Networking Industry A New Way to Listen to the Music: ROIC by Paul Silverstein, Paul Johnson, CFA & Ara Mizrakjian – Robertson, Stephens & Company

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  • Over an intermediate to long-term investment horizon, an investor’s primary focus should be value creation—how much economic value has been and will be created from the funds invested in and deployed by a company.
  • Return On Invested Capital (ROIC) is a superior quantitative touchstone with which to assess value creation. We believe ROIC to be an important guide to a company’s future prospects for value creation and to be significantly more informative than traditional investment heuristics—EPS, EBITDA and ROE—which can be misleading indicators of value-creating industries and companies, in our opinion.
  • Confirming our belief that the networking industry is in the early stages of what we believe to be a relatively long investment cycle, the industry continued to generate an exceptional ROIC throughout the past 11 calendar quarters.
  • 3 of the 12 companies we follow in the networking industry achieved an ROIC in excess of 100% over the four-quarter period ending in the third quarter of calendar 1996; 5 of the 12 companies exceeded 60%; 9 exceeded 35%; and 10 exceeded 25%. These 12 companies collectively achieved an aggregate ROIC of 62% during this same period.
  • Benefiting from both industry consolidation and high barriers to entry, the industry’s leading vendors are well positioned to reap the lion’s share of the billions of dollars to be invested in building advanced networks, and should be able to maintain their extraordinary levels of profitability, over the next decade, in our opinion.
  • Largely by avoiding competition with Cisco and the other leading networking vendors, a number of smaller, younger networking companies—Ascend, PairGain and VideoServer in particular-have achieved impressive levels of ROIC by successfully gaining “first mover advantage” in their specific market segments of the networking industry.

Value Creation Is King

Traditionally, guided by security analysts and the financial press, investors have focused on reported earnings as the single most important investment criteria in evaluating a corporation’s operating performance and investment merit. In recent years, an increasing number of academic scholars, analysts and investment managers have turned to free cash flow as a more accurate analytical tool to assess operating performance and to project future stock prices. We believe, however, that both of these measures have serious shortcomings as effective investment guides.

We instead propose that over an intermediate to long-term horizon an investor’s principal investment criteria should be value creation—more specifically, how much economic value is being and will be created from the funds currently and prospectively invested in and deployed by a company. We believe that the key driver of intermediate to long-term value creation is Return On Invested Capital (ROIC).

ROIC measures the amount of cash generated by each dollar of capital invested in a company’s operations. Alternatively stated, ROIC measures how effectively a company has deployed the capital invested in its business in generating cash flow. A company whose ROIC exceeds its cost of capital generates positive net cash flow, thereby creating value; a company whose ROIC is less than its cost of capital generates negative net cash flow from an economic perspective, thereby destroying value; and a company whose ROIC equals its cost of capital neither creates nor destroys value.

A company can create value by any one of the following four means:

  • Reallocating or otherwise improving the use of its existing capital to increase the spread between its ROIC and its cost of capital.
  • Deploying more invested capital in its current business, provided the returns generated by such capital exceed its cost.
  • Investing additional capital in new projects (lying outside of the traditional scope of its business) yielding a marginal ROIC in excess of the cost of such additional capital.
  • Lowering its cost of capital.

One common theme runs through each of the above value-creating strategies: in order to generate more cash flow than is consumed by its business, a company must earn a higher ROIC than its cost of capital. The ultimate size of this net cash flow to investors is driven by the following three factors:

  • The size of the spread between a company’s ROIC and its cost of capital.
  • The length of time such spread persists.
  • The amount of capital that can be invested at such spread.

The ideal value-creating company is one that has an ROIC that far exceeds its cost of capital and that has an unlimited number of investment opportunities each of which will yield an ROIC greater than the cost of the capital required for such investment. The larger the positive spread, the longer it can be sustained by the company, and the more capital that can be invested in the company’s business, the greater will be the net positive cash flow generated by the company.

While the positive spread between each investment’s ROIC and corresponding cost of capital ideally should be equal to or greater than the spread between the company’s current ROIC and cost of capital, each investment will create value as long as its spread is positive, regardless of the size of the spread. If a company’s cost of capital exceeds its ROIC from current and prospective investment projects, however, any growth will transfer value from the company’s investors to its customers, suppliers, management and/or employees.

Early Warning System: Identifying Changes on the Margin

By analyzing ROIC and its constituent components, cash flow and invested capital, we believe that we can more accurately assess how effectively, how much and how long capital can be invested by a company in its business. In short, we believe that ROIC analysis provides us with insight as to the exploitability, size and time span of a competitive advantage.

Of equal importance as a guidepost to investors, ROIC analysis facilitates the early and accurate identification of fundamental changes in operating performance by quantifying the magnitude and direction of change in operating profitability. In contrast, the reported earnings metrics of EPS, EBITDA and ROE often fail, are slow to reflect or, even worse, mask changes on the margin in a company’s business.

More specifically, analysis of the level of marginal or incremental ROIC relative to historical ROIC—and concomitantly the change in the level of sequential ROIC quarter-over-quarter and year-over-year—for both individual companies within an industry and the industry as a whole can provide an early warning system regarding fundamental shifts and emerging trends in their competitive dynamics, profitability and investment attractiveness.

Industrywide marginal ROIC that exceeds historical ROIC (i.e., increasing sequential ROIC) and extraordinary levels of ROIC are the hallmarks of an industry that is young, strong and growing. Companies that compete in such an industry typically foster high investor expectations and are rewarded with high P/E valuations. In contrast, a sequential decline in ROIC or marginal ROIC below historical ROIC (other than due to seasonal factors) may indicate that the long-term investment opportunities in the industry are dissipating, which is a sign of a maturing industry. While this shift may be due to increased competition within the industry, saturation of demand or a number of other factors, the more substantial the decrease and the longer the trend continues, the more likely it is that this change is indicative of a fundamental shift in the economics of the industry.

Within an industry, a company that

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