November 19, 2011 - 11:49pm EST by
2011 2012
Price: 26.07 EPS $0.90 $1.25
Shares Out. (in M): 155 P/E 29.0x 21.0x
Market Cap (in $M): 4,041 P/FCF 22.0x 16.0x
Net Debt (in $M): -475 EBIT 240 337
TEV ($): 3,565 TEV/EBIT 15.0x 10.0x

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RVBD is the clear market leader in a rapidly growing industry and the company’s symmetric product offering, growing services revenue, and defensible business model will continue to support earnings growth in the near-term despite IT spending headwinds. However, investor concerns of a weaker IT spending environment has sent Riverbed shares down ~40% in the past several months.  As a result, RVBD is now trading at 21X forward earnings.   Granted, this valuation of earnings by no means appears "cheap" on a relative basis, however, in light of a business that has grown LTM revenue ~38% in the past year and nearly tripled EBITDA, the current valuation is attractive for investors seeking expsore to a market leader that should benefit from exposure to the long-term secular trend of virtualtization/growing IP network traffic.    


Riverbed has been presented on VIC previously (http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/17956), which details introductory information on the company’s products, business model, and the market in which it competes.  Hence I will not provide a detailed business description in this posting. 


As quick background on the company/industry’s value proposition its important to remember why internet traffic growth is driving the need for WAN accelerators, which increase the speed of WAN communications and facilitate centralization of IT resources.  WAN communications are substantially slower than LAN communication (LAN communication ~100MBPS vs. WAN communication ~2MBPS).  Riverbed (and the other competitors in the WAN Optimization industry) basically offers a cost-effective solution for enterprises to increase WAN communications (e.g. it’s a limited capital spend for many companies vs. increasing bandwidth capacity.)  Riverbed’s product is essentially box that accelerates communication speeds between branch offices, mobile laptops, and data centers by ~5X-50X and has a high ROI (estimated at 6-9 months) for large enterprises. 


As a result, since 2005, this industry segment has grown at a ~30% CAGR.   Though there may be macro weakness in the next few quarters (which many networking equipment investors are concerned about), the fundamental secular drivers for this industry are not likely to mitigate soon (i.e. growing internet usage, data centers consolidation, virtualization/cloud computing, etc.) and increased demand for efficient WAN communication will continue to stimulate the industry (and RVBD revenues) for many years. 


However, this is a relatively nascent industry that is not well understood by the street.  At the current valuation, it appears that what is currently priced into RVBD shares (at a 21X forward PE) underestimates the upside earnings profile the market leader in an industry that could easily double or quadruple in size in the next 3-5 years.  An analysis comparing the number of enterprise branch office locations in the U.S. vs. installed WAN optimization equipment in the industry implies this market is still highly underpenetrated (<10%).  More detailed industry diligence implies that the total addressable market for these products could be ~$10-$20BN of aggregate equipment spend, implying an annual market size of $2-$4BN (assuming an average replacement life of 5 years).  As a basis of comparison, in the past year the total industry revenues were only ~$1BN.  Various data points can be evaluated multiple ways, but its easy to see there is ample runway left in this industry.    


Riverbed is the current industry leader, offering the best product and as a result the highest market share.  Riverbed has the highest market share (and growing) simply because its sells a better product.  Based on numerous industry checks, RVBD is fairly widely regarded as offering the best product in the market.  (Riverbed’s products are more comprehensive, effective and scalable than competitive products in a segment where product performance, and not price, drives purchase decisions for network administrators/CIOs.  For example, the company’s Steelhead product line is estimated to be ~20-30% faster than Blue Coat.)


As the industry developed, Riverbed expanded its market share from <10% in 2005 to almost ~35-40% market share today.  Riverbed had previously taken share from smaller competitors, however, in the past 18 months increasingly the company has taken share from larger competitors.  In the past year, Riverbed became the clear market leader (principally at the expense of Blue Coat.  Blue Coat had numerous execution challenges as the company underwent a re-organization.  CSCO’s management has simply not focused on WAN optimization (given the challenges CSCO is facing in its core business).  


An important attribute of Riverbed (in light of any near-term weakness in IT spending) is that the symmetry of Riverbed's product, service contracts, and a short replacement cycle provide predictable revenue for Riverbed.  Riverbed offers a symmetric product which enhances repeat sales and has a classic network "externality" (all branches on a client's network would require a RVBD box to benefit from a RVBD product at the client's data center).  Its for this reason that despite a weak IT spending environment in 2009, Riverbed continued to grow revenues from existing customers by +25%. In addition, virtually all of Riverbed’s existing customers sign up for recurring service contracts, which provides a predictable revenue stream.  (In the past year ~1/3rd of revenue was from service contracts and ~70% of new equipment sales were from existing customers).  Importantly, as the existing base of Riverbed customers expands, service and maintenance revenue will continue to grow and increase the recurring revenue in the business.  Finally, though Riverbed's products are capital equipment, and hence inherently cyclical, these products generally only have a short useful life, so there is only a 4-5 year replacement cycle. 



A long position in RVBD would be challenging for short term investors or those concerned about temporary volatility in the share price (Riverbed is unquestionably a volatile stock).  In addition, at 21X forward PE, its hard to get excited about the valuation.  However, for those investors willing to hold a position through this current cycle and invest in a company with clear long-term growth potential, Riverbed is a compelling investment.   (i.e. there are a number of scenarios where you can see 2013E PE of <15X, at the current valuation).  Longer-term, RVBD’s revenue growth could provide substantial upside and current earnings (the company is FCF positive) and the symmetry of the product offering provides consistent cash flows while IT spending remains weak. 



Contraction in IT spending


Though competition is currently weak, the obvious threat is from Cisco, which historically has not focused on this sector




Recovery in IT spending
Continued internet traffic growth
Expansion of market share
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