The Scope Of Aruba Networks' Profitability Before It Reports Earnings: Will It Be A Good Year?

Feb.20.14 | About: Aruba Networks, (ARUN)

As the second largest wireless networking system in the industry, Aruba Networks, Inc. (NASDAQ:ARUN) has been providing large corporations with high security and easy management of mobile devices from a single control point. The company's Mobile Edge Architecture allow corporations to add Wi-Fi networks to the already existing networks and manage these as a single network, facilitating the use of multiple mobile devices in the workspace.

So far, the winning combination of wireless access points, network controllers and the ArubaOS software have established the firm as the popular choice among its 20,000 customers, which include the U.S Air Force, Microsoft Corporation (NASDAQ:MSFT), Google, Inc. (GOOG) and Ohio State University. However, while the firm has been successful at outplaying competitors like Meru Networks, Inc. (NASDAQ:MERU) or Aerohive, Cisco Systems, Inc. (NASDAQ:CSCO) still remains the market leader and Aruba's fiercest industry rival.

In the article below, I will analyze Aruba Networks' past profitability, returns on assets, capital and operating efficiency, in addition to looking at which institutional investors have recently bought the company's shares this last quarter. Based on this information, we will get an understanding of the company's revenues, operating metrics and quality of earnings.

Profitability Analysis

In this section I will study several profitability metrics, such as return on assets, quality of earnings, cash flows and revenues, in addition to comparing the company's revenue growth and operating cash flow growth. Over the past three years, the company's operating cash flow has increased by 1.63%, boosting its $58 million in 2011 to $153 million in 2013.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets, giving us an idea as to how efficient management is at generating earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage.

I do not like the fact that Aruba Networks' ROA decreased from 19.12% in 2010 to a current -4.53%. I am always looking to invest in companies that generate increasing ROAs. However, this company's ratio is evidence of the company generating less from its assets than it did in 2010, therefore making it a less worthwhile investment.

Quality of Earnings

In order to assess the firm's quality of earnings we will compare the level of income with operating cash flows. Aruba generated profits of $71 in both 2010 and 2012, which translates into a growth of -1.55%. This growth surpassed that of the operating cash flow, which implies that earnings could have been created by inventory anomalies.

Working Capital

This ratio indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital), while anything over 2 means that the company is not investing excess assets. The ideal ratio to look for should be somewhere between 1.2 and 2.0.

In order to appreciate a company's working capital structure we need to analyze its current ratio growth. Aruba Networks' current ratio, for example, has decreased from 3.11 in 2010 to 2.60 in 2012, marking a negative trend in the company's balance sheet strength.

Risky Business

Despite Aruba's strong customer base, the firm still faces strong competition from Cisco, which currently holds over 50% of domestic market share. In an industry with low barriers to entry and minimal switching costs, it's extremely difficult to foresee the company's future market gain.

Furthermore, the firm's future expansion into the tough access layer switch market could put a strain on shareholder returns in the long run, which have already been suffering under Cisco's increasing pressure. Also, the company's relatively small size could be a disadvantage if larger vendors like Juniper Networks, Inc. (NYSE:JNPR) or Hewlett-Packard Company (NYSE:HPQ) improve their WLAN offerings.

Gross Margin: Gross Income/Sales

The gross profit tells an investor what percentage of revenue/sales is left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors - and overall industry - is more efficient and investors tend to pay more for businesses that offer higher efficiency ratings than their competitors.

Over the past three years, Aruba's gross margin has increased slightly from 69.1% in 2010 to 70.6% in 2012, which indicates that the company has, in fact, gained efficiency.

Asset Turnover

Asset turnover measures a firm's efficiency in using its assets to generate sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. In this company's case, the fact that revenue growth has outpaced assets growth (24% growth) on a percentage basis indicates that it's making significant money on its assets.

Institutional Sponsorship

I also evaluate recent institutional activity in the stock. In other words, I want to know which hedge funds bought the stock in the past few quarters. The fact that Jim Simons and Steven Cohen bought the stock in the past months at an average price of $17.76 shows that hedge funds have confidence in the stock.

Analyst Outlook

Currently, many analysts have a good outlook for Aruba Networks. Analysts at MSN money are predicting that the tech company will retrieve EPS of $0.95 for FY 2014, while analysts at Bloomberg are estimating that revenue will be at $799.41M for the same year. On 22/11/2013, Needham gave the firm a "Buy" rating with a target price of $20.98, signaling potential growth for the company.

Conclusion

Aruba has done a solid job at expanding its customer base, gaining important corporations as standard clientele, but while revenue growth is up, most of the firm's financial balance sheet is looking rather weak. Growth over the past couple of years has been slow at best, and while efforts are being made to diversify the businesses revenue income stream, I remain worried about the long-term profitability.

Cisco's competition is a particularly strong threat in the wireless networking market as Aruba is still a small scale industry player. And although I do believe the company can expand significantly, I believe it would be wise for investors to wait until the next quarter results before buying large amounts of shares.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.