Polycom PLCM S
December 30, 2005 - 2:18pm EST by
jared890
2005 2006
Price: 15.30 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,439 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

We recommend the short sale of Polycom (PLCM). While the stock has dropped 33% year to date, we expect more bad news on the earnings front in 2006 as a new competitor, Lifesize, enters the video conferencing market with a superior product offering at a lower price.

Background
Polycom designs, manufactures and markets video and audio conferencing equipment, including both the end points and the network infrastructure that make the end points work. As shown below, Polycom generates 69% of its revenues from selling hardware products for the video and voice conferencing markets. The balance of its revenues come from networking products that support its hardware offering, and from providing services to its distributors and end use customers.

Revenue % of Revenue Operating Margin
Communications 375 69% 48%
Voice 108 20%
Video 267 50%
Network Systems 109 20% 34%
Services 57 11% 27%
Total 540 100%

Polycom enjoys a near monopoly in audio conferencing with around 90% market share. Using Polycom as a proxy for the market, the audio conferencing equipment has grown 6% per year between 2000 and 2004. However, this segment has begun to grow faster of late due to VoIP adoption. While Polycom does not break out the margins for audio endpoints, we believe that this is an extremely high margin product line as Polycom has a near monopoly.

The video conferencing industry is a duopoly in which Polycom and Tandberg (ticker: TAA NO) each have around 40% of the market by revenue. There are two primary types of end points: rooms, which are larger and more expensive, and executive units, which are essentially cameras attached to a TV or desktop monitor. Between 1997 and 2004, the market grew at a 19% CAGR in terms of units, but ASP declined at a similar rate. Thus, on a top line basis, the industry has been relatively flat, though it is highly volatile from year to year.

In network systems, Polycom provides the infrastructure needed for video, voice and data conferencing. This includes products such as multipoint control units (MCU) that allow multiple participants to connect in a conference call and bridges that translate traffic between networks. Polycom’s service segment is comprised of maintenance programs, integration services, consulting, design services, project management and training.


Market Share

Video Conferencing Revenue
2002 2003 2004 ’04 ytd ’05 ytd
Polycom, end points: 256 238 267 196 204
Tandberg, end points: 206 186 236 169 195
Total Industry Revenue: 539 517 642 460 493
Polycom % Total: 47% 46% 42% 43% 41%
Tandberg % Total: 38% 36% 37% 37% 39%

As mentioned above, Polycom dominates the audio conferencing market, with 90% market share. In video conferencing, Polycom entered the market in 1998 through the acquisition of Via Video. Subsequent to this acquisition, Polycom released the Viewstation, which rapidly took share from the then dominant PictureTel, causing PictureTel’s revenue to decline by 50%. Polycom acquired PictureTel in 2001 after having taken the top position in the market.

However, in the process of taking over the number one position in the video conferencing market, Polycom made a few missteps that Tandberg ultimately was able to exploit. First, Polycom over distributed its products. This led to reduced margins for resellers as they often have had to out-compete each other to move inventory sitting on their books. As a result, to this day, Polycom is still dealing with the effects of ill will that exists amongst its reseller partners. Second, because Polycom built its product line through a series of acquisitions that were never adequately integrated, maintaining its various product platforms contributes to Polycom being a high cost producer relative to Tandberg. Since 2000, we estimate that Polycom has lost approximately 20-25% of the video conferencing market, primarily to Tandberg, and the companies are now running neck and neck as industry leaders.

Margins
From a profitability standpoint, Polycom IS the audio market and, while not disclosed, presumably has extremely high margins in this segment. In video, Polycom’s margins are substantially below Tandberg (see table below), which is its only real competitor. As mentioned above, Polycom’s lower margins can largely be explained by its acquisition history. Video conferencing is essentially a software business. Gross margins are high and a main component to cost of goods sold is updating the software code that connects the hardware components. Tandberg grew its product line organically and therefore only has to work on one code base. Polycom’s product portfolio was formed through numerous acquisitions and has numerous code bases, causing Polycom to be the high cost producer in the industry.

