Juniper’s (NYSE:JNPR) stock shot up by almost 8% in trading Monday after activist hedge fund Elliott Management Corp announced that it has acquired a 6.2% stake in the company and will be pushing the management to consider cost cuts, dividend payouts and stock buybacks to increase shareholder returns. In a letter to the management, Elliott suggested that the company return about $3.5 billion through stock repurchases spread across two years and cut operating costs by around $200 million to create significant long-term value for shareholders.  Elliott believes that Juniper’s shares are currently undervalued, and a successful implementation of its suggestions could help unlock upside potential of 57-77% over the share price before the recent run-up. While the magnitude of the upside can be debated, we believe that the suggestions do carry merit and will help Juniper become a more attractive value proposition for investors.
However, much of the attraction for long-term shareholders isn’t so much the return of capital in the near term as the reorganization that Juniper may undertake to reduce expenses and grow more focused. While a share repurchase program will allow Juniper to return excess capital to shareholders, while reducing share count and increasing EPS levels, not much will change from a free cash flow perspective. Unless Juniper manages to repurchase stock at a significant discount to its fair value, we anticipate little upside to its valuation from this move alone, other than the sentimental relief it may bring to shareholders that the management is optimistic about the stock’s future. On the other hand, a reasonable reduction in operating expenses, brought about by a slimming down of R&D focus to a few key areas where Juniper’s core competencies lie, will lead to market share gains, increase cash flow and create long-term shareholder value.
R&D cost savings to drive cash flow gains
Juniper has historically been an innovation-focused company, relying heavily on an expensive R&D budget to out-innovate rivals and gain market share. Even in recent years when macroeconomic uncertainties caused the networking market to stagnate and Juniper’s revenue growth to slow, the company continued to invest aggressively in R&D and create new product lines. Historically therefore, Juniper’s R&D costs as a percentage of revenues have mostly been one of the highest in the industry. Compared to peers such as Cisco and F5 networks, Juniper’s R&D spend as a % of revenues of about 21-22% is 9 percentage points higher, according to Elliott. Reducing this to peer average levels of 11-12% could drive cost savings of about $420 million. Elliott estimates that about half of this, or about $200 million in operating cost savings, can be reasonably achieved in the near term.
If Juniper manages to cut its R&D costs by $200 million, or reduce R&D as a % of gross profits to 27% from around 34% in 2013, its EBITDA margins would improve by as much as 400 basis points (4%). Adjusted for taxes, this could lead to an improvement of about $150 million in free cash flows going forward. We estimate that such a scenario could add about $1.6 billion to Juniper’s valuation, or about 15% to our current $23.50 price estimate. This could push our price estimate for Juniper to about $27, or towards the lower end of the $28-32 range given by Elliott.
Scaling back security and switching aspirations
However, in order to achieve these cost savings, Juniper will have to scale back efforts to develop new product lines such as QFabric and reduce R&D expenses in underperforming businesses such as security. The company hasn’t done well in the switches market, where it faces tough competition from big entrenched enterprise players such as Cisco. As a result, despite entering the switching market almost six years ago, it has managed to grab a share of only 3%. Nor do we expect substantial market share increases going forward as well. Juniper has also been losing market share in network security, where its revenues have declined by almost 8% over the past five years. According to IDC, Juniper’s market share in the security appliance market has declined from 14% in 2003 to 6% in the first three quarters of 2013.
Streamlining the cost structure to decrease exposure to underperforming business lines could allow Juniper to eliminate distractions and target investments on its core carrier product portfolio of core and edge routers. The company derives almost two-thirds of its total revenues from telecom service providers, but its market share in this segment has been slumping due to growing competition from the likes of Huawei and Alcatel Lucent. Juniper’s core router market share has declined from more than 35% in 2004-05 to about 28% in 2013, by our estimates. Its market share in edge routers has also declined from about 22% to 17% in the same period. Elliott believes that focusing on these product lines could help Juniper regain all its lost market share in the coming years, while allowing it to return the excess capital back to shareholders.
Increasing exposure on the core and the edge
While the strategy should help Juniper gain core and edge market share in the coming years, it does seem a tad optimistic that the gains would be of the magnitude of 5-7 percentage points given the rising competition. An increasing proportion of global router sales in the coming years is going to be driven by the LTE transition in emerging markets such as China where local rivals such as Huawei have an upper hand. If we take a more conservative estimate of 3-5% for Juniper’s market share gains in the core and edge router market, its overall revenues could increase by around $1 billion, or 15%, in the long term. Together with the $200 million in operating cost savings, this could lead to a 50% increase in Juniper’s long-term free cash flows and increase its valuation by about 35%, or about $4 billion, by our estimates.
However, a lower focus on security and switching could cause these businesses to stagnate. Assuming that both Juniper’s switching market share as well as security revenues remain around the current levels going forward, there could be a downside of about 8% over our previous estimate. In sum, the upside to our valuation for Juniper as a result of the restructuring suggested by Elliott nets out at about 25%, or about $3.2 billion. This brings our price estimate for Juniper to $30.
Any upside to this as a result of share repurchases will depend on the average price at which Juniper buys back its shares in the coming years. If the average buyback price is around $24, Juniper’s valuation jumps by another 8% by our estimates. On the other hand, if Juniper buys back shares at an average of $27, further upside is limited to only 4%. At the same time, if the average buyback price is higher than $30, it could turn out to be dilutive to our valuation estimate for Juniper. Juniper’s shares are currently trading at about $25 after the recent run-up.Notes: