Network Associates Rallies, but Obstacles Remain

The security-software maker says 2005 EPS should exceed estimates.
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Updated from 10:32 a.m. EDT

Shares of

Network Associates

(NET) - Get Report

were climbing Thursday after the security-software maker forecast a larger-than-expected jump in earnings and operating margins in 2005, although revenue guidance fell short of analyst estimates.

The bottom-line number and improving margins won out as the big story as investors pushed the stock as high as $18.11 intraday. Shares were recently up 99 cents, or 5.9%, at $17.74.

Despite the company's bullish tone and surprise earnings outlook, Network Associates is still going to have to overcome some skepticism on Wall Street in the aftermath of a rash of financial restatements dating back to 1998, as well as some disappointments in the past couple of years.

"The biggest challenge facing shares of NET is management's credibility," Piper Jaffray senior analyst Gene Munster wrote in a brief note on the company's analyst day. But Munster, who has a market perform rating on Network Associates, is becoming more positive on the name because its end markets are improving and visibility has increased as a result of its sale of its underperforming Sniffer business.

"Given that the current valuation of NET, excluding cash, is 11 times next year's number, we believe the risk-reward favors giving management another chance at righting the business," Munster added. (His firm hasn't done any banking with Network Associates.)

At its analyst day in New York, Santa Clara, Calif.-based Network Associates said that it expects 2005 earnings of 98 cents a share on revenue ranging from $775 million to $805 million. Network Associates also projected it will achieve 25% operating margins by the second quarter of 2005 and for the full year.

The earnings number represents an approximately twofold increase from the company's 2004 estimate of 47 cents a share. It also shoots far beyond the 83 cents a share forecast by analysts for 2005 and even surpasses the highest analyst estimate of 97 cents a share, as gathered by Thomson First Call.

The company's top-line estimate, however, falls short of analysts' $862.9 million revenue projection for 2005 and represents only about 7% growth from the company's $740 million estimate for 2004, excluding revenue from its Sniffer and Magic businesses. The company sold Magic earlier this year and expects to close on its Sniffer sale on June 30.

When asked about that low revenue growth, Network Associates CEO George Samenuk characterized it as a "baseline conservative view."

"Are we satisfied with 7% revenue growth for 2005? No, we aren't satisfied," he added. But Samenuk called it the "most responsible objective" the company can give in June, six months before 2005. Samenuk also noted that the 2005 estimate comes three months earlier than when the company typically offers guidance for the following year.

Transamerica Investment Management portfolio manager Chris Bonavico, whose firm holds Network Associates shares, believes the company may end up doing better on the top line and described the estimate as conservative.

"I love it. This is the perfect example where Wall Street looks backward and says, 'Hasn't been good, hasn't been good,'" Bonavico said. "The Street was just too negative."

"Now we'll start to see that the business not only has stabilized but will grow in the coming years," added Bonavico, who believes the stock is worth in the low-$20s on a discounted cash flow basis.

The bulk of the earnings improvement projected by Network Associates comes as a result of cost-cutting tied in part to its Magic and Sniffer divestitures. The company expects to reduce pro forma operating expenses by 18% in 2005 and to nearly double its operating margin to 25% in 2005 from 13% in 2004.

Network Associates, which plans to change its name to McAfee, projects its biggest business, enterprise security, will achieve only as much as 5% sales growth in 2005. The company projects consumer security will grow 10% to 15%, small- and medium-sized business sales will grow 5% to 10% and its IntruShield intrusion detection business, the smallest segment, will grow 40%.

In addition to its 2005 outlook, Network Associates said it expects to earn 11 cents a share on $175 million to $185 million in revenue in the third quarter and 21 cents a share on $195 million to $205 million in the fourth quarter. Analyst estimates were calling for third-quarter earnings of 10 cents a share on $193 million in revenue and fourth-quarter earnings of 20 cents a share on $216.4 million in revenue.