The Tech Edge Fave, Juniper, Has Some VPN Business Brewing

Issue 5: Tuesday, January 8, 2002

In This Issue

Page 1 Tech Focus: Virtual Networks = Real Opportunity Page 3 Tech Screen: Low-Grade Debt Spells Trouble Page 4 Tech Sector Updates Page 6 George Mannes: Beware the Tech Sirens Page 6 Reader Feedback and Questions for Scott Moritz

Tech Focus: Virtual Networks = Real Opportunity

As phone companies attempt to shift from cash-burning to cash-earning strategies, virtual private networks (VPNs) offer one of the few new offerings that may please the bean counters.

VPNs allow encrypted information to “tunnel” from point to point, through the Internet and the public phone network. As such, VPNs serve as a far cheaper alternative to the conventional method of hauling secure data along specially installed, dedicated lines. CIBC World Markets’ equipment analyst Steve Kamman says these private-line data services, which typically use frame-relay or asynchronous transfer mode (ATM) protocols to ship information, amount to a $26 billion-a-year business for the telcos.

Introduced as cheap, secure computer links between employee homes and office networks, VPNs simultaneously became the telecommuters’ lifeline, and the tech support staffs’ nightmare. Since VPNs use existing networks, revenue-hungry telcos don’t face steep upfront construction costs before they can tap this lucrative market. And with a much lower-cost technology, Kamman says the telcos can offer alternative data services at cheaper prices with higher margins.

Sensing this outsourcing opportunity, telcos increasingly are offering to take the burden off IT teams and manage the whole range of corporate VPN data services, from remote access to corporate private line alternatives.

East Coast phone giant Verizon (VZ:NYSE), for one, is gearing up for the VPN push, and joins AT&T (T:NYSE) and WorldCom (WCOM:Nasdaq) among other telcos shopping for the necessary hardware and software. I know, not exactly the stuff telco empires are made of, but given the stodgy spending environment on hand, a boomlet even in a far corner of the industry merits a closer look.

Currently, about one in four service providers offer managed VPN services, says Jim Slaby, an analyst with Giga Information Group, a Cambridge, Mass., tech research and consulting firm. But Slaby says that number should double in the next three years as more corporate IT departments turn their external networks over to the professionals.

So, Tech Edge readers may be asking, which suppliers are poised to benefit from the growing VPN gear demand?

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Issue 5: Tuesday, January 8, 2002

The telcos will be shopping at a few choice VPN superstores like Cisco (CSCO:Nasdaq), Nortel (NT:NYSE), Alcatel (ALA:NYSE), Lucent (LU:NYSE) and even some smaller shops such as Nokia (NOK:NYSE ADR), which partners with software vendors Check Point Software (CKPT:Nasdaq), Juniper (JNPR:Nasdaq) and NetScreen (NSCN:Nasdaq).

It’s fair to say a boost in VPN gear spending, while incrementally positive, isn’t likely to have a dramatic effect on the big four suppliers. It’s the upstarts that stand to gain the most, and The Tech Edge fave, Juniper, has some VPN business brewing.

Juniper is said to be close to sealing a contract with Verizon for some VPN gear to be installed at data service subsidiary called Verizon Advanced Data. Notably, the deal would be the first between Juniper and Verizon, the nation’s top equipment buyer.

While a Verizon source declined to comment on Juniper, he did say that Verizon was talking with several VPN vendors.

Juniper, as I’ve mentioned before, has a few positive long-term trends going its way, but the short term will be rough as spending continues to dry up. Investors must be cautious and opportunistic. Juniper is expensive at its current $22 level, but as more bad news comes out of the upcoming earning season, keep in mind that $15 is a likely bottom for the stock, since at that level Juniper trades at about five times 2002 sales.

Another challenger sitting in a sweet spot is NetScreen (NSCN:Nasdaq), a Sunnyvale, Calif., network security shop that’s gained fans with its denser, faster, cheaper technology. NetScreen, which came public last month, aims to combine VPN, security and traffic management functions in one box.

However, Wall Street’s post-Sept. 11 security enthusiasm has pumped NetScreen’s market capitalization close to $2 billion, an absurdly rich valuation for an outfit that brought in a mere $34 million in sales in the past year. So it’d probably be wise to watch this outfit from the sidelines and look for some buying opportunities after the IPO hoopla subsides.

SafeNet (SFNT:Nasdaq) is another member of the VPN food chain. But this chip and software maker has suffered from the cuts of the carriers. Third-quarter revenue dropped 46% to $4.1 million from year ago levels. You should steer clear until that trend starts to reverse.

Regardless of which supplier you choose to back, the relatively mundane land of VPN offers hope for the telco community. This hope stems less from the technology angle as from the fact that when bean counters get ready to start loosening the purse strings, they are always likely to pick the cost with the highest potential return.

