Companies deal with fading growth prospects in different ways. Some companies, like F5 (Nasdaq:FFIV) try to use relatively small-scale M&A and their own internal R&D to develop new products and enter into new markets. Others, like Cisco (Nasdaq:CSCO) and Riverbed (Nasdaq:RVBD) take bigger swings on the M&A front, putting more of their shareholders' capital at risk in the hopes of bigger long-term rewards. While the growth prospects for WAN optimization are no longer as bright as they once were, Riverbed hopes to benefit from a more comprehensive suite of technologies and solutions for the network performance market, and the stock may just be cheap enough to be worth consideration.
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Waiting For Synergies To Kick In
When Riverbed reported 10% organic revenue growth for the first quarter back in April, that was actually a pretty strong report relative to what most of its peers in the IT hardware space managed. WAN optimization growth of 6% was not exactly thrilling, but then other hardware incumbents in areas like application delivery controllers (ADC) (F5), security (Check Point (Nasdaq:CHKP and Cisco), switching/routing (Juniper (NYSE:JNPR) and Cisco), and storage (EMC (NYSE:EMC) saw pretty unimpressive performance as well.
Importantly, the recently-acquired OPNET business seemed to do pretty well, with revenue of $52 million. Overall, Riverbed's network performance monitoring business was up 42% (excluding OPNET), with solid growth in ADCs (off of a low base).
Operating synergy is another story, though. While Riverbed's gross margin did improve more than a point from the year-ago level, operating margin declined more than three points from last year and more than five points from the prior quarter. Given that Riverbed has had operating/execution issues in the past, it is very important for the stock's valuation that management show that it has a handle on the integration of the OPNET business and that it offers more than just a bigger revenue base.
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Building For The Future
One point that I've made repeatedly when talking about tech companies, particularly those more skewed towards hardware, is the importance and difficulty of building a second act. That is, taking the company's initial success and using it to develop products and markets that can allow the company to continue to grow at an above-market rate on into the future.
WAN optimization is slowing. While Riverbed has actually been doing pretty well from a market share standpoint relative to Cisco, Juniper, Blue Coat, and F5, the market is nevertheless maturing and growth is slowing. That makes the company's transition towards becoming a broad network performance monitoring/management company all the more important.
Riverbed paid a lot for OPNET and there could be a lot of strong natural synergies between the two businesses, but companies like Cisco, CA (Nasdaq:CA), IBM (NYSE:IBM), and Hewlett-Packard (NYSE:HPQ) will be aggressively competing for at least some of the same business. What's more, as previously mentioned, Riverbed doesn't have the best history when it comes to sales force management/execution or launching/updating product families. In my mind, then, that raises a very valid question as to whether management will succeed in fitting these pieces together and creating a situation where the new Riverbed is more than the sum of its parts.
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The Bottom Line
Not unlike with F5, I do have some worries that the trend of outsourcing more enterprise IT functions to providers like Amazon (Nasdaq:AMZN) (Amazon Web Services or AWS) will impair the market growth potential in Riverbed's core markets. That said, while I don't think the network performance monitoring/management market is necessarily a hugely high-growth market over the next five to 10 years, I do believe it will be a pretty steady one, and I do believe that will support high single-digit growth for Riverbed.
All told, I'm looking for long-term revenue growth of over 9% for Riverbed, helped to a significant degree by the OPNET deal. If the integration fails (or underwhelms), that's a significant source of downside risk. I do expect the new business to be less profitable for a cash flow perspective, and so my free cash flow (FCF) growth assumption is slightly weaker (about 8%).
Altogether, that suggests a fair value to me of more than $21 per share, which is well above both the average sell-side price target (around $17) and the current price (around $15). Riverbed's past performance and execution issues do give me reason for pause (and do lead me to give the company a higher discount rate than some of its peers), but it's hard not to find today's price pretty compelling from a long-term perspective.
At the time of writing, Stephen D. Simpson owned share of EMC.