Key Takeaways From Aruba Networks' Q2 Earnings Call

| About: Aruba Networks, (ARUN)
Aruba Networks (NASDAQ:ARUN) recently released fiscal Q2 earnings (transcript) ending January 31st, 2011. There is a lot to like about this wireless network leader, and its earnings offer insight into its future as well as the future of corporate IT spending, the cloud, and more. Let’s take a look at the ARUN conference call and see what inferences can be made about those topics.
Three Facets of Growth
Dominic Orr, CEO of Aruba Networks, spoke to three things that are contributing to the rapid growth of ARUN. There is an overarching mobility trend that is driving that growth, which he explained in the call:

The proliferation of smart phones and tablets in addition to laptops is radically changing how enterprises and organization approach the network edge.

These changes involve creating networks that can connect to these devices. When was the last time you saw a phone with an Ethernet port? This is the main driver for upgrading from old, wired legacy networks to newer, wireless ones. Despite executive hesitance to adopt a wireless infrastructure, there is no question that the time has come to do so. Secondly:

The sharp increase in demand for multimedia-rich mobility applications, particularly video, has set a new bar for user expectation and a network that must not only connect but deliver the experiences and user demand.

Now this might apply to associates watching YouTube at work, but it also impacts video conferencing, network phone service, Internet speed, remote network access and more. The network must be able to deliver at a high level securely, something that wireless has heretofore seemed to lack. Businesses, slow adopters that they are, seem to finally be realizing that wireless can keep up. Next, he said:

The rise of both server and desktop virtualization has quickly increased the business relevance of the incoming wave of new mobile devices and tablets.

The cloud. Not much needs to be said about this burgeoning phenomenon. Everything will change as applications, storage and data are moved from on-site, temperature-controlled server rooms to the less tangible cloud architecture. In order to have this work seamlessly, the wireless network needs to be top notch. Can Aruba satisfy all of these facets of growth? It certainly seems to think so.
Bring Your Own Device (BYOD): Proliferation of Mobility
As mobile devices become more and more crucial to everyday life from a professional and personal standpoint, the networks under which they operate come under increasing strain. BYOD is the idea that people are now bringing such a variety of mobile devices to work that the network has to mesh with that. Aruba is positioned to capitalize on the move from wires to air, and its CEO believes it has reached that point:

We have reached a tipping point in the market as more and more enterprises grasp that the traditional approach to the network edge is outdated in an increasingly mobile world … Forrester (NASDAQ:FORR) predicts 82 million U.S. consumers will have tablet PCs by the year 2015, with roughly half of them being used at work. Add in over 700 million smart phones as predicted by IDC over the same period.

This is the proliferation of mobility, and it is happening now. Aruba seems best positioned to capitalize on the move to wireless, despite many firms insisting on holistic solutions from companies like Cisco (NASDAQ:CSCO); if Cisco doesn’t get in gear on the cutting edge of wireless, it could lose more market to its agile competitors.
Dominic mentioned that ARUN added the former vice president of Data Center & Virtualization Marketing at Cisco to its team in January, which is just another in a long list of executive experts from networking leaders at Aruba.
The main differentiator between Aruba and other wireless providers is its security. According to its CEO, Aruba is focused on:

Delivering a new network edge that allows our customer to quickly deliver cloud services, reduce cost and mitigate risk for this rapidly changing mobility environment. And most of all, it is about providing a comprehensive security implementation to ensure this accelerated path to mobility is a safe one.

Its ability to provide a simple but holistic security framework through its software gives it access to customers who may not be ready to fully upgrade their legacy systems. Its acquisition of AirWave also positions it well to work with competitors’ systems. More recently, the acquisition of Amigopod gave it a leg up. Orr stated:

Amigopod is a leader in network authentication solutions that allow businesses to provide time- and policy-bound network access to visitors, contractors and employees. We view Amigopod as another opportunity like AirWave to sell an Aruba product both in conjunction with our own technology but also into networks running our competitor's technology.

It looks like these acquisitions are mainly focused on giving Aruba the ability to network with competitors’ solutions and provide the software that gives it the highest margins. So if a company doesn’t want to do a full upgrade, it can still start a relationship with Aruba. I would guess this is one of the reasons it added over 1,000 new customers this past quarter. This ability is a huge advantage, given the state of IT spending in this country, which is recovering but not growing. Dominic said in the call:

I can tell you that despite that the IT spending seems to have recovered, at least in the enterprises that we deal with, nobody is having an increased budget on infrastructure. So given that there is a pressure of spending to support mobility, somewhere has to give. And it has not escaped a lot of people's attention that the wired infrastructure upgrade, maybe they don't need to do a full-blown upgrade, and that's the way that they balance the budget to meet all their pending needs.

The recipe seems to be working. Versus main competitor Cisco’s comparable product growth of 34% year over year, Aruba grew 52%.
The Numbers: Is the Strategy Working?
So the reasoning is sound, but do the results reflect that? It certainly seems like Aruba is growing in the right direction. CFO Steffan Tomlinson (who is leaving in March to pursue a career in VC), said:

In Q2 2011, total revenue of $93.9 million increased 13% sequentially and 50% year-over-year. Product revenue of $79.1 million increased 14% sequentially and 52% year-over-year. Professional services and support revenue of $14.6 million increased 6% sequentially and 41% year-over-year. In Q2, approximately 93% of our revenue came from indirect channels while 7% was direct.

The 50% year over year number is very healthy. Also, increasing 13% in one quarter can’t hurt a company that needs about 25% annual growth to become GAAP-profitable over the next couple years. I would like to see services and support produce more robust growth, but that will follow as the company pursues its new AirWave/Amigopod-driven piggyback strategy. As for international exposure, Aruba is well positioned. Steffan said:

Approximately 67% of our revenues were generated in the U.S. while 33% came from international theaters. [In terms of growth, the] U.S. was … up 14% quarter-on-quarter and international was up 12%.

That is strong international presence, especially when you consider that emerging markets have very little mobile device penetration. As that spreads, so too will the ability of Aruba to penetrate those markets with their solutions.

Short-term margins are very healthy, standing above 70%. Additionally, its research and development expenses are increasing due to its acquisitions of Amigopod and Azalea. The CFO said:

Non-GAAP research and development expense was $15.2 million, up approximately $2.1 million from the prior quarter and up as a percentage of revenue from 15.8% in Q1 to 16.2% in Q2.

Its expenses seem to be progressing nicely, and I believe R&D is in good shape. Additionally, its financial position is very solid. Its history of positive free cash flows continued and it increased cash and equivalents on hand. Steffan said that:

Turning to the balance sheet, we finished January with cash and short-term investments of $187.8 million, an increase of $13.4 million over the prior quarter. Cash flow from operations was $10.7 million. We ended Q2 with $54 million of accounts receivable, up from the Q1 '11 balance of $43 million.

Finally, its days sales outstanding increased to 52 days from 47, which is still in line with its goal of 50-55. It is still something to keep an eye on. Its inventory turns decreased from 5.0 to 4.9. Guidance for Q3 11 was slightly lower than Q2, but still very strong. Steffan disclosed that:

In Q3 '11, we expect Aruba's revenues to increase 38% to 42% year-over-year in the range of $95 million to $98 million.

There's still a long ramp for this wireless network leader.
Aruba delivered again, and seems poised for economic profitability within the next two years. However, given its recent run-up in price, it will be interesting to see if that profitability is worth an investment at this point. In a later article, I’ll analyze Aruba from a cash flow perspective and make a buy or sell recommendation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.