Issue 5: Tuesday, January 8, 2002

Tech Screen: Low-Grade Debt Spells Trouble

Tech investing is synonymous with speculation and risk, but there’s a place for reason and there's no reason to damage your odds by dabbling in dubious stocks. I pulled out the top 10 tech names for your viewing pleasure from a recent Standard & Poor’s list of sub-investment-grade companies. These stocks have rebounded from September lows, but so has the market. And it’s the debt that is the problem.

For example, Leap Wireless (LEAP:Nasdaq), number one on this chart, offers low-priced cell service to mostly younger folks in about 38 small cities, a debatable business plan to say the least. During the wireless frenzy of 1999 and 2000, its market value soared into the billions, convincing the company and its creditors that it was always going to be worth billions. Today, Leap's market cap is $750 million vs. total debt of $1.5 billion, and that’s after the stock rose 47% in the past three-and-a-half months.

The main thing about credit ratings, beyond flagging potential deadbeats, is that a sub-investment grade ranking makes it difficult and very expensive to raise more money. Typically, if more loans are made, they carry a much higher interest rate, increasing the cost when things get tough. And you can bet things will get tough for these heavily levered companies.

Stock Credit Total Performance Company Rating* Debt Since 9/21 Comment Leap Wireless Stock of this small-city cellphone venture CCC $1.5B 47% (LWIN:Nasdaq) has leapt up despite CCC rating. XM Satellite Radio Outerspace stock and high-orbit credit CCC+ $630M 143% (XMSR:Nasdaq) risk befits this car-radio service. Level 3 Without junk bonds this mega network CCC+ $6.2B 43% (LVLT:Nasdaq) wouldn't get built… hmm. EchoStar Star light, star bright, big wish on dish B $5B 32% (DISH:Nasdaq) tonight. Fairchild Semi Venerable chipmaker really slumming it a B $940M 79% (FCS:NYSE) bit. Nextel Nation's #5 wireless company second B $15.1B 22% (NXTL:Nasdaq) only to Sprint PCS in total debt. Adelphia Debt coming due next year, and B+ $14.8B 30% (ADLAC:Nasdaq) refinancing won’t be easy. Charter What’s worse than a lot of debt? A lot of B+ $15.6B -2% (CHTR:Nasdaq) poorly rated debt. It’s merger repellent. Lucent Lucent and its creditors: What hurts one, BB- $6.2B 30% (LU:NYSE) also hurts the other. Apple Computer New crop of flat-panel I-Macs may draw BB $320M 46% (AAPL:Nasdaq) attention away from S&P's black mark.

Issue 5: Tuesday, January 8, 2002

George Mannes: Beware The Tech Sirens

In ancient mythology, the Sirens were nymphs that lived on a rocky island in the middle of the Mediterranean. Once sailors heard their song, they'd ignore all safety considerations, aim their ships straight toward the Sirens and invariably crash against the lethal coastline.

The modern-day sirens are a certain type of alluring tech stock. Stocks that will kill you, or at least drive you crazy with desire, even though deep down inside you know they're bad news.

And singing lead in the band these days is Apple Computer (AAPL:Nasdaq). Apple’s every twitch, and every pronouncement made by cult -- excuse me, I mean chief -- executive officer Steve Jobs captivate investors and the investing press. Exhibit A: the appearance of the new flat-panel Mac – faintly reminiscent of the desk lamp once animated by the Jobs-led film studio Pixar (PIXR:Nasdaq) – on the cover of Time magazine. As my colleague Peter Eavis points out, how many new electronics products can get on the cover of Time? Not even Dean Kamen's two-wheeled wonder Ginger made the cut.

But really, why should investors care about Apple? I don't care how many cool desk lamps or iMacs or iBooks or iPods or MessagePads or cracking cube computers the company puts out. It’s always had, and always will have, a fraction of the computing market. And its stock, hovering above $22 after a three-month runup, is right where it was, oh, about 14 years ago. I have no particular gripe against the company (full disclosure: I'm a Windows guy). But let's get real here: Apple is a lousy investment.

Want to see something really depressing? Examine a chart comparing Apple's and Microsoft's (MSFT:Nasdaq) stock price over the past 15 years or so. One of the increments on the chart reads 40,000% and it ain’t in Apple's favor.

Past and present backup singers for the Sirens include Iomega (IOM:NYSE), JDS Uniphase (JDSU:Nasdaq), Netscape (back before it got bought by AOL), Lernout & Hauspie and AT&T, the widows and orphans siren.

What all these stocks have in common is that they actually did something. They ruled the world, changed the world or promised to.

But things change. Microsoft added icons to PC screens and got its Internet act together. Voice recognition turned out to be neither as simple or cool as it was on Star Trek. Upon clinical examination, once- appealing stocks become losing propositions. Yet investors won't give up on them.

