By Graham Burton
How much does it cost to buy a ‘market leader’ in a hot technology sector, even before that company has actually become a leader? Almost as much as it would cost to buy it afterwards the answer now seems to be. And in really hot sectors, such as internet infrastructure, almost no price is too much to pay. Following a pattern set by America Online Inc, Amazon.com and Yahoo! Inc, the industry’s largest companies, many investors are now betting far earlier and far more aggressively on potential winners, something that may have a major affect on the way technologies emerge.
Juniper Networks Inc, the tiny manufacturer of internet backbone routers which floated on Nasdaq in June, has been widely tipped to become the next big player in the internet infrastructure market. But with projected revenues of just $75m for 1999, and with the mighty Cisco Systems as a direct competitor, Juniper is still a long way from realizing the full promise of its super- fast M40 routers. Investors, however, have already bid Juniper’s market value up to nearly $10bn, an incredible 130 times revenues. To put that in perspective, this is on a par with the value of networking giant 3Com Corp, a company with annual revenues of $5.7bn.
Initially, it looked as though over-enthusiasm for internet stocks had finally spilled into the infrastructure market. Then in August, Cisco spotlighted what was really going on by paying $6.9bn in shares for a loss making start-up in next-generation networking that could only boast cumulative revenues of $10m. The company, Cerent Corp, said John Chambers, Cisco’s CEO, was well worth the price. If he had not paid this much, then one of his competitors would have.
The theory behind these valuations is that both Juniper and Cerent, despite their nascent revenues, are the inevitable future leaders in what will be a multi-billion dollar industry. As such, the slim sales and huge losses are an irrelevance when compared to the value that will flow from being the first mover in that new networking area. It is an argument that was first explored by analysts Geoffrey Moore (of the Chasm Group) and Paul Johnson (a networking analyst with BancBoston Robertson Stephens) in their 1998 book The Gorilla Game, but it is not an argument that everybody in the industry subscribes to.
I think the only justification behind Cisco paying so much for Cerent is that they could afford it, says 3Com CEO Eric Benhamou, highlighting how Cisco’s own stratospheric share price is providing it with an inflated takeover currency. It flies in the face of everything I ever learnt about return on invested capital, says Benhamou. I doubt you could ever build a case that it was a good acquisition. He admits that he is frustrated by how 3Com’s own comparatively poor share price does not afford him the same opportunity, but he still believes that expectations from mere start-ups have become over stretched.
We think that there is very little good value [in terms of companies to buy] these days. Many small companies, while they may have interesting technologies, have built up expectations that are totally out of whack with reality, and we think it would be a very poor use of shareholders’ money to buy them, says Benhamou.
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He is not the only industry veteran uncomfortable with current valuations. Bill Joy, the co-founder and chief scientist at Sun Microsystems Inc looks on in disbelief. I don’t really understand Juniper. It’s quite unbelievable that someone could sell at 200 times forward sales. There is the ‘Gorilla Game’ argument that this is going to be a winner-takes-all market, but even so, a thousand times earnings two years out is a big number. Joy suspects that a kind of Las Vegas casino mentality is more to blame than anything to do with Gorillas.
Paul Johnson, however, is more supportive of the theory than ever. If Cerent is worth $7bn to Cisco, why is Juniper not worth $15bn to Lucent Technologies? And if Lucent wants to go toe-to- toe with Cisco in the [internet] infrastructure market, they have no choice. So at a valuation of $10bn, Juniper is actually a bargain? Sure, says Johnson. And as for Cisco’s Cerent purchase? They underpaid, he adds, they could have easily paid another three to five billion. This is an event that will take some time to prove itself but I’m willing to go on record that we will look back on this event and realize they underpaid by a lot.
There are precedents. Johnson points to Cisco’s 1995 acquisition of Crescendo Communications Inc for $100m. At the time, Crescendo had revenues of $10m, revenues that have since blossomed into an estimated 40% of Cisco’s business, valuing Crescendo at $80bn based on Cisco’s market capitalization. Its about what you buy, not what you pay. First mover advantage, together with reasonable to good execution, wins, says Johnson.
Scott Kriens, CEO of Juniper, says his company operates under that winner-takes-all – or a least most – premise. We’re not much smarter than anyone else, but hopefully we’re not much dumber than anyone else either. What we have is one year’s lead. Companies that get a lead in technology, if they invest aggressively and execute well, will protect that lead.
In Johnson’s and Kriens’ world, that puts Juniper on the fast- track to becoming a Gorilla. And there is only one major risk. My biggest fear is that maybe the Internet isn’t such a big deal after all, says Kriens. The company’s $10bn valuation says few people share that fear.
This article originally appeared in Computer Business Review á
