Buy Juniper Networks At A Discount

| About: Juniper Networks (JNPR)

Juniper Networks (NYSE:JNPR) sells network infrastructure products, such as switches and routers. The company competes directly with two much larger competitors, Cisco Systems, Inc. (NASDAQ:CSCO) and Hewlett-Packard Co. (NYSE:HPQ).

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JNPR ChartClick to enlarge

JNPR data by YCharts

Juniper stock currently trades at $16.14, off from a high in the mid-40s in early 2011. It currently trades close to its five-year low in early 2009. Certainly, the company is stronger than it was at the depths of the recession, so it is likely the stock is significantly undervalued. Let's take a look at Juniper's financial results for the last five years.

(In Million $) 2007 2008 2009 2010 2011
Revenue $2,836 $3,572 $3,315 $4,093 $4,448
Operating Cash Flow $786 $875 $796 $812 $986
Capital Expenditure $-147 $-165 $-154 $-186 $-267
Free Cash Flow $639 $710 $642 $627 $720
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Juniper recorded revenue of about $4.5 billion in 2011, up over 50% from 2007. This pales in comparison to market-leader Cisco's 2011 revenue of $45 billion. Free cash flow has remained largely stagnant since 2007.

Owner earnings

Owner earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines owner earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate owner earnings by taking the net income and adding back various non-cash items, such as depreciation, and then subtracting the five-year average capital expenditures. I'll also add interest payments adjusted for taxes since interest is tax deductible.

(In Million $) 2007 2008 2009 2010 2011
Net income $360 $511 $115 $619 $425
Depreciation and amortization $193 $172 $148 $155 $170
Stock based compensation $0 $108 $139 $177 $217
Other non-cash items $64 $-40 $-4 $-49 $-32
Interest payments $0 $0 $0 $8 $49
Avg capital expenditure $-184 $-184 $-184 $-184 $-184
Owner Earnings $434 $568 $215 $726 $634
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Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the owner earnings figures to determine Juniper's cash return on invested capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the owner earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.

(In Million $) 2007 2008 2009 2010 2011
Owner earnings $434 $568 $215 $726 $634
Invested capital $6,885 $7,187 $7,590 $8,467 $9,983
CROIC 6.31% 7.91% 2.84% 8.58% 6.35%
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Juniper's CROIC sits at 6.35%, which isn't particularly high. Cisco's CROIC is nearly double this number. Let's take a look at the most recent balance sheet.

Cash and cash equivalents $3,430
Investments $785
Debt $999
Pension obligations $0
Minority interest $0
Net cash (Debt) $3,216
Diluted float 536
Cash/Share $5.99
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Juniper is sitting on $5.99 in cash per share, which currently represents 37% of the market capitalization. This means that Juniper's future earnings is valued by the market at only $10.15 per share. Juniper has plenty of cash to cover its debt and its balance sheet is extremely strong.

Valuation

I use a discounted cash flow analysis to estimate the fair value of the company. I will use a discount rate of both 12% and 15% and use these values to define a fair value range. I will assume an initial owner earnings growth rate of 9% and let that rate decay over 20 years to a perpetual growth rate of 3%, as per the growth table below.

Year 1 2 3 4 5 6 7 8 9 10
% 9% 8.7% 8.4% 8.1% 7.8% 7.5% 7.2% 6.9% 6.6% 6.3%
Year 11 12 13 14 15 16 17 18 19 20
% 6% 5.7% 5.4% 5.1% 4.8% 4.5% 4.2% 3.9% 3.6% 3.3%
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For reference, the average analyst estimate for five-year earnings growth is 14.42%. Using the above parameters, I arrive at a fair value range of $20.46-$26.11. A table of buy targets for various margins of safety is shown below.

Margin of safety Buy target
10% $18.41
15% $17.39
20% $16.37
25% $15.34
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Conclusion

Juniper currently trades at $16.14, which is a 21% discount to the lower bound of my fair value range. Being a smaller company than its competitors, Juniper has a lot of room to grow. With cash on the books representing 37% of its market capitalization, it seems that the market is greatly undervaluing Juniper's future earnings. Juniper offers a great value and substantial margin of safety for the long-term investor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.