has also grown deferred revenue rapidly over the past few quarters, this is partly due to customers taking delivery of new products, which are not immediately accepted. As products mature and are accepted by the customer faster, services revenue will become a more important part of deferred revenue and the overall rate of growth will slow.
Key Dates
April 21, 2003 FQ2 Earnings Announcement
Consensus: Sales $86 million, EPS $0.14
Sales
Annual Estimates / Quarterly Estimates9/2004 / 9/2005 / 3/2004 / 6/2004
Most Recent Consensus / 379 / / 508 / / 86 / / 99 /
Zacks Consensus / 375 / / 489 / / 89 / / 98 /
Sales estimates for FY 2004 range from $366 million (Merrill, JP Morgan) to $389 million (UBS) and estimates for FY 2005 range from $455 million (Merrill) to $541 million (UBS). The analyst (Merrill) on the low-end for both years is positive on the company fundamentals, but neutral on the stock and the other analyst on the low-end for 2004 (JP Morgan) is concerned that the pause in new products will hurt deferred revenue growth. The analyst (UBS) on the high-end for both years has a neutral rating on the stock and believes NSCN faces challenges from growing competition and acquisition integration.
Margin
As NSCN matures, analysts have forecasted a declining gross margin as prices decline, increasing operating margin as economies of scale help operating expenses and a falling net margin as NSCN’s tax rate increases.
Consensus Margins2003 / 2004E / 2005E
Gross Margin / 78.5% / 77.7% / 76.3%
Operating Margin / 25.0% / 24.2% / 25.6%
Net Margin / 20.7% / 15.5% / 16.4%
Earnings Per Share
Annual Estimates / Quarterly Estimates9/2004 / 9/2005 / 3/2004 / 6/2004
Most Recent Consensus / 0.60 / / 0.82 / 0.14 / / 0.15
Zacks Consensus / 0.60 / / 0.79 / / 0.14 / / 0.15 /
Zacks Most Accurate Consensus / 0.61 / / 0.82 / / 0.14 / / 0.15 /
Analysts’ EPS estimates for FY 2004 range from $0.55 (US Bancorp) to $0.62, which is shared by seven analysts, and for FY 2005, estimates range from $0.67 (Friedman Billings) to $0.86 (Thomas Weisel, Legg Mason). The analyst on the low-end for FY 2004 (US Bancorp) is positive on the stock and the analyst on the low-end for FY 2005 (Friedman Billings) believes that gross margins will fall and is also one of the analysts with a $0.62 estimate for 2004. The analyst on the high-end for FY 2005 (Thomas Weisel) believes several items, including the new ASIC and push into the SMB market, will drive results ahead of expectations and is also one of the seven analysts on the high-end for FY 2004.
Target Price/Valuation
Analysts’ target prices for NSCN range from $30 (Kauffman) to $42 (Deutsche Bank) with an average of $35.17. NetScreen has agreed to be acquired by Juniper Networks in exchange for 1.404 Juniper shares for each share of NSCN, which translates to $37.91 in Juniper stock as of 2/11/04. Most analyst do not expect any competitive bids or regulatory delays.
Long-Term Growth
Analysts’ estimates for NetScreen’s long-term growth rate range from 14% (UBS) to 60% (Thomas Weisel) with an average of 30.2%. Firewall and VPN sales are growing rapidly and are expected to reach $5 billion in 2006, up from $2.7 billion in 2004, according to Infonetics research. NetScreen has been able to grow faster than the market, as it has been able to leverage its technology lead to take share. Most neutral rated analysts see stronger competition as the biggest risk to the company’s growth. Cisco has historically been able to enter net markets without best-of-breed technology, and take share as the gap narrows by bundling the product within a suite of products, which is what it appears to be trying in firewall/VPN. Integrated vendors such as Cisco, Nortel, Lucent and others may be motivated to compete on price, as firewall/VPN is just one part of their offering to customers. Many analysts believe that Intrusion Detection & Protection (IDP) could be an important growth are in the future, currently however IDP has struggled as the products have a reputation of being difficult to implement and unreliable.
Individual Analyst Opinions
POSITIVE RATINGS
Deutsche Bank – Stock is rated Buy with a $42 price target. Analyst believes that security is a high priority for enterprise spending, particularly appliance solutions and resellers are motivated to sell NetScreen products given the higher profit margins than competing products. As a result of strong innovation, NSCN is taking share.
Legg Mason – Stock is rated Buy with a $35 price target. Analyst believes NSCN is well positioned in the firewall/VPN market and well positioned to expand beyond this market, Neoteris provides the potential for upside and mitigates risk for slowing growth.
Lehman – Stock is rated Overweight with a $32 price target. Analyst believes NSCN’s leadership position in the firewall/VPN market will continue to drive strong growth through the upgrade cycle and the company is benefiting from expansion into the SSL VPN.
Pacific Crest – Stock is rated Buy with a $34 price target. Analyst believes that NSCN is gaining momentum in the firewall/VPN and intrusion detection markets and is rapidly taking share from competitors, which should continue for the foreseeable future as it is focused on the right segments of the firewall and VPN markets and its ASIC based intrusion detection appliances.
Pacific Growth – stock is rated Over Weight. Analyst believes NetScreen is capturing market share in the rapidly growing VPN market. NetScreen has an opportunity to replace installed firewall infrastructure with its consolidated solutions, particularly within the Check Point installed base.
