Juniper Networks (NYSE:JNPR) seems to have finally woken up to the threat that software-defined networking (SDN) poses to its business. The networking vendor announced Tuesday a multi-year strategy that will help it embrace the ongoing transition in the networking world towards flatter, more scalable architectures in a way that stops hardware from being commoditized completely. The new SDN strategy will entail a more flexible pricing wherein instead of selling expensive gear with built-in software at an upfront price, Juniper will sell the gear first and then the software for a recurring licensing fee in a separate transaction. While the company didn’t give details about the financial impact of this strategy, we expect this to adversely impact the top-line but margins should improve in the long run. Additionally, a subscription-based business model that relies on stable recurring revenues will decrease the downside risk in a weak spending environment like the one the networking industry finds itself currently in.
The macroeconomic uncertainty surrounding the Eurozone crisis has put a lid on network spending, adversely impacting the likes of Juniper which saw its revenues and operating margins fall last year. According to Infonetics Research, service provider spending on networking gear in Q3 2012 dropped 5% over the same period last year. In addition to Juniper, concerns over the macro environment are taking a toll on competitors Alcatel-Lucent (NYSE:ALU) and Cisco (NASDAQ:CSCO) as well, with the latter doing slightly better than the rest. However, we are positive about Juniper’s outlook as the long-term trends of data growth and mobility remain strong, which the company should be able to capitalize on with its new products and a new-found focus on software licensing.
Juniper’s stock has rallied almost 25% over the past three months and is now trading at $21 levels. We maintain our $25 price estimate for Juniper, about 20% ahead of the current market price.
Increasing data usage demands scalable SDNs
With macro-economic uncertainty likely to persist in the near term, we expect Juniper’s customers to continue to be cautious with their capital spending. While the company managed to grow its Q3 revenues by 4% sequentially, its guidance for Q4 implies a roughly flat quarter y-o-y at the midpoint. Juniper is not alone in giving subdued guidance. Even Cisco continues to maintain a conservative stance while setting quarterly expectations, implying a challenging industry outlook over the next few quarters. However, we see this as only a near-term phenomenon since the ongoing economic concerns have only resulted in longer project cycles and extended delivery timelines from customers. Network spending and hence, Juniper’s revenues, should once again grow as economic conditions stabilize.
Additionally, since the broader market continues to be strong driven by the key trends of mobile Internet and cloud computing, we expect higher demand for Juniper’s products and services as mobile devices such as smartphones, e-readers and tablets proliferate. Mobile data traffic grew 133% in 2011 and is expected to grow at a CAGR of close to 80% over the next five years, according to a recent Cisco VNI report.
Service providers, who will need to buy networking gear to support the burgeoning demand for data, account for almost two-thirds of Juniper’s revenue with some of the largest U.S. wireless carriers such as Verizon (NYSE:VZ) contributing as much as 12% as of Q2 2012. AT&T (NYSE:T), also one of Juniper’s bigger customers, has increased its CapEx guidance by $14 billion over the next four years.
However, with data needs burgeoning, the networking world is undergoing a paradigm shift. Enterprises and service providers are demanding more programmability and therefore flatter networking architectures that decouple the software from the hardware so that it decreases physical complexity and allows networks to scale out through virtualization. The ensuing commodification of the hardware however endangers the traditional business model of networking vendors such as Juniper that have relied on hardware complexity to drive margins. Juniper’s SDN strategy can ward off this threat by avoiding hardware commoditization by relying on tried-and-tested protocols such as BGP while embracing network virtualization that SDNs promise through inter-operability with public standards like OpenFlow. Its recent $176 million acquisition of Contrail Networks, which enables IT employees address network issues virtually rather than in person, fits in well with this strategy.
We expect the company’s operating expenses to remain high going forward as Juniper continues to invest in R&D to enhance its SDN platform as well as to come up with new versions of its core router and switching products. The T4000 and PTX core routers launched in 2011 have done well so far, and the new line of MX edge routers and the ACX Universal Access product family should help Juniper continue to win clients in a fast-changing environment. Meanwhile, the company expects that its focus on streamlining operations by cutting jobs will bring about operating cost savings of about $150 million annually.
Disclosure: No positions.