Extreme Networks: Great Value Or Value Trap?

Aug.16.14 | About: Extreme Networks, (EXTR)

Summary

Extreme Networks is selling at a very attractive P/S of only 1.09. Is this a great value, or a value trap?

George Soros holds a 10% stake in the company. Insiders are holding their shares. Analysts recommend Buy or Hold.

Market share is flat. The company replaced five CEOs in seven years. Workers fared no better with three workforce reductions in four years.

Losses were compounded by a recent acquisition of Enterasys. FYQ4 results are in. Is that all behind them now?

Cloud computing favors larger competitors.

Extreme Networks (NASDAQ:EXTR) provides computer communications networking equipment, a highly competitive field. Historically it has concentrated on being a low-cost vendor of high-speed Ethernet switches. More recently, its is starting to move into the intelligent monitoring and control and automation layers of the network. (It should be noted that switches are the least "smart" of the Ethernet connecting alternatives.)

In the last year, the stock has fallen from grace twice, with no recovery between them. Statistically, companies which disappoint more than once in a short period of time are more likely to do so again. Lately the stock is showing new signs of investor interest. The last three months the price has ramped up quite impressively. An investor might easily conclude that the problems are over and the company is on the mend. Analysts are certainly encouraging this view. They're united that the company is a Buy, or at least a Hold. Investors might take additional encouragement from the 10% stake that George Soros holds in this stock. There also is encouragement to be taken from the fact that insiders are not flooding the market with their shares. Revenue is up impressively compared to last year, and gross margins are holding up pretty well. Is the optimism justified though?

The latest earnings report, released this week, is a considerable improvement over last quarter. However guidance for next quarter can only be termed "disappointing." Revenue, Gross Margin percent, Operating income percent, Net income and non-GAAP EPS are all projected to be down from this quarter, and this quarter was far from stellar.

FQ4'14

FQ1'15 Guidance

Revenue ($M)

$156.9

$150-$155

Gross Margin %

56.9%

55%

Operating Income %

7.2%

5.0%-6.0%

Net Income

$8.4

$6.0-$8.0

EPS: non-GAAP

$0.09

$0.06-$0.08

Click to enlarge

Extreme's problems are more than transitory, it would seem. A recent string of quarterly GAAP losses are only the start. The S&P quality ranking is B-, which is well below average since S&P grades on an 8 step scale ranging from Grade D to Grade A+ with B/B+ at the center. The company seems to go through CEOs like an athlete goes through Gatorade. The following quote is from a NetworkWorld article on the latest round of musical chairs in an article dated April 25, 2013, 6:18 PM:

Extreme's market share in Ethernet switching has languished below 1.5% for the past several years. The company has undergone at least three double-digit percentage workforce reductions in less than four years, and its market cap, at $289 million, is less than its annual revenue of $301 million.

The same article in a sub-headline noted "Rodriguez out, Berger in as beleaguered company sees fifth leader in 7 years."

The company also reports in its 10Q that the company has difficulty retaining key personnel and it "experienced high levels of attrition" and also "we have had difficulty in hiring employees, particularly engineers, in the time-frame we desire." One can reasonably also infer that the remaining employees have low morale at this point and may be overburdened. Quality of work may suffer.

The 10Q also has a section entitled "Provisions in our charter documents and Delaware law and our adoption of a stockholder rights plan may delay or prevent an acquisition of Extreme, which could decrease the value of our Common Stock." Such provisions are not at all unusual, but could present roadblocks to any potential suitor. I was unable to find any speculation pertaining to a takeover of Extreme.

The company authorized in October 2012 a three-year share repurchase program. Of the $75 million that was authorized, only $14.5 million was spent. This failure to follow through with the program was not due to an excessive share price during this period. Until September 2013, the price remained below $4.35 at all times. Currently, the market cap is barely larger than a single year's sales. Despite the current low price of the shares, there does not appear to be any intention of completing the buyback before next year's deadline.

Earlier this year, the company completed its acquisition of Enterasys. With the Enterasys acquisition, Extreme no longer needs to rely on Motorola as its OEM for its wireless products. This may, eventually, improve profitability. With Enterasys also came two lawsuits. Such patent lawsuits are common for high tech companies. Most likely these suits can be settled without materially affecting the bottom line.

More worrisome is that the Enterasys acquisition makes the year-over-year revenue increases an apples-to-oranges comparison. The revenue growth that seems to be so impressive was mostly bought for $180 million. The company does include some "Pro-Forma" charts in the latest earnings report, where we can see that non-Enterasys revenues are flat or down in most regions. Also worrying is that integrating this acquisition into the Extreme organization is likely to be the source of additional one-time charges. Equally, any progress (or lack thereof) in reversing Extreme's operating losses is also obscured, perhaps deliberately so. A favorite ploy of corporate executives faced with ongoing operating losses is to start binging on acquisitions and then reorganizing/restructuring and taking lots of one-time charges. To be fair, one acquisition is not a binge, only the potential start of a binge. But the company does warn in its 10Q that it may binge: "We may engage in future acquisitions that dilute the ownership interests of our stockholders, which may cause us to incur debt or assume contingent liabilities." What can be said for sure is that the Enterasys acquisition has not done anything to improve the bottom line yet.

Extreme Networks is in a very competitive market with products that are not sufficiently differentiated or compelling, as indicated by the lack of significant market share growth. Competitors are generally larger and include Brocade Communications Systems (NASDAQ:BRCD), Cisco Systems (NASDAQ:CSCO), Dell (NASDAQ:DELL), Hewlett-Packard Company (NYSE:HPQ), Huawei, and Juniper Networks (NYSE:JNPR). Some of these companies are much less dependent on networking products because of their greater diversification. Furthermore they may be able to make more attractive and compelling deals because they have a larger catalog of products from which to construct a bundled package deal. Extreme can counter this tactic to some extent by partnering with other companies, and they do use marketing partners. The move to cloud computing implies fewer but larger datacenters, and this would tend to favor Extreme's large competitors and make Extreme less competitive.

Losses continue in 2014Q4 despite several changes of leadership in the last 7 years and now a major acquisition. Free cash flow has improved from last quarter's $-30.569M to $-1.214M, but it is still negative. So is GAAP EPS, now $-.17 versus $-.26 in 2014Q3. On a non-GAAP basis, of course, they've been able to ignore the EPS losses all along. Year-over-year operating margin (non-GAAP) is still down 1%.

It may well be that the Enterasys acquisition will eventually provide the compelling products that will save the company, but right now it only serves to give the appearance of revenue growth while the core business remains flat and GAAP losses continue. Of course, it also provides badly-needed cover for management. Maybe with this cover in place, a CEO can stay in office long enough to implement some changes. The company will almost certainly disappoint again in the future, if only with one-time charges, before it finds the road to sustainable profitability. Cloud computing does not favor networking companies with only 1.5% market share. Bargain hunters are advised to stay away from this value trap, at least for now.

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