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Morningstar | Delays in Refresh Cycles and Infrastructure Shifts Continue To Plague Juniper; Maintaining FVE

Juniper delivered solid third-quarter results, with revenue that was within guidance and adjusted earnings that were above our expectations and the consensus. We are maintaining our narrow moat rating, as well as our $26 fair value estimate, and shares continue to look fairly valued. Going forward, management lowered top-line guidance for the fourth quarter, now expecting another year-over-year decline in lieu of the previously anticipated return to growth. The pessimism continues to be driven by MX to PTX routing transition issues within the cloud vertical, as customers are delaying sign-offs on new hardware as they re-evaluate their network topologies. We think the firm’s core routing business will return to growth in the near term as cloud deployments unfold. Ultimately, however, headwinds abound in the form of pricing pressure, both due to hyperscale cloud provider negotiating clout and intense competition, as well as structural disadvantages in the realm of software differentiation. Consequently, we believe our negative moat trend rating remains intact.

Revenue came in at $1.18 billion, representing a 6.2% year-over-year decline. Weakness was most evident within the routing segment and cloud vertical, with sales falling 15% and 28%, respectively. Conversely, the switching and security segments, along with the enterprise vertical, delivered revenue growth of 4%, 8%, and 15%, respectively.

The firm performed well on the margin front, as it benefited from operating leverage due to high-margin software revenue growing to 10% of sales. This is not sustainable for two reasons. First, most of the firm’s software licenses are still sold under the perpetual model, meaning growth and leverage will be lumpier and less predictable than it would under a ratable model. Second, as differentiation among networking providers becomes more predicated on software, we view Juniper’s offerings as inferior from an orchestration and integration perspective.

Given Juniper’s about-face regarding the highly touted return to year-over-year revenue growth, management was inundated with questions surrounding the nature of the weakness within the cloud vertical. From our vantage point, pricing commentary was most notable. It seems like the pricing disparity between MX and PTX routers is not commensurate with their hardware specification differences, as management’s strategy has been to reduce per-port PTX pricing significantly. The rationale behind this strategy has been a maintenance of footprint, as the firm intends to dilute margins and maintain incumbency rather than lose market share within this vertical. We don’t necessarily disagree with this strategy, and believe the firm’s incumbency will benefit them in the short to medium term. However, these dynamics are indicative of several secular headwinds, including intense price competition from players such as Nokia and Cisco, as well as growing negotiating leverage on the part of hyperscale cloud providers like Microsoft and Amazon. We believe these challenges will persist longer term.

Management highlighted tariffs as an additional risk going into the fourth quarter and 2019. The impact on margins is expected to be muted in the fourth quarter, as the firm plans to pass on higher input costs to customers through an import tax charge for all impacted SKUs. Going into 2019, however, we think it stretches credulity to suggest that margins will not be impacted. Given the increasing hardware commoditization and concomitant price competition that we see amongst network equipment providers, we do not believe Juniper will be able to consistently pass along price increases to their customers. To the extent that tariffs persist and escalate, we see this as an additional headwind for Juniper over the medium-term.

Finally, we found interesting management commentary surrounding MX to PTX transitions in the cloud and telco verticals. While there has been a rapid shift toward PTX within the cloud vertical, the mix between high-margin MX and low-margin PTX products has remained relatively stable within the telco vertical. This is because cloud networks rely more on software intelligence within the data center, while telco networks rely much more on the speed and capacity of purpose-built, high-performance hardware. In our view, however, disaggregation of software and hardware will continue to be a secular trend, and eventually all networks will rely on the intelligence and integration capability of network software. We think Juniper will struggle to differentiate itself competitively on this front, and this reality underpins our negative moat trend rating for the firm.