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Why Redback Got Whacked

Light Reading
News Analysis
Light Reading
1/18/2001

Redback Networks Inc. (Nasdaq: RBAK) appears to have run out of luck pleasing Wall Street, following another quarter that beat estimates but was plagued by several warning flags.

The company reported earnings per share (EPS) that came in a penny over most estimates. At the same time, however, the company indicated that gross margins had once again dropped. Investors appear to be getting weary of the caveats attached to Redback's quarterly reports (see Redback Blows Away the Numbers). As a result, the stock took a hit today in early trading, down 7.87 (16.22%) to 40.69.

Also contributing to the selloff was a downgrade by SG Cowen, which lowered Redback's rating from a Strong Buy to a Buy. Analyst Christon Armacost cited lower margins due to volume discounts on the Subsciber Management System product as a reason for the demotion. "Volume discounts on the SMS caused another shortfall in gross margins, down to 54.3 percent."

Earnings for the fourth quarter were 114.6 million, compared with 26.1 million for the period last year, an increase of 339 percent. Pro forma net income was 7.8 million or 5 cents per share, compared to 2.0 million or 2 cents per share for the same period last year, an increase of 290 percent.

Of primary concern concern to analysts and investors was the decline in margins from 76.3 percent to 54.3 percent. Gross margins are a general measure of the profitability of a product line.

Concerns about the company’s gross margins point to looming challenges for Redback. Not only is its SMS product line coming under pricing pressure, but its new product line, the SmartEdge, will be competing in a crowded marketplace, making it subject to similar competitive pressures. The SmartEdge optical networking product line will be competing with products from Cisco Systems Inc. (Nasdaq: CSCO) and Ciena Corp. (Nasdaq: CIEN), which this year plans to have a similar product on the market through its merger with Cyras. To a lesser extent, the SmartEdge series will compete with a number of other companies marketing optical networking products for the metropolitan area, including Sycamore Networks Inc. (Nasdaq: SCMR) and ONI Systems Inc. (Nasdaq: ONIS).

In addition to worries about Redback’s gross margins, there are concerns about accounts receivable growing faster than revenues in the fourth quarter. Accounts receivable grew from 59.0 million in Q3 to 96.0 million in Q4. When compared to revenue, which grew from 80.0 million to 114.6 million, flags are thrown.

According to Steve Levy, an analyst at Lehman Brothers, this has contributed to the reaction to Redback's quarterly numbers. “There has not been a consistent negative trend in Redback’s account receivables, but the numbers this quarter definitely warrant concern," says Levy.

-- Matt Malina, research associate, Light Reading http://www.lightreading.com

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dc boy
dc boy
12/4/2012 | 9:00:29 PM
re: Why Redback Got Whacked
Yes, I admit it was a big factor this quarter, and it will probably be for the next 2 - 3 quarters. Any kind of drag like this will bound to have the Street jumping up and down. Hence the downgrades....6 - 9 months is a long time on the Street.

But if one can look beyond 9 months, there should be some positives at the end of the gross margin rainbow. Two things that stand out from the cc: 1) rbak has taken market share from csco and expect to continue to do so, and 2) higher margin products for both the SMS and SmartEdge are expected to start shipping in the 2nd and 3rd quarters. If this is realized, gross margins should trend upwards, thereby allowing earnings and revenues to grow nicely hand in hand.
joestudz
joestudz
12/4/2012 | 9:00:29 PM
re: Why Redback Got Whacked
A 70+ percent gross margin is unrealistic in the long term. Bad analysis by analyst (wearing rose colored glasses) who think any company can maintain 70+ percent margin
lightheart
lightheart
12/4/2012 | 9:00:29 PM
re: Why Redback Got Whacked
margins become very crucial since they would determine ur future earnings .
malina
malina
12/4/2012 | 9:00:29 PM
re: Why Redback Got Whacked
Is the margin issue really and issue? One analyst points out that NT has a 45% gross margin rate on its Shasta line.
ackronym
ackronym
12/4/2012 | 9:00:27 PM
re: Why Redback Got Whacked
Actually Zaffire is starting to move some boxes in the next-gen SONET space and startups like Mayan Networks will also start populating the space. I agree the competitive landscape may get a little more messy for Redback.
lightreading
lightreading
12/4/2012 | 9:00:26 PM
re: Why Redback Got Whacked
I would be willing to bet that most of the margin pressure is from Cisco dropping prices on the 6400...

... which will only get worse for RBAK.
lightreading
lightreading
12/4/2012 | 9:00:26 PM
re: Why Redback Got Whacked
Actually, Zaffire makes a metro DWDM box that is complimentary to the SmartEdge. It fills a glaring hole in RBAK's (and CSCO's) product line. Mayan, CIEN (cyras), Metro Optix, SCMR, and others more focused on next gen SONET will make life hard for the SmartEdge. They will all have trouble catching up to the 454 which currently OWNS the market.

RBAK jumped out early with the SMS and defined the space, but, that early lead was based on a lot of small ISPs, CLECs and telcos selling DSL that have now fallen on tough times. I'd be worried about RBAK exposure to this market and the lack of traction so far with the SmartEdge. A large part of their success I think will ride on whether or not they can transition revenues to the SmartEdge. This breakdown is critical to their success - I haven't seen it.

I would be very wary that growing accounts recievable comes from these small ISPs who are now strapped. If they're going to survive, RBAK badly needs to round out their product line with the buyout of one of the many struggling optical (DWDM) startups.

It looks like a long uphill battle right now.
Cisco Watcher
Cisco Watcher
12/4/2012 | 9:00:25 PM
re: Why Redback Got Whacked
I have to agree with lightreading on this one and disagree with dc boy. Redback is in for some serious competition (it already has a tough job catching up to the 454 which was released a year before the SmartEdge 800), with Ciena/Cyras releasing their product soon and umpteen new next gen Sonet startups on the scene.

As far as dc boy's comment about the SmartEdge taking market share away from the 454, I believe that the SmartEdge is taking market share away from the old Sonet equipment -- as all of the carriers want to install the next gen equipment. Without the SmartEdge's data plane fully operation, it's nothing more than a 454 that arrived later to market, is not OSMINE compliant (i.e. no RBOCs), its software hasn't been stressed to the same levels as the 454's.

In the end Redback is going to have a difficult time over the next year and as CLEC/ILEC spending continues to decrease the only viable customer for the long term is the RBOCs (since they essentially own the local market and thus always have a source of income) -- which Redback can't touch because it hasn't started the expensive and grueling (not to mention time consuming, 10-12 months) process of bowing down to the Telecordia monopoly.

It looks like the 454 (and its sibling) will continue to own the next gen Sonet market. While the SmartEdge 800 (and 400, if they can finish developing it) will continue to plod along.

CW
oc-3072
oc-3072
12/4/2012 | 8:59:55 PM
re: Why Redback Got Whacked
Care to respond?
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