Consolidated Net Sales
2002 2003 2004 ’04 ytd ’05 ytd
Polycom 452 420 540 394 425
Tandberg 272 235 305 216 262

Gross Margins
2002 2003 2004 ’04 ytd ’05 ytd
Polycom 59% 61% 63% 59% 61%
Tandberg 72% 69% 67% 66% 64%

EBIT Margins
2002 2003 2004 ’04 ytd ’05 ytd
Polycom 11% 9% 14% 11% 14%
Tandberg 35% 26% 26% 26% 27%

Polycom’s margins have improved in 2005 as the company moved to consolidate its video conferencing product base to one platform, the VSX line. However, the benefits of these changes have now been realized and Polycom will still have to support legacy products for several years.

Investment Thesis
Why is Polycom a good short? LifeSize, a new competitor, has begun releasing video and audio conferencing equipment this quarter. While largely aware of LifeSize, the street downplays the effects that LifeSize will have on the industry, e.g. “we believe that the impact [of LifeSize] will be marginal in the near term on the market leaders” (Wedbush Morgan Securities, December 27, 2005). We think this conclusion is materially wrong.

What exactly is LifeSize? In 2002, Craig Malloy and Michael Kenoyer, the founders of Via Video, left Polycom and formed LifeSize. Malloy and Kenoyer have developed an audio phone that, is the first serious threat to Polycom’s high end conference phones, a product line that we believe has very high margins. According to our channel checks, Lifesize’s phone compares favorably to Polycom’s.

In addition, Lifesize has developed several video conferencing solutions that are able to capture and broadcast HD video. Without getting into the technical standards, current video conferencing is below TV quality. Getting video conferencing up to HD quality is not trivial. First, an HD camera is needed. LifeSize developed its camera internally. Neither Tandberg nor Polycom have an HD camera and commercial solutions are expensive. Second, HD compression/decompression is much more processor intensive than current standards. Tandberg says that its current product line has the processing power and will only have to issue a software update to make its equipment HD capable (if and when they have an HD camera). Polycom has announced one upgrade and only for its high end VSX 8000 product. The upgrade costs $6,000 and includes an addition to the VSX 8000’s processor. This upgrade will make LifeSize significantly cheaper by comparison.

In terms of price, LifeSize’s flagship product, the LifeSize Room, costs less than similarly equipped Polycom units. In sum, LifeSize is offering a better widget at a better price.


LifeSize is currently shipping its phone, room and control units. Next year it will ship an executive unit, essentially a LCD screen that can plug into your computer that will also function as an HD video phone, and its networking product.

LifeSize’s go to market strategy is to work through a limited set of distribution partners. The company has cherry-picked the channel, selecting many of Polycom’s platinum partners. While many these resellers continue to sell Polycom and Tandberg, they have signed non-cancelable purchase agreements with LifeSize and face virtually no competition from other resellers carrying LifeSize products.


Polycom’s Earnings expectations

In video, LifeSize has somewhere between six months to one year lead time on the competition with HD. Industry experts lead me to believe that LifeSize might be able to address 15% of the market share initially and increase this number over time. LifeSize began shipping its room product on December 19, 2005, at which time it announced that had already shipped 130 rooms to end users, or $1.6 million pre-orders in an industry that did $165 million in 3q05. Remember, this has not been a growth industry over the cycle (in terms of revenues). Thus, in order for LifeSize to post sales, Tandberg and Polycom are going to have to lose sales.

We expect LifeSize to take more share from Polycom than Tandberg for the following reasons: 1) Tandberg’s products will be better able to compete against LifeSize’s from a technical perspective (ie, they are higher end), and, 2), the channel which LifeSize is using is more weighted to Polycom than Tandberg. For our model, we assume that the market for video end points grows 6% in 2006.

In audio, we believe that it will be more difficult for LifeSize to take significant share because 1), the company is not offering a full suite of products, and 2) Polycom has a strong brand name in audio conferencing. However, we do expect LifeSize to pick up some share on the upper end phone sales.

Based on our forecasts for the conferencing markets generally and LifeSize in particular, we expect Polycom to miss street estimates significantly in 2006.

