In response to activist calls to increase shareholder returns and cut costs, Juniper (NYSE:JNPR) unveiled an “Integrated Operating Plan” on February 20, which promises to return $3 billion to shareholders over three years and cut $160 million in operating costs by Q1 2015.  The capital allocation program involves purchasing $2 billion worth of stock through the end of the first quarter of 2015 and initiating a quarterly dividend of $0.10 per share, starting in Q3 this year. In addition, the company plans to restructure operations by realigning its focus on the fastest-growing segments in the networking market and creating a “One-Juniper” corporate structure that will help its non-GAAP operating margins increase to 25% in 2015 – about 580 basis points ahead of last year. Juniper’s moves come amid growing pressure from activist investors such as Elliott Management to improve its finances and increase shareholder value. The outlined strategy is almost in line with what Elliott had suggested in January, which it believed could unlock a potential upside of 57-77% over the company’s stock value at the time. Juniper’s shares have since risen by almost 25% in anticipation, and are currently trading close to our $28 price estimate for the stock.
While the magnitude of the upside can be debated, we believe that management’s recent move 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 repurchasing shares 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 management is optimistic about the stock’s future. On the other hand, a reasonable reduction in operating expenses, brought about by limiting its R&D focus to a few key areas where Juniper’s core competencies lie, could lead to market share gains, increase in cash flow and create long-term shareholder value.
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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. Consequently, Juniper’s R&D costs as a percentage of revenues have generally been among the highest in the industry. Juniper’s R&D spend as a percentage of revenues of about 21-22% is about 9 percentage points higher than peers such as Cisco and F5 networks, according to Elliott.  Reducing this to peer-average levels of 11-12% could drive cost savings of about $420 million in the longer run. Juniper’s plan to cut expenses by $160 million is about 40% of that and can be reasonably expected to be achieved in the near term.
If Juniper realizes the planned cost savings by 2015, we expect its OpEx as a percentage of gross profits to decrease from around 63% in 2013 to about 54% two years out. Consequently, its EBITDA margins would improve by almost 540 basis points (5.4%). Adjusted for taxes, this could lead to an improvement of more than $100 million in free cash flow going forward. Our current estimates assume that the company will be able to implement its planned initiatives successfully and realize the aforementioned increase in cash flows as a result.
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 under-performing businesses such as security. The company hasn’t done particularly 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%. We do not expect substantial market share increases going forward. Juniper has also been losing market share in network security, where its revenues have declined by almost 25% over the last four 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 under-performing business lines could allow Juniper to eliminate distractions and target investments in its core carrier product portfolio 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 28.5% in 2013, by our estimates. Its market share in edge routers has also declined from about 22% to 17.6% in the same period. Elliott believes that focusing on these product lines could help Juniper regain its lost market share in the coming years, while allowing it to return excess capital back to shareholders.
Increasing Exposure To The core And The Edge
While renewed focus could help Juniper gain core and edge market share in the coming years, it does seem somewhat 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 $700 million, or 10% in the long term. Together with the $160 million in operating cost savings and the corresponding increase in margins, this could lead to a 20% increase in Juniper’s long-term free cash flows and increase its valuation by about 12%, or about $1.7 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 5% over our previous estimate. In sum, the upside to our valuation for Juniper as a result of the renewed service provider focus nets out at about 7%, or about $1 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 months. If the average buyback price is around $23, Juniper’s valuation jumps by another 5% by our estimates. On the other hand, if Juniper buys back shares at an average of $27, further upside is limited to only 2%. 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 $28 after the recent run-up.Notes:
- Juniper Networks Announces Integrated Operating Plan, February 20th, 2013 [↩]
- Elliott Management’s Perspectives on Juniper, January 13th, 2014 [↩]
- Security Appliance Revenue Up 6.5% in Third Quarter, According to IDC, December 16th, 2013 [↩]