When Riverbed (RVBD) reported quarterly earnings on February 7, 2013 after market close, the company provided a soft outlook. Shares plunged as low as $15.92 shortly on the next trading day, and recovered slightly, closing at $16.56. Investors hoped the company would report better results, but 2012 was a year of transition. For the year, Riverbed launched a record number of new products, acquired OPNET for over $1 billion, and refreshed its core WAN optimization business offering. All of these activities necessarily disrupted the consistency in Riverbed. By innovating on all fronts, Riverbed's short-term decline provides an entry for investors interested in exposure to network technology.
Riverbed sells optimization hardware that allows customers to get better performance from their existing wide area network ("WAN"). Growth in this subsector of technology is clear. VMWare (VMW), Microsoft (MSFT), Juniper (JNPR), and Dimension Data are all partners with Riverbed. Although VMWare shares dropped 16.5% in the last month, VMWare trades at a P/E far higher than that of Riverbed. Conversely, Microsoft has a market capitalization that is 100 larger, but is conservatively valued at 15 times earnings.
Pro-forma, Riverbed's $0.99 per share earnings values the company at just 16.7 times earnings:
Source: Yahoo Finance
The forecast from Riverbed is lower than consensus, largely because the company is baking in disappointment and worst case scenarios. Its OPNET acquisition assumes that there is little overlap, which limits cost savings. The net impact is a quarterly (Q1) guidance of $257M to $266M in revenue and earnings of $0.23 - $0.24 per share. This is shy of the $265.3M revenue and earnings of $0.26 per share.
The narrow miss provides investors with a time frame of greater than 1 year another entry point. End-user traffic is moving to WAN. Riverbed cited that Gartner estimates up to 80% of end-user traffic will be in WAN by 2014, making Riverbed a beneficiary of this trend. In the fourth quarter, WAN optimization contributed to 83% of Riverbed's total revenue.
Last year, Riverbed refreshed its WAN-based solutions: RiOS software was updated and CX and EX Steelhead appliance platforms were launched. Management explained that Riverbed Steelhead accelerates data transport over the WAN, regardless of the point of origin of that data. Riverbed Granite optimizes the WAN by centralizing data services and projects it to the remote site. Users may access WAN data as if it resided on the LAN.
Riverbed earned $239M in the last quarter, an increase of 17% from the previous year. Product revenue grew to 66% of total sales ($157 million), while service and support revenue rose 28% to $82 million. Expenses rose to $125 million, with $6 million attributing from OPNET.
Gross margin was 81.4%, compared to 80.8% in the previous year. Operating margins were 27%, down from 29% last year. Riverbed was cash flow positive in Q4, as free cash flow was $49 million and $217 million for the year.
For the fiscal year, Riverbed earned $0.99 per diluted share.
Riverbed ended the quarter with $530 million in cash and investments, or $3.08 per share fully diluted on 172 million shares.
Long-term Outlook is Positive
Investors should expect the outlook for Riverbed to remain bright. First, Riverbed expects OPNET to add to earnings (non-GAAP) in 2013, while synergies will be achieved a year later. Together with OPNET, Riverbed aims to grow revenue by 30% by the end of 2014. Second, Riverbed increased its headcount by 79 last quarter. In addition to the 686 employees from OPNET, Riverbed now employs 2,567 people in staff. The increased staff suggests that the company has room to improve margins without cutting costs. Growth will depend on successfully selling new products. Last year, the Cascade product grew the fastest proportionately. If Cascade revenue becomes a greater proportion of revenue, investors should expect profits to grow even faster by 2014.
There are three risks to consider:
- The departure of Steve McCanne, Riverbed's co-founder and CTO added uncertainty to the company's future. A search for a replacement could distract the company and reduce the pace of OPNET integration.
- Another risk is macroeconomic: sequestration, or spending cuts by the White House, was not factored in the forecast. Since the "Fiscal Cliff" was resolved without any impact to Riverbed, this upcoming risk appears to be minimal. If the market falls ahead of this uncertainty, it could take Riverbed shares down too. Investors will be given another entry point to accumulate shares at a lower cost.
- Day sales outstanding ("DSO") worsened in Q4 to 43 days, up from 36 days in Q3. Excluding OPNET, DSO was 34 days. OPNET also contributed to the majority of the inventory increase by adding $4 million.
The drop in Riverbed shares is nothing new for current shareholders. In the last two years, shares dipped at least twice before, only to start recovering over the next few months. Investors looking for a pure software play should consider VMware instead, whose decline recently is also likely to be temporary. Microsoft continues to generate most of its revenue growth in enterprise database and CRM software sales, and is more conservatively valued than Riverbed shares. Juniper is a network company that is frequently speculated as a takeover target, but this is unlikely. Juniper has a market capitalization of $11.1B, which is over 4-times greater than Riverbed's $2.55B market cap. If anything, Riverbed would be a more likely takeover target for any company that wants to benefit from the growth in WAN.
Disclosure: I am long RVBD.