If you invest long enough, you eventually get used to the idea that there can be a big difference between what analysts say and what they do. In the case of Riverbed Technology (Nasdaq:RVBD), there's ample skepticism about the company's ability to navigate a real slowdown in its core wide area network (WAN) optimization business and successfully produce a second act in application/network performance management.
While analysts say they're skeptical, the numbers they produce in their models point to significant growth potential at the company and real undervaluation. I've learned to be more skeptical of analysts' numbers than their "body language," and while Riverbed certainly has an opportunity to resume a good growth trajectory, that outlook has to be tempered with caution about its operational and execution capabilities.
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Margins an Issue in the Fourth Quarter
Riverbed's fourth quarter wasn't that bad as a whole, but the underperformance in margins is problematic, particularly as it seems to point to lower margin assumptions going forward.
Revenue rose 17% this quarter (9% on a sequential basis), with product revenue up 12% and 9%, respectively. Recently acquired OPNET made only a modest contribution to revenue, but the company's core WAN optimization business looked soft (up in the low single digits). On the other hand, Cascade (the company's network performance management business) was quite strong.
As mentioned, margins were problematic. Gross margin improved more than a half point from last year and came in as expected, but adjusted operating income rose only 8% and the company's operating margin (which declined more than two points) missed the average analyst estimate by about 150 basis points.
SEE: Analyzing Operating Margins
Is Disappointing First-Quarter Guidance Becoming a Habit?
Hopefully Riverbed isn't going to make a habit of starting the year off on a sour note. Shares sold off last year after the fourth-quarter report, as management guided lower on issues tied to new product rollouts. Once again, guidance was a talking point - and not in a good way.
Looking through management's comments, it sounds like OPNET's revenue run rate is looking about 15% lower than analysts projected prior to the deal close. The WAN optimization market is also looking sluggish in 2013, which makes the company's strong share relative to Cisco (Nasdaq:CSCO) and F5 (Nasdaq:FFIV) worth much less.
Worse still, though, is where analysts have taken their margin assumptions. While there should be some meaningful long-term synergies in the OPNET deal, it seems like it's going to take a little longer for those to materialize (operational issues). At the same time, I'm a little concerned about the company's ability to effectively co-market the OPNET and Cascade products for the APM/NPM markets (execution issues) - "go to market" has been a challenge for the company before, and that's not made easier by what's looking like a tough 2013 IT hardware market.
SEE: Can Earnings Guidance Accurately Predict The Future?
Performance Management Sounds Good - but Riverbed Has to Perform
I like the fact that Riverbed is positioning itself to address both application performance management (APM) and network performance management (NPM). At the end of the day, getting enterprise IT systems running better is the name of the game and the company can now approach it from different angles.
All told, this is a multibillion-dollar market likely growing at a high single-digit rate over the next four to five years. The question is whether Riverbed can execute on the opportunity. Like Cisco and F5, Riverbed is motivated by slowing growth in other areas of its business, but coming up with a successful act in technology is not easy and Riverbed's prior go-to-market challenges (as well as the resignation of chief technology officer and co-founder Steven McCanne) are a definite risk factor when projecting their future market share and revenue growth.
The Bottom Line
If Riverbed can produce a double-digit long-term free cash flow growth rate, fair value today is in the high $20s. As I have my doubts about the company's ability to generate long-term free cash flow margins above the mid-20%'s, that growth is largely going to have to come from revenue growth. While Riverbed's addressed markets could conceivably support that sort of growth, it will place a premium on execution. I have my doubts about management's ability to deliver, but so long as OPNET doesn't completely fail, these shares look cheap anywhere below $20.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.