Acme Packet and Innovation Leadership

Acme Packet (APKT) reported earnings on 04.26.11.  The stock was off ~600 bps in reaction to the numbers.  By 1800 hours it was only off ~200 bps.  The primary driver of the stock reaction was the high multiple of the stock and the guidance of Y/Y growth of ~35%.  This was raised from 30% when the company reported Q4 FY2010 numbers.  I suspect that this growth rate will be raised two more times in 2011.  We know that CAPEX was off to a slow start in Q1 2011.  For entertainment purposes I put a chart at the bottom that still has the original channel I drew for the stock in early 2010.

The purpose of this blog is not really to talk about CSCO, because I plan to write a deeper analysis of CSCO in the coming days, but rather to talk about innovation.  As a primer, I suggest that you watch this video (part 1 and part 2) from Andy Bechtolsheim on innovation, why it fails and why it works. There are some interesting corollaries to APKT and CSCO.

When I was on the buy side and I started looking at APKT, I understood the concept of a SIP translator built on an appliance for service mediation.  If you have no idea what I just wrote then think: build a language translator that allows people calling from different locations, speaking a different language to communicate.  Next, substitute machines for the people in the visualization.  Now you understand the APKT business plan.  What you do not understand is (1) why they have a ~$5B market cap for a company turning out $70M quarters, (2) how innovation meets luck and (3) the similarities to CSCO.

Let me start with #2.  APKT got lucky.  I define luck as: where planning meets opportunity.  The APKT team made the assumption that the proliferation of billions of IP enabled devices will use thousands of networks to communicate with each other and these networks will need devices on the borders to translate the languages between the networks.  This is called session border control and it is a software function that resides on an appliance.  The technology assumption was correct; all the company needed was an event to make the market.  Luckily for APKT a large number of investment banks (IB) massively over inflated the residential as well as the commercial real estate markets using leverage, derivatives and synthetic financial products.  I am pretty confident that the global financial crisis was not in the APKT business plan in the years leading up to 2009.

When the global credit crisis hit in 2008, it changed the technology buying process.  APKT became a winner and CSCO not so much a winner.  What really happened was the buying decision process and decision makers for technology provided by APKT changed.  CFOs started showing up in the decision making process and they wanted to buy technology that had a longer shelf life.  They wanted to break from the past and acquire technology that had longer deployable life span in the network.  You can see this in the revenue line in mid-2009.  Quarterly revenues start to move significantly higher after ten quarters of a relatively tight range.  This is when the market began to broadly adopt their technology and eight years of work began to pay off.

Turning to #1 the reason APKT has a $5B market cap is the revenue growth, operating metrics of the business model and in large part the potential size of the market.  Investors like growth stories and they like growth stories with an operating margin of 39.7%, but they really like a growth story that says the evolution from old school PSTN networks to IP/packet networks will take years and that APKT will play into this sea change transition for years to come.

Looking at #3 and the primary reason I wrote this post was the similarities I see in APKT with CSCO from the early days (late 1980s and early 1990s).  CSCO was building routers for years before many people had heard of the company and years before their market exploded.  CSCO was able to hone their routing code; test it, try it out, and acquire field experience.  Routing and network control plane code is not optimized in the lab.  It is needs field testing and real world experience.  Things happen in production networks that do not happen in lab networks.  CSCO had a huge developmental lead on competitors and this was a significant advantage when their market exploded.

When I look at APKT I see that same developmental lead in their product set and they have a innovation lead in real production networks.  It will be interesting to see if other companies try to put a competitive solution set into their product lines.  The router vendors tried to do this to compete against RVBD and FFIV and failed.  This is going to be part of a future post, but for now I look at the developmental lead (i.e. years) that APKT has in their market, the potential for that market to grow strongly and I believe that APKT has a high probability to increase in value over the lower probability that the company is done growing, competitors will catch up and the market will reverse or slow adoption rates.

/wrk