By Alex Salkever Robert Thomas wants to sell you an appliance. A firewall appliance, that is. The CEO of red-hot network-security contender NetScreen Technologies (NSCN), Thomas is on the forefront of a rapid transition in the industry from software-based products to appliances designed and built for specific tasks.
NetScreen is leading that move by designing circuit boards and hardware components specifically for its firewalls and virtual private network (VPN) systems, which protect company networks from intruders and enable secure, encrypted communications. NetScreen even built a proprietary operating system to run the appliances.
A CUSTOM JOB. That's a key difference between this company and its chief appliance competitors, Check Point Software Systems (CHKP) and Cisco Systems (CSCO). Check Point is a software-based outfit. And although Cisco makes firewall/VPN appliances, they don't contain custom-designed circuits and represent more a specialized piece of software running on Intel chips. NetScreen, however, designs security appliances from chips and circuit boards up.
Its firewall- and VPN-on-a-chip tactic should theoretically boost the scanning speeds of security systems. It helps, too, that NetScreen has won a reputation for easy installation of its products, something that's often a complex and time-consuming process.
Customers seem to like what they see. While sales languished for other Net-security rivals, NetScreen managed to increase its revenues 10% in the fiscal first quarter of 2002, ending Dec. 31, 2001 -- a very tough period. During that time, sales rose from $26.3 million to $29 million.
BUYER BEWARE. However, investors might want to exercise caution before buying the stock. While no one doubts the quality of NetScreen products, many analysts are concerned that the company's growth prospects are already priced into the stock.
After a stellar initial public offering on Dec. 12, 2001, that pushed the stock up over 40% on the first day of trading, NetScreen shares have since retreated to the $16 IPO range -- and even dipped into $12 territory in early March. Plus, a huge chunk of company shares could come on the market in June, 2002, when the six-month post-IPO lockup on insider shares ends.
Founded in October, 1997, by three graduates of Beijing's Tsinghua University, NetScreen remained a low-profile player until 2000. That's when the security shift from software to appliances started to pick up steam among chief technology officers, putting NetScreen in the sweet spot. Even sweeter, tech managers started taking a cotton to NetScreen's strategy of integrating the firewall and VPN system into a single device to reduce overhead.
HOT NICHES. NetScreen's growth compares favorably to the flat fourth-quarter 2001 revenues for rivals Cisco and Check Point, implying that it's grabbing market share. Annualized, NetScreen could pull in a quarter of the revenues this year that are racked up by Check Point, which grossed $528 million in 2001.
Savvy positioning is the reason for NetScreen's growth. According to Walter Pritchard, an associate at Soundview, a tech-focused investment bank, the software-firewall market that's Check Point's primary lair is now expanding by 15% to 20%. In the firewall-appliance market, where NetScreen is strong, sales are rising by 20% to 25%. And the VPN appliance market, where NetScreen is either No. 1 or 2, is swelling at a brisk 25% to 35% annually. The combined VPN/firewall market should see compound annual growth rates of 46% going forward, according to tech research firm Infonetics. "The markets NetScreen are doing well in are the ones that are growing faster," says Pritchard.
NetScreen has also managed to be among the top three players in all segments of the security-appliance market. Among high-end firewall users, defined as those who plunk down $50,000 or more for massive coverage, NetScreen has a 57% market share, according to tech consultancy IDC. This segment should hit $250 million in sales by 2005.
ALL IMPRESSED. The company also ranks in the top three in terms of market share in the small and midsize firewall-appliance market. "I have yet to talk to a technology guy who knows security and who's familiar with their product but isn't very impressed with it," says Garrett Bekker, an analyst with Kaufman Bros.
What's more, NetScreen has come on strong with product improvements. CEO Thomas crows: "Six months months ago, [Check Point was] better than us. With the latest product, we're as good as Check Point. And we have some pretty impressive feedback where the majority of them say we have a better product."
But NetScreen's enthusiasts have received a sober reminder from its first earnings report on Jan. 23. It revealed that net losses for the first fiscal quarter of 2002 had skyrocketed to $34.5 million, from less than half that amount for the same period in 2000. Sure, the company was barely profitable on a pro forma basis, bagging $225,000. But the lack of a profitable track record has likely hurt NetScreen's valuation as more and more investors have become wary of story stocks.
FLOOD WARNING. So what looms over this stock? June 10, to be exact. That's the day the Securities & Exchange Commission will let insiders unlock their shares of NetScreen and sell them on the open market. According to Kaufman Bros.' Bekker, executives and investors could flood the market with up to 56 million shares. That represents nearly two-thirds of the total, enough to seriously depress the stock's value.
For now, Bekker has a hold on the company. According to FirstCall, analysts are mildly bullish on the stock. But smart investors might want to wait and watch. While NetScreen could blast through the next quarter and wow everyone, the true price of its shares probably won't emerge until after the lockup period expires. Salkever is BusinessWeek Online's Technology editor