Juniper Networks’ Renewed Focus

By Grady Burkett, CFA
May 2015
“Executing a significant organizational change is not a trivial task for established firms, and improvements are rarely linear.”

In February 2014, Juniper Networks, Inc.’s (JNPR) management announced its intent to implement a new operating plan designed to improve operating results and unlock shareholder value. The plan included a reduction of Juniper’s cost base, a narrowing of the firm’s product focus, a dividend initiation, and an accelerated share repurchase program. Juniper is owned across multiple Diamond Hill strategies, and our investment team is therefore focused on understanding the impact that these initiatives might have on Juniper’s long-term competitive position.

In our view, this operating plan makes sense. After all, Juniper long ago established a defensible competitive position selling high-capacity data routers to large telecom service providers. Because of this defensible position, the firm has generated positive free cash flow in every year since 2003 and enjoys solid financial health. However, from 2004 through 2013, management acquired numerous firms in the pursuit of product and customer diversification, and results were disappointing, from our perspective. Importantly, Juniper’s best businesses – selling high-capacity routers, firewalls, and data center switches to large network operators – were primarily built internally, and we believe that these businesses can grow profitably going forward.

Still, executing a significant organizational change is not a trivial task for established firms, and improvements are rarely linear. Juniper’s 2014 revenue fell short of our expectations. This revenue shortfall in turn masked underlying cost structure improvements. While demand weakness contributed to Juniper’s revenue disappointment, we also believe that the firm’s restructuring initiatives and an abrupt CEO change may have weakened execution throughout 2014. Juniper has largely completed the majority of the initial operating plan, and we believe that the actions taken over the past fifteen months will yield improving financial results going forward. Our confidence stems from three primary factors – 1) Juniper’s installed base of networking equipment and sticky customer relationships provides a growing base of high-margin recurring service revenue, 2) we believe that Juniper will be more competitive going forward as a result of the firm’s narrower product focus, and 3) management’s tighter cost controls and improved capital allocation should lead to above average shareholder returns. We will consider each of these points in a bit more detail.

First, Juniper sells products that are deeply integrated into the data network infrastructure of service providers and corporations. The firm’s customers face implementation costs when replacing Juniper’s equipment with a competitor’s products. These customer switching costs have allowed the firm to maintain a relatively stable share of the North American service provider router market and capture small, but sustainable, shares of the firewall and switch markets. Juniper offers services with its products which include annual maintenance agreements covering technical support, hardware replacement and software updates. Product sales are transactional and partially dependent on customers’ capital spending budgets in any given year. Service revenue, however, is mostly recurring in nature as maintenance agreements are typically renewed as long as the supported products remain installed and active. As such, Juniper’s service revenue has grown consistently, even during years in which product revenue declined. As shown in Figure 1, service revenue has compounded at nearly twice the rate of product revenue since 2006 and now accounts for more than a quarter of Juniper’s total sales.

Figure 1: Juniper’s service revenue has grown steadily, even during periods of weak product demand

Source: Company reports. CAGR = compound annual growth rate.

Investors tend to focus a lot of attention on the quarterly volatility of product revenue. In doing so, they may miss the fact that Juniper’s steady long-term growth in service revenue implies that its products remain highly relevant as active components of its customers’ networks. This high-margin service revenue stream should also contribute to consistent free cash flow generation for many years, irrespective of short term fluctuations in product sales.

Second, management has narrowed Juniper’s focus toward its areas of strength – selling high capacity routers and firewalls, and data center switches to operators of large networks. We believe Juniper’s primary competition over the next three years will come from five companies: Cisco, Huawei, Alcatel-Lucent, Arista Networks, and Brocade. As demonstrated in Figure 2, Cisco, Huawei, and Alcatel are all significantly larger than Juniper, while Brocade and Arista are much smaller.

Figure 2: Juniper invests heavily in product development, but is still dwarfed by its largest competitors

Source: Company Reports, Diamond Hill Estimates
Operating income has been adjusted for certain non-recurring and non-cash expenses.

Importantly, we estimate that close to 90% of Juniper’s total revenue is now attributable to routers, switches, and related services. Given Juniper’s renewed product focus, we believe it’s appropriate to directly compare Juniper’s router and switch businesses to its competitors’ router and switch businesses when gauging relative scale. After all, with the exception of Arista, each of Juniper’s router and switch competitors also have sizeable businesses that do not compete with Juniper. As shown in Figure 3, we believe that Juniper’s relative scale improves significantly when considering only routers and switches.

Figure 3: By focusing its resources, Juniper improves its relative scale in the router and switch industries

Source: Company Reports, Diamond Hill Estimates
Operating income has been adjusted for certain non-recurring and non-cash expenses.

Figure 3 excludes Huawei, as disclosures are limited. Also, our assumption that each firm allocates its R&D (research and development) and other operating budgets in direct proportion to each business unit’s revenue contribution is clearly a simplistic interpolation. Still, the table provides a proper lens from which to view Juniper’s relative scale. For example, Cisco sells collaboration software, set top boxes, and servers. Alcatel and Huawei each have large wireless equipment businesses to support. Each firm must invest resources in businesses that do not compete directly against Juniper. Now that Juniper has narrowed its product focus, its relative scale in the market segments in which it competes has improved. We believe this improvement in relative scale should eventually translate to higher levels of profitability, market share gains, or both.

Finally, management is now maintaining appropriate expense controls and practicing sound capital allocation. First quarter 2015 operating expenses declined 12% from the previous year, and we believe that this improvement is sustainable. Diluted share count fell roughly 17% over the same time frame, and management repurchased shares at prices below our estimate of intrinsic value. In addition, the firm now pays a quarterly dividend of $0.10 per share. We expect share count to decline a bit further, and we believe the dividend can grow.

Juniper’s investment margin of safety has narrowed recently as investors have become more confident in the firm’s future prospects. Still, we believe that the combination of Juniper’s improved operating focus, sustainable competitive position, and better capital allocation will translate into an above-average investment return going forward.

Originally published on May 21, 2015

The views expressed are those of the research analyst as of May 2015, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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