It would seem that this earnings season hasn't exactly been kind to tech investors, especially those that have placed huge bets on cloud companies. After subpar results from F5 Networks, the Street showed no mercy to VMware, sending the stock down 20% after what was really a decent report. But when the company issued its outlook for Q1, investors absolutely despised what VMware implied about the prospects for the virtualization industry.
Essentially, the market had little patience for poor performance and was poised to punish anything with a hint of caution. Unfortunately, Riverbed Technology (RVBD.DL) met this criteria. While this company has been doing well by making the best of a bad situation, concerns about management's ability to pilot Riverbed out of a weak wide area network -- or WAN -- optimization business have heightened. But amid the slowdown, the company was still able to secure 52% market share, surpassing rivals like Cisco (CSCO 0.25%).
Nonetheless, the stock dropped as much as 22% following Riverbed's fourth-quarter earnings results. The company has been going through periods of transition, including the acquisition of OPNET for roughly $1 billion. For several reasons, this was a move that I was not in favor of. But I'll get to that in a moment. Plus, it was clear in the earnings report that there were some disruptions in Riverbed's core business. How much of that can be attributed to OPNET can only be speculated upon. But suffice it to say, the Street was not pleased. But was the punishment deserved?
Guidance was soft, but let's not get carried away.
Despite the stock's beat down, fourth-quarter earnings weren't that bad, relative to expectations. Revenue climbed 17% year over year and 9% sequentially. Likewise, product revenue was solid, up 12% year over year and advancing 9% from Q3. However, profitability was another issue, as profits tumbled close to 80%. But this was not a surprise. I think some investors are dismissing the costs related to the OPNET deal. But a few other metrics raised eyebrows.
Operating margin arrived at 27%, down 2% year over year and 2% sequentially and missing Street estimates by 150 basis points. But minus the deal for OPNET, which has averaged operating margins in the mid to high teens, Riverbed would have fared 1% better. But 8% growth in operating income was a bit weak. This is even though the company advanced gross margin by almost 1% year over year. But it was down close to 2% sequentially. So, overall this report was far from a disaster.
However, as with VMware, it wasn't so much was Riverbed did, it was it said. Analysts absolutely hated the company's tepid guidance, which presumes very little synergistic OPNET benefits for the entire fiscal 2013. For that matter, the deal doesn't present any sort of cost advantage, at least not until 2014. For the first quarter, Riverbed expects to earn $0.23-$0.24 per share on revenue $257 million. Even if revenue arrived at $266 million -- the high end of its range -- it will (at best) top estimates by less than half of a percent. And EPS would be $0.02 shy of the consensus of $0.26 per share.
A lucrative deal requiring more patience than investors have
It is clear that Riverbed is treading cautiously knowing that OPNET is not yet fully integrated. As a result, the company wants to leave as much margin for error as it can, even it if means near-term discomfort to investors. I can't fault Riverbed there. However, and as I said above, I had my doubts about the OPNET acquisition when it was first announced. The timing seemed off, especially since enterprises were showing little interest in spending.
The direction of the WAN optimization business was (at the time) unclear. Making matters worse, paying $1 billion in cash and stock was a hefty 34% premium to pay over OPNET's prior closing price of $32. What's more, based on OPNET's projected 2013 revenue, there wasn't much the company was expected to immediately bring to Riverbed's table, which in this recent quarter netted out to revenue of $6 million.
Then again, aside from these logistics, this was a deal that Riverbed had to make to keep up with Cisco, which has put together a string of deals as it looks to offset its struggling hardware business. These include paying $141 million in cash for Cariden, followed by $1.2 billion for Meraki. Most recently, Cisco acquired BroadHop to help strengthen its position in enterprise mobile. And before these deals Cisco had not performed all that well against Riverbed in WAN optimization. The net effect of these recent acquisitions will put Cisco in a better position to attack Riverbed.
Riverbed understands this. And given OPNET's application management business, or APM, which is growing at a 30% rate and makes up more than 60% of sales, Riverbed now has a way to offset potential weakness in WAN optimization. The good news is, the current weakness in WAN might be temporary. While citing research from Gartner, the company believes that 2014 will be a breakout year. Gartner estimates that by 2014, roughly 80% of end-user traffic will be in WAN.
This means that as long as Riverbed hangs on to its WAN lead, it will be on the receiving end of significant demand. This now makes Riverbed a very attractive takeout candidate, especially since it's lost 20% of its value. With a market cap of just $2.5 billion, the first and obvious suitor would be Cisco, which has $45 billion in cash and can close this deal tomorrow if it wants to.
Just near-term bedbugs
Riverbed has an excellent management team, one that is more than capable of fixing what I consider just near-term bedbugs. In the meantime, the company deserved more patience than it has received from investors. Granted, the stock is far from cheap at a P/E of 48. But given its high-teens revenue growth, coupled with Gartner's projected WAN demand, this company should trade in the $20s. And any synergies Riverbed can realize with OPNET will simply be icing on the cake. I would be a buyer here on this weakness, as this drop seems exaggerated. Investors should stop crying a river.
