NetScreen's careful path to Wall Street

NetScreen Technologies, a developer of network security systems and appliances, last week said it earned a penny per share in the fiscal first quarter, if charges related to last month's initial public offering are excluded. Profitable tech companies, especially small ones, have been rare enough in the past few quarters given the U.S. recession. And investors in recent years have learned not to expect tech companies to report profits soon after their initial public offerings. NetScreen's decision not to go public until its first profitable quarter shows just how strict Wall Street has become with new tech companies.

The company, which makes firewall devices, went public as interest in security stocks peaked in December; shares of NetScreen's closest pure competitor, Check Point Software Technologies, easily outpaced the Nasdaq by rising more than 40 percent from late September to Dec. 12, when NetScreen debuted on the Nasdaq with a 48 percent gain on the first day. NetScreen ended last week at $20.60, a 30 percent gain from its IPO price of $16.

NetScreen executives say, however, that the smart thing to do is restrain investor expectations.

"It sounds like a kind of naive answer, but I think the way to stop the stock getting ahead of itself and getting overvalued is to continue to be as honest as you possibly can and as you're allowed to be with the people who follow the stock," said Robert Thomas, CEO of NetScreen. "And don't hype it too much, and don't try and live on the edge of topping every quarter just for the sake of that quarter," he said. "Try and take a longer-term view and a more balanced view...I think that's the only way to do it: honesty and conservatism, rather than flamboyant predictions."

To be sure, the practice of "guiding down estimates" has been going on for a long time on Wall Street. And with the tech market's downturn since 2000, even companies traditionally known for brash forecasts, such as Oracle and Sun Microsystems, have gone out of their way to be cautious in recent quarters.

But companies hitting the stock market for the first time usually paint a portrait of strong growth. "Conservatism" hardly fits the standard profile of an IPO candidate.

"In our view, we've always been very conservative in the way we forecasted numbers," Thomas said. "We've been very conservative in the ways we recognize revenue; we try to not be one of those companies that's out there on the bleeding edge of accounting technique."

Even though high-end appliance makers don't expect much growth in the already saturated markets for protecting Web sites and corporate databases from outside the network, many analysts believe there's plenty of room for growth in other areas. Companies like NetScreen argue that corporations need to set up more internal barriers to protect individual departments from unauthorized access within a corporate network and over virtual private networks.

A glance at NetScreen's income statements for the past three years might make a reader wonder if the company isn't far more aggressive than its CEO likes to portray. NetScreen's reported sales have risen astronomically over the past three years, from $5.9 million in 1999 to $26.6 million in 2000, and then to $85.6 million in 2001. Wall Street analysts--not necessarily objective in this case, since several are underwriters for NetScreen--predict revenue of $133.8 million this year.

However, outside experts also believe NetScreen has been doing well. Market research firm IDC estimates that NetScreen sells the most high-end appliances used to erect firewalls for virtual private networks. Cisco Systems is a close second, IDC analyst Jason Smolek said.

And NetScreen's approach to raising money has been relatively restrained, for a tech company. Although the company, begun in 1997, could have gone public in the frothy IPO waters of late 1999 or early 2000, it didn't file for an IPO until October of last year--the start of a two-month surge for security stocks and the Nasdaq in general, but more importantly, also the first time NetScreen could see a profitable quarter ahead.

"Our revenue forecast for the December quarter was basically set in stone in our plan at the beginning of September, and we didn't change it," Thomas said.

Dwarfed by competitors
The company's fiscal restraint might not be enough if the economic downturn lasts longer than expected, IDC's Smolek says.

Until the IPO, NetScreen survived on venture capital and debt; at the end of September, the company had about $8.3 million in working capital, or roughly half a day's worth of expenses for Cisco. With a profitable quarter and an IPO in hand, NetScreen ended December with $220.5 million in cash and short-term investments.

Although the company has established itself as the leader in firewall/VPN devices for large corporations and expects to be profitable from now on, a protracted economic slowdown would hurt NetScreen much more than its larger rivals, Cisco and Check Point (in a partnership with Nokia), Smolek said.

"If one product's not going well, they (Cisco and Nokia) can go other ways to keep revenues up," he said. "NetScreen can't weather a crisis as well as their competitors. They're still a dwarf to the big businesses they compete against."

Cisco was not available for comment Friday.

NetScreen believes it can survive on the strength of its products. The company touts its firewall/VPN devices as cheaper and easier-to-manage than those of competitors, though that doesn't necessarily mean NetScreen's hardware is user-friendly. "Everyone's box is hard to manage," Smolek said.

Wall Street analysts, though, pointed to NetScreen's profit in the December quarter as evidence the company can get by even in a terrible economy. "NetScreen passed its first test as a publicly traded company, posting solid results...in a challenging environment," Kaufman Bros. analyst Garrett A. Bekker III wrote recently.

Some experts tout a 70 percent to 80 percent contract win rate for NetScreen over competitors, but those aren't responsible for the majority of NetScreen's business, Bekker said.

"We believe that most of NetScreen's successes are in new customer deployments and not competitive displacements," he said.

One obstacle that NetScreen faces against competitors is cachet associated with bigger brands such as Cisco or Check Point/Nokia, Smolek said. An enterprise already using Cisco's routers or Check Point's software in other parts of the network has a certain comfort level with those brands, Smolek said.

Companies that make single products will need to expand their offerings at some point or be acquired to be part of a wider suite, Thomas said. Smolek believes the security industry's period of frenzied acquisitions has already passed. And with a market capitalization of more than $1.5 billion, few companies could easily buy NetScreen at this point; the largest potential buyer of all, Cisco, generally doesn't acquire competitors.

Thomas said he isn't worried.

"Security companies are going to have to look at providing broader, more integrated solutions for customers, no doubt about it," he said. "And lots of ways to do that: develop it yourself, acquire somebody, be acquired. And they're all options."