These sirens are like old college romances. When you meet at a reunion years later, you see that she isn't quite the goddess you remember. But that doesn't matter. She still looks beautiful to you, because you remember what she once was, once did and once stood for.

Be warned: the newest siren is Yahoo! (YHOO:Nasdaq). Who can forget the symbolic value of how two grad students with a PC and an Internet connection changed the world? But we've got to remember that Yahoo! is a different company these days. The ad money that fueled Yahoo!'s wonder years has dried up. The friction-free profits aren't there; Tim Koogle, the Jobsian dressed-in-black mystical guru, has left the building. Yahoo! has grown up. It's sadder and wiser. It wears a tie to the office. It won't change the world. It will simply find a place in it. Feel free to invest, but remember that Yahoo! isn't the kid you remember from college anymore.

Issue 5: Tuesday, January 8, 2002

Tech Sector Updates

Personal Computer Sector: Though digital entertainment products were the top draw at electronics stores this Christmas, signs are emerging that there was also strength in an unexpected category: personal computers.

After several quarters of declining sales, electronics chain and turnaround favorite Circuit City (CC:NYSE) said PC sales growth was slightly positive in December on a same-store sales basis. Circuit City's comments came just as Compaq (CPQ:NYSE) surprised investors by saying it expects to make money in the fourth quarter and some Wall Street analysts upgraded their outlooks for PC makers.

The upturn in the notoriously slow-growth and low-margin product line helped Circuit City report a 10% increase in comparable-store sales in December, compared with a year ago. At the same time, Circuit City said it expects fourth-quarter earnings of 72 cents to 76 cents a share, compared with analyst expectations of 71 cents, according to Thomson Financial/First Call.

Personal Computer Sector: The fourth quarter was a little kinder to Compaq (CPQ:NYSE) than most people had expected. But notwithstanding the stock-trading opportunities that could attend further upside surprises in the sector, it'll take more than a solid Christmas to put the personal computer industry back on track.

Compaq said Monday that it will post a profit for the fourth quarter rather than a loss, and estimated that revenues would exceed $8 billion, up from previous forecasts of $7.6 billion to $7.8 billion. Analysts were expecting the company to lose 3 cents a share for the quarter, according to Thomson Financial.

The news sent Compaq's shares up and contributed to a small gain in Dell (DELL:Nasdaq), in part because of investors' expectations that it, too, might have had a better-than-expected Christmas.

Gateway (GTW:NYSE), which had also gained on the Compaq news, reaffirmed guidance after the bell for a fourth-quarter profit before taxes, but said revenues would be less than expected because of an

15% reduction in unit volume. The company expects revenues of $1.16 billion. Gateway will still hit its profit outlook because of a higher average selling price of about $1,660 per unit.

Networking Sector: Lucent (LU:NYSE) came to the proverbial fork in the road and decided to retrace its steps. In a move some call a lost opportunity, Lucent concluded its nearly year-and-a-half search for a CEO by naming its former head of operations and current Kodak (EK:NYSE) COO Patricia Russo to the top job.

Defying pressures from some investors and industry experts who wanted to see fresh ideas and new blood atop the once-promising New Jersey networking colossus, Lucent's Chairman and Interim CEO Henry Schacht instead handpicked his successor to ensure that his restructuring plans are implemented, say analysts and investors.

Wall Street viewed the news almost as a nonevent. While Russo is widely viewed as a superb manager who inspires loyalty, Lucent, in effect, appears to have turned its back on bold reinvention by choosing to stick with a far humbler plan of coddling a few dozen favored customers, say some dismayed Lucent watchers.

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Issue 5: Tuesday, January 8, 2002

Semiconductor Sector: Altera's (ALTR:Nasdaq) management thinks the worst is finally over. In a call after the bell Monday, CEO John Daane said that a recovery in orders during November and December led the company to believe its business has finally bottomed and the March quarter will herald "modest growth."

The programmable logic chipmaker refined its fourth-quarter guidance, preparing investors for a 7% decline from the third quarter's $174 million in revenue. The Street was expecting a 6% decline, despite Altera's previous range of a 5% to 10% revenue falloff, which it formally re-emphasized as recently as Nov. 28. Analysts expect the chip company to earn 3 cents in the fourth quarter, with an uptick to 4-cents-a- share profit in the first quarter of 2002 and a 3% climb in revenue to $169 million.

Altera reports fourth-quarter earnings on Jan. 22.

Home Satellite Service Sector: "I want my MTV!" had a nice ring to it. But "I want my ABC Family Channel!" might be a tougher sell.

Yet that's the new rallying cry out of Disney (DIS:NYSE) in what promises to be an ugly, ongoing struggle between the media and entertainment giant and EchoStar Communications (DISH:Nasdaq).

