The Street Doesn't Seem To Believe Radware Will Become A Player

| About: Radware Ltd. (RDWR)
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Wall Street doesn't typically have all that much patience with tech growth stories, so while Radware's (NASDAQ:RDWR) historical growth is hardly embarrassing, it doesn't seem like analysts or investors expect big things from this company in the future. Maybe that's fair given the slowing ADC market and the rampant competition in security, but Radware's technology and rich cash balance could generate more growth than currently expected.

Just A Small Player In A Slowing Market?

It might be easy to dismiss Radware at first. After all, the application delivery controller (ADC) market is not all that large (roughly $1.6 billion/year) and most analysts expect it to see slowing growth in the coming years - from double digits into the high single digits. What's more, while Radware has been at it a while, they haven't made all that much of an impression - F5's (NASDAQ:FFIV) share is in the high 40%s, while Citrix (NASDAQ:CTXS) holds about 20% and Cisco (NASDAQ:CSCO) holds more than 10%. By comparison, Radware's share is in the high single digits.

Even with that somewhat grim prologue, there may be something here. Although Radware hasn't been a mover and shaker in the traditional ADC market, the company has been having more success with its virtual application delivery infrastructure (VADI). Boasting competitive win rates between 60% to 80%, Radware has been doing better in winning business in highly virtualized environments and has higher share (north of 10%) in the "advanced" ADC market (a category that is admittedly more arbitrary).

The company also has a growing market opportunity in security (built around attack mitigation), and OEM relationships that should begin to deliver results in 2013. With Cisco leaving the ADC market and a rich cash balance of its own, it may be premature to dismiss Radware as an also-ran in a market that has already lost its luster.

Virtualization Leads To Real Dollars

Radware's platform seems to come into its own when virtualization is a significant factor. Radware's products offer superior virtualization (though I think F5 and Citrix would fiercely debate this point), improved scripting, and attractive "pay as you grow" pricing. In addition, the company offers high-touch customer support and a formless product offering that lets customers pick from hardware, software, or a combination to achieve their ends.

I will be curious to see how Radware can leverage this edge in virtualization. F5 is competing hard here with new products/technologies, and Citrix has built its share in part by bundling ADC with virtual desktop infrastructure (VDI) and hypervisors.

It's also worth noting that the overall ADC market growth is starting to fade. The proliferation of smartphones has increased the need for ADC technology on the service provider side, but most sell-side analyst surveys have shown a steady erosion in the prioritization of ADC in overall IT spending budgets. Granted, five-year compound annual growth of 7-10% isn't terrible, but I don't think investors should overlook the fact that F5 is looking at markets outside of ADC for future growth and Cisco has decided to bail entirely rather than fight to regain share in the ADC market.

Will Partners Deliver Growth?

One of the bull points on Radware for a little while now has been the company's OEM partnerships with Juniper (NYSE:JNPR) and Check Point Software (NASDAQ:CHKP). While both are theoretically promising, neither has delivered yet and there are inherent risks to any company betting on third parties to drive their revenue growth.

With Juniper, the company embeds its ADC technology into Juniper's edge routers. While that has been a relatively strong business for Juniper in the past, Juniper has had its challenges recently with the service provider business. Worse still, the company later licensed ADC technology from Riverbed (NASDAQ:RVBD). The deal with Riverbed didn't supplant Radware entirely and is more focused on enterprise switches, but it's very much fair to ask what it says about Radware's technology and/or the companies' relationship that Juniper went to another ADC technology vendor for this second deal.

The Check Point deal seems more promising at this point. Check Point is using Radware's technology in attack mitigation in products that will address distributed denial of service (DDoS) attacks, and attack mitigation could be a market opportunity worth as much as ADC. While Check Point is a great partner in security (the company enjoys excellent market share with large customers and a large installed base), Check Point has struggled to grow of late and there are concerns that the company has lost momentum to newcomers like Palo Alto Networks (NYSE:PANW).

Growth Potential Is There…Or Is It?

Modeling Radware's potential growth gets a little squirrely, as it seems like nobody really believes their own numbers - if you look at what sell-side analysts project, it doesn't really line up with the resulting price targets (though very few sell-side analysts use free cash flow to derive their price targets).

Most analysts and independent research groups seem confident that ADC market growth will continue on at a high single-digit rate for the next five years, and then taper off into the mid-to-low single digits. At the same time, Radware's addressable security market should be growing at least as fast, and the company has the opportunity to gain share in both markets. The share growth potential in ADC is particularly significant. Cisco's approximately 10% share is up for grabs; while Cisco has partnered with Citrix to transition customers, everybody (including F5) is taking aim at that business.

I also believe that Radware will buy more growth for itself over time - there's over $250 million in cash on the balance sheet and management does not seem inclined towards a dividend or buyback. So, I expect more deals like the recent Strangeloop transaction to broaden the company's technology offerings and end market opportunities.

Right now, I'm looking for long-term revenue growth of between 9% and 10%. That's below the company's 10-year historical rate (about 15%) and below what I project for F5, and I do not believe that Radware will ever become a serious threat to F5's share in the overall ADC market. That said, Radware must improve its marketing profile/brand awareness in North America for this growth target to be viable.

Radware also trails companies like F5 in terms of free cash flow margin. I expect that to improve largely due to better operating leverage from revenue growth, but I think it will be difficult for the company to match the level of free cash flow production (as a percentage of revenue) from the likes of F5, Riverbed, or Cisco in the short term. Longer term, I think Radware can gradually improve into the mid-20%s, sufficient for about 13% long-term free cash flow growth. One major concern I have, though, is whether the company will choose to up its marketing spend and/or see operating deleverage from sizable acquisitions.

This is also as good a time as any to point out one of my complaints with Radware. The company's reporting to investors is sub-optimal in my view, as the company's Investor Relations website is quite spartan and the company does not regularly provide cash flow statements with its quarterly reports. It's not the end of the world, but it's an unneeded irritant.

The Bottom Line

I realize that it's ambitious to project low-teens cash flow growth for a company with sub-10% share in a slowing tech market segment. On the other hand, I think the company's relatively stronger position in virtualized environments is significant, and I do believe that the company's relationship with Check Point will deliver decent growth.

My free cash flow growth assumption leads to a fair value target of about $51.50 per share, which frankly surprised me. I get that Radware is not a market darling and that the decision by Juniper to go with Riverbed rattled investors and changed a lot of investors' minds. Still, to see that sort of apparent undervaluation makes me a little nervous that I've overshot the market on my growth assumptions.

If Radware can grow at a double-digit clip (and the magnitude of that "if" is going to vary from reader to reader), this is a seriously undervalued tech stock (even with a relatively high P/E and EV/EBITDA). I've long been a fan of F5, but even I have to admit that Radware seems to be worth a much closer study at these levels.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.