Pay Me Now or Pay Me Later
Will Belt Tightening at Juniper Networks (JNPR) Cost It Down the Road?
In our inaugural piece, An Introduction to Peek Behind the Numbers, we discuss the difference between the two types of earnings management. The first involves the use of aggressive accounting assumptions or the use of “cookie jar” accounts to store up sources of earnings that can be drawn on later. This is known as “accrual earnings management.” The second type involves companies simply choosing to delay the payment of certain discretionary spending until a later quarter. While this may improve the appearance of the bottom line now, the company will pay in later quarters either in the form of higher-than-usual expenses as it catches up in its spending or worse, in the form of lost sales and future growth.
The current supply chain interruptions have led to many companies postponing the delivery of products. Customers still want this product, but these unfilled orders have piled up driving backlog figures to record levels for many companies. The parts to complete these orders are on the way and when they arrive, products can be completed and delivered. However, until that occurs, the sales cannot be recognized on the income statement which is leading to depressed reported revenues for many manufacturers.
In the meantime, these companies were faced with a decision of how to manage their costs. If parts were not available and there was nothing to assemble, they could save money by scaling back on running the factory. However, what about other discretionary expenses like sales and marketing and research and development? Sure, they can cut those to make net income look a little better. The problem is that those activities are exactly what will keep future orders coming in the door and preserve or grow their share of the market. If they skimp on spending in those areas now, they either must double up spending in future quarters or risk losing orders or market share later.
We have praised National Instruments (NATI) in the past for continuing to spend on R&D and marketing despite its rising backlog hampering sales growth. When the backlog is released into revenue, it will enjoy significant positive margin leverage. However, we have seen exactly the opposite response from Juniper Networks (JNPR) which has chosen to skimp on such expenses for the temporary benefit of the bottom line. We will take a closer look below.
Please note that this is not a sell recommendation on JNPR but rather an educational piece on the impact of cutting discretionary expenses. The company’s spending cuts in key areas have led to unsustainable benefits in recent quarters that will limit its margin leverage in the future when compared to a company like NATI. JNPR has tripped multiple other red flags in our reviews but closer inspection has led us to conclude they are not a problem for now.
Evidence that JNPR Is Skimping on Key Spending
JNPR does not disclose a specific backlog number each quarter, but we were able to piece together the following table from management commentary:
Backlog continues to grow as JNPR is still struggling to get lead times down to normal. The company currently has about 6 months of backlog and it grew by another $250-$300 million in the second quarter. The company also does not expect to be able to work it down meaningfully until later in the year. Consider the following from the 2Q22 press release:
“For the third quarter, we expect to see solid revenue growth driven by the strength of our backlog, strong demand and an improved supply outlook. Our better than expected supply outlook is the result of strategic actions we have taken to improve our access to components. We will continue to prioritize delivering products to our customers as timely as possible.”
Also, from the 2Q22 10-Q:
"Similar to others, we continue to experience increased component costs. This has had a negative impact on our gross margin. During the past year, we experienced strong product orders across all verticals, customer solutions, and geographies. We also anticipate backlog to remain at elevated levels through the course of the year. We believe some of the strength was attributable to industry supply chain challenges that were causing certain customers to place orders early in an effort to secure supply when needed. We continue to work to resolve our supply chain challenges and continue to increase our inventory levels and purchase commitments. We are working closely with our suppliers to further enhance our resiliency and mitigate the effects of recent disruptions. We believe the extended lead times and increased component and logistic costs will likely persist for at least the remainder of the year.
This growing backlog represents sales that have yet to be recognized which has been a headwind to recently-reported revenue growth. The company is recording $1.2-$1.3 billion in sales, but its customers are actually ordering $1.6 billion every quarter. JNPR has to run its sales department, its R&D department, and its overhead as if it was doing $1.6 billion in sales. On top of that, JNPR is noting that employee pay is rising with inflation. This is easy math. If doing $1.6 billion in sales requires $400 million in overhead or 25% of sales, isn’t overhead still $400 million when sales cannot be completely fulfilled, and on $1.2 billion in sales isn’t it closer to 33%?
However, the numbers indicate that JNPR has limited its spending in certain key areas. The following table shows the company’s non-GAAP spending figures for the last eight quarters for research and developments, sales and marketing, and general and administrative:
There is some seasonality to sales with 4Q being the highest and we’d expect some margin leverage from that. But look at some of these costs:
R&D before the supply chain issues was 19%-20% of sales but they just posted a 17.7% figure for 2Q. 100bp is worth about 3 cents in quarterly EPS. This is supposed to be future investment in the business and it’s been flat in dollar terms for three quarters.
Selling and Marketing costs include the amortization of deferred commission costs. Sales just rose sequentially by $100 million. Employees are getting higher pay – yet cash selling costs were basically flat sequentially and the recognition of deferred commissions should tie closely to sales recognition – and it fell last quarter. Just that $5 million drop in recognized commission expense added 1 cent to EPS.
General and Administrative may have benefited from some of the restructuring JNPR has done in the last year and could explain the y/y drops. But, with salary inflation, how long can this cost decline as a percentage of sales?
We fully expect some margin leverage here when the backlog levels off or declines because that should indicate sales are rising faster than costs and some of the costs for those incremental sales could have been incurred in prior quarters. But when we see margin gains in these types of costs when the company is NOT fulfilling 20% of orders received in a quarter, that makes us question if they are investing enough in the business.
Meanwhile, at NATI…
National Instruments (NATI) is seeing similar pressure on its top line from parts shortages leading to delayed orders winding up in its backlog. As we have pointed out in past reviews of the company, it is as if the company is currently reporting only 11 weeks of revenue in a 12-week quarter. However, when it begins to fill the backlog, it will begin reporting 13-14 weeks of revenue in a quarter, leading to increased expense leverage.
In this environment, NATI has taken the opposite approach of JNPR by continuing to invest in key areas of the business. The following table shows NATI’s non-GAAP spending on R&D, sales and marketing, and general and administrative.
We can see that despite limited top-line growth, the company has steadily increased its spending on R&D, sales and marketing, and general and administrative throughout the pandemic and the supply chain interruptions.
The following table highlights the difference in the two companies’ spending patterns by calculating the sequential dollar increase in each expense item as a percentage of the sequential dollar increase in revenues. For example, JNPR’s adjusted R&D fell by $4.8 million from 1Q22 to 2Q22. That -$4.8 million is divided by the change in revenues from 1Q22 to 2Q22 of +$101.4 to produce a -4.7%. During the same period, NATI’s R&D spending increased $3 million with the backlog growth only allowing sales to rise $10.2 million.”
The results for each company are shown below:
This highlights how JNPR’s R&D spend has been particularly weak in the last two quarters while the rate of investment in sales and marketing has lagged that of NATI over the last year.
What Does This Mean for JNPR?
To put this perspective, JNPR missed earnings targets by 3 cps in the second quarter. However, just $10 million in incremental spending on R&D in the latest quarter would have cost it about 2.5 cps in earnings. Without the benefit of delaying these expenses, the miss would have been even worse. While the company’s margins will benefit in future quarters by the operating leverage produced by releasing backlog, its R&D, sales and marketing, and administrative costs will have to rise too which will limit the benefit when compared to a company like NATI which has kept its spending consistent.
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