Stock Watch: Foundry Networks
Foundry competes primarily in the Layers 2-3 and Layers 4-7 Ethernet switch markets, going up against such names as Cisco Systems Inc. (Nasdaq: CSCO), Nortel Networks Corp. (NYSE/Toronto: NT), and Extreme Networks Inc. (Nasdaq: EXTR). In the latest quarter, Foundry generated roughly 75 percent of its revenue from Layers 2-3 switches and 15 percent from Layers 4-7 switches. Edge routers provided the remaining 10 percent of revenue.
The problem is Foundry gets more than 60 percent of its total revenue from service providers, many of whom have been cutting back on spending. And although Foundry does count AOL Time Warner (NYSE: AOL), AT&T Corp. (NYSE: T), and Microsoft (NYSE: MSFT) among its customers, it's generally regarded to have weaker telecom accounts than its competitors in that market. J.P. Morgan & Co. (Nasdaq: JPM) H&Q telecom equipment analyst Erik Suppiger reports that less than half of Foundry’s service provider revenue comes from top-tier accounts, so the company is highly exposed to weaker players. Foundry was forced to lower guidance at the end of last year because of a decline in service provider spending.
In the fourth quarter, Foundry experienced a 7.2 percent sequential decline in sales. This indicates the company is losing market share in its core business, as evidenced by the fact that a key competitor, Extreme Networks, reported 20 percent sequential revenue growth in its latest quarter. Foundry is also experiencing hefty new competition in the Layers 4-7 switch market as both Cisco Systems (ArrowPoint) and Nortel (Alteon) have made significant acquisitions in that space in the past year.
Banc of America telecom equipment analyst Shaw Wu, who recently began coverage of Foundry with a Buy rating, says the outlook is not so bleak. Wu says the revenue shortfall last quarter was caused by weak customers, not poor products, so the company still has the ability to win market share away from Cisco and Extreme. "Foundry is in the process of realigning its sales force in order to focus on the right accounts, mainly quality service providers and enterprise accounts," says Wu. Although he says it will take one or two quarters to get a clearer picture, he believes the stock offers a turnaround opportunity for investors and has set a 12-month price target of $40 a share.
Other analysts are not so optimistic. They say gross margins will slip as Foundry refocuses on the enterprise market, because it will ship more lower-margin stackable switches into this space. While chassis-based switches accounted for 70 percent of its switch sales in the latest quarter, analysts say this could fall into the 60 percent to 65 percent range in the coming quarters. In addition, international sales, which are made through a lower-margin reseller channel, are on the rise; they now account for 35 percent of total sales, up from 20 percent in 1999.
Brean Murray & Co. Inc. telecom equipment analyst Gina Sockolow, who has a Hold rating on Foundry shares and has been cautious on the stock for months, says the company, faced with increased competition from Cisco and Nortel, has been forced to cut prices more than expected. But Sockolow says Foundry is still losing market share because its software technology is at least a year behind. Most analysts look for Foundry’s earnings to be flat this year, at around 73 cents a share, but Sockolow forecasts a 30 percent decline, to 52 cents a share.
On top of these worries, there is Foundry's recent marketing about-face (see Foundry Retreats from the Core). Foundry had planned to go head to head with Cisco and Juniper in the core IP router market, but backed off when it realized its products didn’t have the functionality to compete at that level. Management now says it will instead focus on the edge router segment, but some analysts question whether Foundry will ever be a serious competitor even in that market.
-- Rob DeFrancesco, special to Light Reading http://www.lightreading.com