Extreme Networks (EXTR) offers investors tremendous upside potential for two primary reasons: Valuation and takeover potential. First, I will comment on the upcoming expiration of the anti-takeover rights agreement on April 27, 2011 and some of the forces at play. Second, since I rarely make investments based solely on takeover potential, I will highlight some key valuation metrics that make EXTR both an extraordinary value and growth stock, a very rare combination indeed. Beyond these two primary drivers behind my thesis, readers can view a multitude of other compelling factors highlighted in my prior article on the company entitled "Extreme Networks: Extreme Upside Potential" (February 27, 2011).
A significant amount of EXTR shares are closely held by funds that are pushing for the sale of the company, some of the same funds anxiously awaiting April 27, 2011. Those that follow the company closely know that Ramius, an activist hedge fund with substantial holdings in EXTR, sent a letter to the Board stating (see (Ramius Letter to Board, August 4, 2010):
Although the Company has made some progress over the past year, we continue to believe there are substantial opportunities to unlock value at Extreme that have gone unrealized....
The Board Of Directors replied five days later, indicating:
Extreme's ability to use its tax benefits may be substantially limited if there occurs an "ownership change" as defined under Section 382. The Plan will expire on April 27, 2011, and at that time, the Board will review the Plan and determine which aspects, if any, of the Plan, including the Tax Benefit Preservation aspect, should be extended....The Board is currently evaluating requests to grant an exemption to the Plan to increase stock holding to 9.9% from Ramius and from another shareholder...
At that time, Ramius wanted to nearly double ownership stake from 5.3% to 9.9%. And clearly, from the comments, Ramius was not the only institution looking to increase its ownership share. Since that time, we have seen key changes that indicate a takeover is more likely, including changes in the Board structure and in executive management. Most recently, EXTR announced the departure of the former CFO and the VP of Engineering.
Some have attributed the recent selloff to these exits, but I actually see this as increasing evidence that either a turnaround or a takeover bid are imminent. As I mentioned in my prior article, the company has a new CEO, Oscar Rodriguez, who was formerly the Chief Marketing Officer of Alcatel-Lucent (ALU), a key competitor in Extreme Networks' space. He is delivering well on turn around initiatives, and such sweeping changes often prompt executives to leave. Alternatively, the executives may have jumped ship because they expect the company will be on the block after the shareholder rights plan expiration on April 27, 2011.
At a minimum, I expect Ramius and other investors to increase their ownership stake significantly at that time. In fact, the buying by institutions has already trended upward as net institutional shares bought during the current quarter are 1.1 million versus versus 441.4 thousand net shares bought during the previous quarter, an increase of nearly 150%.
First Call's mean estimated earnings growth for 2012 versus 2011 is an impressive 40% ($0.35 EPS versus $0.25, respectively). Furthermore, and most indicative of the market's mis-valuation, EXTR's current quarter consensus estimate has increased 100% (from $0.03 to $0.06) over the past 90 days.
On both forward and trailing P/E bases, EXTR is tremdenously undervalued compared to its peer group. As a note, our fund analysts consider EXTR's primary peer group to be Preformed Line Products (PLPC), Sierra Wireless (SWIR), EMS Technologies (ELMG), and Aviat Networks (AVNW). Even comparing EXTR to the S&P, the trailing and forward P/E discounts to the S&P are 29% and 36%, respectively. The company has been debt free for over 4 years, and had reduced its outstanding shares by 27% down to 91.4M from 123M in 2005.
As I noted in my prior article,
The company's financials are solid with zero debt and nearly half its market cap in cash and investments ($142 million as of end of 2Q2011), which have actually increased over the past four consecutive quarters....the company is about to go through a period of rapid, sustained earnings growth and will form strong barriers to entry.
The last comment was echoed by Zues Kerravala, Senior Vice President and Distinguished Research Fellow at the Yankee Group, who said (Extreme Networks Roadmap has Greater View of Mobility, March 3, 2011):
I don't know of any other switch vendor marketing around mobility...It's the best positioning they've had in a long time.
Since my prior article, the stock tested $4 a share. But, the stock sold off with the news of executive departures and is now trading at a bargain in the $3.40 range. In fact, my company's analysis yields a 12-month target of $7. While I do not mind holding 12 months for the price of $7 per share, I strongly believe that the company will be acquired well before that time at a price north of $8 per share.
Despite the reduction in the number of shares, the increasing estimates, and the discounts to peers, the market has overlooked this gem. It's this mispricing by the market, coupled with the expiration of the Shareholder Rights Plan, that should lure potential suitors.