Unfettered by context, the dispute between Disney and EchoStar, the home satellite service provider, is simply a contractual dispute: Does EchoStar have the right to drop the ABC Family Channel from its programming lineup? EchoStar, which started carrying the Family Channel back in 1995, says yes. Disney, which acquired the channel in October, says no. And on Dec. 31, a federal judge in Los Angeles said not yet, issuing a temporary restraining order preventing EchoStar from pulling the plug as planned on New Year's Eve. A court hearing on the order is slated for Jan. 10.

Online Retail Sector: What's good for online retail is good for Amazon.com (AMZN:Nasdaq). This simple and seemingly widespread belief helps explain why shares in the Seattle-based bellwether are up over 70% since November.

But Wall Street analysts aren't buying it. None raised earnings or sales estimates for the company in December, according to the ILX database, and at least two brokerages -- McAdams Wright Ragen and Wells Fargo Securities -- have downgraded the stock because of the jump in share price.

After years of giving the money-losing company the benefit of the doubt, some analysts have grown super- skeptical about Amazon. And there's plenty to fuel their doubts.

On the one hand, a slew of data and press reports have suggested online retailers had a bang-up holiday season, and investors have reacted by bidding up Amazon shares. Overall online spending increased 10% in November and an estimated 15% to 25% in December, according to research firm Nielsen/NetRatings.

That doesn't look bad when you consider that sales at bricks-and-mortar retailers are expected to have edged up just 2.2% for the fourth quarter, according to estimates published by the National Retail Federation.

Yet the online growth rate was much lower than Nielsen/NetRatings' projection of a 43% rise in November and December, according to Sean Kaldor, an analyst at the research firm.

Issue 5: Tuesday, January 8, 2002

Reader Feedback and Questions for Scott Moritz

Scott welcomes your questions on The Tech Edge and his investing strategy. Please email Scott with your questions at [email protected]. However, please remember that The Tech Edge is not intended to provide personalized investment advice. DO NOT EMAIL SCOTT SEEKING PERSONALIZED INVESTMENT ADVICE, WHICH HE CANNOT PROVIDE.

Question: I noticed that when you have written about the growing popularity of Wi-Fi you mention Intersil (ISIL:Nasdaq) and Texas Instruments (TXN:NYSE) as the only companies to invest in. But there seem to be other companies that make wireless network equipment like 3Com (COMS:Nasdaq), Linksys, Belkin. What’s your opinion of them? – L.N.

Scott Moritz: Well, 3Com is the only one of the three you mention that's publicly traded. And while 3Com has plenty of gear -- a legacy from its days as the king of local networking -- they compete in a very tough, low-margin consumer product market. I feel Intersil and Texas Instruments as well as Agere (AGRA:Nasdaq) offer what Wall Street calls higher barriers to entry. These outfits control the intellectual property, the patents, the licenses and ultimately some of the key components to go into the networking devices. Think of it as that Intel inside thing.

Question: Could you provide more detail and/or comment on why, given the current outlook for telecom profit, which in turn drives capital spending, some predict a telecom equipment upgrade cycle. Internet traffic is slowing, long distance profitless and, as you mentioned, local phone margins are under pressure, so again why are some predicting an upgrade cycle? – D.R.

Scott Moritz: The answer is in your question, sort of. Internet traffic is actually still growing, but not as fast as earlier predicted. Competition has cut long-distance profitability and margins. Service providers need new faster systems to handle more traffic more efficiently, just like you need a new computer every few years to keep up with fast connections or new photo software. The only thing that's going to make phone companies spend more money are upgrades that help lower operational costs. They'll have to spend on some gear just to keep up. This, of course, assumes the phone companies don't go out of business first.

Question: Scott, question for you concerning comparing 2001 to 2002 capital spending levels. I see the spending levels in the second half of 2001 were much lower than the first half of the year. Could the first half of 2002 actually be flat or up from that level? – M.B.

Scott Moritz: A few analysts had floated that fuzzy-math notion at the end of the third quarter, much to the chuckles of less optimistic industry observers. Put it this way, spending in 2002 will be between 20% -to- 50% lower than last year. Given the magnitude of those year-over-year budget reductions, I'm inclined to think there is going to be no way to avoid a quarter-over-quarter drop down. Convincing yourself otherwise might be foolish.

Issue 5: Tuesday, January 8, 2002

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About Scott Moritz

Scott is a senior reporter at TheStreet.com. Before joining TheStreet.com in July 1999, Moritz was the telecommunications reporter at The Record of Bergen County, N.J., for three years. Prior to that, he worked as a municipal reporter for the same publication.

Moritz received a bachelor's degree in political theory from the University of Massachusetts - Amherst and a master's degree in journalism from New York University.

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