2005E 2006E Y/Y
Communications 417 418 4%
Voice 139 167 20%
Video 278 251 -9%
Network Systems 97 97 0%
Services 70 83 20%
Total Revenue 583 599 3%
EBIT 91 75 -17%
Net Income 75 61 -18%
EPS 0.76 0.63 -18%

Specifically, we assume continued strong growth in voice communications revenue of 20%, as VOIP continues to make inroads. This is down from 30% growth in the last 9 months, as we expect LifeSize to generate some. We assume that the total video end point market grows 6% next year but that LifeSize takes 6% of the market share or $43 million in sales from Polycom. We assume that services revenue continues to grow at its current pace, 20%, next year, and that the management is able to stem sales declines from network systems, currently declining -11% y/y for the last 9 months.

The street expects Polycom to improve its EBIT margins in 2006 to 16.8% from an expected 15.2% in 2005. However, we expect margins to decline in 2006 due to new competition from Lifesize in both video and audio, including its first viable competition in audio in many years. For context, since 2001, Polycom’s EBIT margin has averaged around 12%. In this scenario, Polycom will miss its topline expectations by -6%. Assuming a 27% effective tax rate, we predict that Polycom’s EPS will be $0.63, a -28% difference from the street expectations. This is a largely fixed-cost, software business and operating leverage cuts both ways.

Long Term
Beyond the near term threats from Lifesize, longer term, we believe that Polycom faces significant threats from two of the gorillas in the technology marketplace: Microsoft and Cisco. Starting with Microsoft, the video conferencing industry is essentially a software business. Microsoft is developing its Live Communications Server (LCS) as a solution to communicate voice, data and video across the enterprise. LCS is poised to become the software center for an office that connects various telephony and conferencing hardware components together. If LCS takes off, Polycom would be transformed from software and hardware provider to component manufacturer, thus commanding drastically lower margins.

In addition, Cisco sees video conferencing as a means to drive incremental revenue to its networking products. Video conferencing is bandwidth intensive and requires high quality of service, translating into increased demand for IP infrastructure. In 2004, Cisco acquired Latitude Communications, which produced MeetingPlace, a hardware and software product that runs voice, data and video communications, allowing users to easily automate and record these communications. Cisco’s value proposition is this: buy Cisco and we will give you everything needed to run your business. Cisco is going directly after networking infrastructure, 20% of Polycom’s revenue, in addition to taking the central role in the conferencing value chain, thus leading to lower margins in audio and video end points and threatening Polycom’s services revenue (11% of Polycom’s revenue).

If Microsoft and Cisco take over the value chain, Polycom will be relegated to a small, niche market with lower margins. Both Microsoft and Cisco have a much more extensive channel and much deeper roots in corporate IT departments than Polycom. The transmission and encoding of video signals is based on open standards, so Polycom cannot transform this shift into an IP licensing stream. Remember that conferencing is essentially a software business and enjoys corresponding margins. Microsoft and Cisco moving into enterprise video and audio means that Polycom will command drastically lower margins. While some have speculated that Microsoft and Cisco might want to buy Polycom, we believe that this is unlikely as the video conferencing endpoint market is less than $700 million a year and thus too small to be attractive from a hardware standpoint.

Risks to short thesis
• Continued execution problems at Tandberg could potentially benefit Polycom.
• Despite Malloy’s and Kenoyer’s experience in the industry, it is unclear how much share LifeSize can capture.
• There might be quality issues with LifeSize’s products that are unknown at this moment.
• The growth of IP infrastructure might lead to a sudden boom in audio/video conferencing that would raise all boats.
• Polycom may enter the consumer video capture market à la Logitech. While this is an uncertainty, any success that Polycom can eke out in consumer desktop cameras will boost Polycom’s earnings.

Catalysts
• LifeSize’s continued product introductions begin to significantly take market share.
• A reinvigorated Tandberg could accelerate the pace at which it is taking share from Polycom.
• Polycom’s management continues to oversell the Polycom story.

Catalyst

Catalysts
• LifeSize’s continued product introductions begin to significantly take market share.
• A reinvigorated Tandberg could accelerate the pace at which it is taking share from Polycom.
• Polycom’s management continues to oversell the Polycom story.
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