SG Cowen – Stock is rated Strong Buy. Analyst believes that recent results of strong deferred revenue growth and current results, lays to rest concerns that rapid growth may be decelerating. NSCN is continuing to take share and will benefit from a shift towards either total solutions or best-of-breed solutions. The stock is a must own name in the security space considering the valuation is still in-line with the peer group.
Sanders, Morris – Stock is rated Buy with a $32 price target. Analyst believes that security will grow as it remains a priority for both enterprise and government and any pickup in IT spending will benefit security hardware vendors disproportionately. The biggest risk to the story is price competition, particularly from Cisco.
US Bancorp – Stock is rated Strong Buy with a $42 price target. Analyst believes strong product offering is driving market share gains from Cisco and CheckPoint and the new ASIC will drive a strong product cycle, justifying a premium valuation to its peers.
NEUTRAL RATINGS
First Analysis – Stock is rated equal-weight. Analyst believes NSCN is well positioned, but revenue strength relative to guidance is beginning to deteriorate and sequential growth will be difficult to achieve going forward. Stock is fairly expensive at current levels.
Friedman Billings – Stock is rated Market Perform with a $37 price target. Analyst believes NSCN is the technological leader in firewall/VPN with its GigaScreen ASIC the key advantage, but recently downgraded the stock on expectations of lower gross margins going forward.
JMP Sec. – Stock is rated Market Perform with a $34 price target. Analyst believes NSCN will trade in line with JNPR, which is rated Market Perform. Analyst believes NSCN is establishing itself as a leading player in the network security market and revenue growth will be driven by new product releases over the next few quarters and integration of SSL/VPN technology.
JP Morgan – Stock is rated Neutral. Analyst recently downgraded stock based upon the belief that multiple expansion is unlikely and further appreciation will rely upon upside to earnings above recent results. Analyst also believes that deferred revenue growth could slow given the pause in new product launches, hurting visibility.
Janney, Montgomery – Stock is rated Hold with a $21 price target. Analyst was impressed with most recent results, but is concerned about weaker than expected forward guidance, decelerating deferred revenue and increasing operating expenses.
Kaufman Bros. – Stock is rated Buy with a $30 price target. Analyst believes that appliance strategy is taking share from security software from vendors such as Check Point. Analyst believes that recent results may not be enough to support current valuations and would be more aggressive on the stock if the price dips.
Prudential – Stock is rated Neutral. Analyst downgraded stock as its price will be determined by JNPR’s value and the unwinding of the arbitrage spread.
Raymond James – Stock is rated Market Perform. Analyst believes that the firewall market is becoming increasingly competitive, risking commoditization. Although NSCN has differentiated itself, with superior price/performance, this is only a high-end phenomenon.
SoundView – Stock is rated Neutral with a $36 price target. Analyst downgraded the stock as the shares will now trade in-line with Juniper, rather than its own fundamentals. Previously, the analyst had upgraded NSCN on increasing comfort with the Neoteris acquisition and the belief that upcoming product introductions will drive revenue and earnings ahead of expectations.
UBS – Stock is rated Neutral with a $38 price target. Analyst believes NSCN’s competitive momentum is reflected in its stock price and the company faces a number of challenges going forward, including; R&D payoff, integration of Neoteris and OneSecure acquisitions and margin pressure driven by competition from Cisco and Check Point.
Unterberg Towbin – Stock is rated Market Perform. Analyst believes NSCN offers the industry’s leading throughput speeds and is likely to continue to gain share, but at a more moderate pace. Analyst believes that short-term visibility is good and the stock will remain at the upper end of its trading range.
Wachovia – Stock is rated Market Perform with a $28 - $32 valuation. Analyst believes NSCN has established itself as the market leader, differentiating itself with superior VPN, SSL VPN and deep packet inspection technology, and sustainable strong growth and margins.
SUSPENDED RATINGS
Buckingham – Rating is suspended due to pending acquisition. The analyst does not expect any regulatory issues and is positive on the combination.
Goldman Sachs – Advisor to Juniper, rating suspended. Analyst believes the acquisition highlights the necessity for technologies to solve security issues. Previously the analyst believe NSCN has an attractive position in the security arena and the release of its new ASIC will drive an upgrade cycle, but is rich at current levels.
Merrill – Analyst has no rating as the stock will no longer trade on fundamentals. Previously the analyst believed the combination of NSCN’s security-specific technology, ease of use and compelling price/performance has enabled the company to tap into a “market inflection point”. Analyst also believes the company’s limited distribution strategy provides strong motivation for channel sales partners.
Needham – Rating is suspended due to pending acquisition. Previously the analyst believed NSCN is well positioned to compete against Cisco and Check Point with its best-of-breed technology at cost-effective prices and its appliance approach.
Thomas Weisel – Rating is suspended due to pending acquisition. The analyst does not expect any regulatory delays as NSCN competes with large established vendors.
NEGATIVE RATINGS
AG Edwards – Stock is rated Sell. The analyst does not expect another bidder to raise the acquisition price and the stock should trade at the implied market value less an arbitrage risk premium.
First Albany – Stock is rated Sell. The analyst downgraded the stock on the acquisition announcement as the analyst does not expect a competitive bid to come in. The analyst is positive on the combined company.
Southwest – Stock is rated Sell. Analyst downgraded from buy following the acquisition announcement on the belief that at the current valuation of 6x – 7x EV/CY05 revenue investors should take profits.