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On March 20, Bill Simpson wrote an analysis of Aruba Networks (NASDAQ:ARUN). On March 26, the company raised $88 million with an offering of 8 million shares at $11, above the forecasted range of $8 to $10. On Tuesday April 3, ARUN closed at $14.10.

The text of Mr. Simpson's original writeup follows:

• • •

Aruba Networks plans on offering 9.2 million shares (assuming over-allotments) at a range of $8-$10. Goldman Sachs and Lehman are lead managing, JP Morgan and RBC Capital co-managing. Post-offering ARUN will have 76.4 million shares outstanding for a market cap of $688 million on a $9 pricing.

Note - In a trend we've seen with a few ipos lately, ARUN has excessive option/warrant/employee incentive shares already outstanding and ready to be converted to shares. ARUN has 19.9 million options outstanding with an average exercise price of $2.71 per share. In addition, ARUN has approximately 1.6 million warrants and employee incentive shares already awarded. These 21.5 million options/warrants/employee incentive awards will be converted into shares sooner than later and must be added into the initial market cap. Factoring in this upcoming dilution, ARUN will have 97.9 million shares for a market cap of $881 million on a pricing of $9.

IPO proceeds will be used for working capital and general corporate purposes.

4 venture capital firms will own between 55%-60% of ARUN post-ipo. Fully expect these firms to divest a portion of their holdings at the 180 day lock-up expiry.

From the prospectus:

We provide an enterprise mobility solution that enables secure access to data, voice and video applications across wireless and wireline enterprise networks. Our Aruba Mobile Edge Architecture allows end-users to roam to different locations within an enterprise campus or office building while maintaining secure and consistent access to all of their network resources.

Yet another networking ipo whose primary competition is Cisco (NASDAQ:CSCO) and Motorola (MOT). As we'll see in the financials, Cisco's size and ability to compete on price are greatly effecting ARUN's ability to book a net profit even while growing revenues.

ARUN's focus is enterprise WLAN or 'wireless local networks.' ARUN, which began shipping product in 2003, calls its product Aruba Mobile Edge Architecture [AMEA].

Industry - Enterprise wireless networking has grown appreciably due to the desire for mobile computing. WLAN or VPN (Virtual Private Networks) have been the solution enabling open access on wired network ports. These type networks extend the fixed network over the air. ARUN believes its AMEA product takes WLANs to another level by providing additional security features, allowing secure roaming over the entire network, increased performance, easy scalability and integration etc. Essentially ARUN believes it's built a better enterprise WLAN product.

According to ARUN:

Our architecture allows end-users to roam to different locations within an enterprise campus or office building while maintaining secure and consistent access to all of their network resources. Our architecture also enables IT managers to establish and enforce policies that control network access and prioritize application delivery based on an end-user’s organizational role and authorization level.

ARUN's differentiators from traditional WLANs:

1 - Secure mobility - Enables secure roaming over the network in various remote locations.

2 - Improved application performance - non-fixed port user centric and application aware allowing prioritization and optimization of data, voice and video services based on the specific user and/or the application being delivered.

3 - Ease of deployment and integration - Designed as an overlay to existing enterprise networks, allowing customers to deploy ARUN's products without causing any disruption to existing network operations.

4 - Scalability - Can be scaled to support up to 100,000 concurrent users from a centralized point-of-control.

5 - Flexibility - Designed for ease in introducing new applications.

The majority of ARUN's revenues are derived through resellers, distributors and OEMs, not ARUN's direct sales force. Third parties accounted for 75% of 2006 revenues. Largest channel partner/re-seller of ARUN's products is Alcatel-Lucent (NYSE:ALU) which accounted for 18% of revenues the past 18 months. ARUN has two interesting agreements with Alcatel-Lucent:

1) ARUN is restricted from selling products to other 3rd party sellers without consent of Alcatel-Lucent. Lot of power for a company that was responsible for just 18% of revenues in the past 18 months.

2) A 'most-favored nations' clause in which Alcatel-Lucent is guaranteed a match of the lowest price-point ARUN is selling its product to another channel partner/re-seller.

ARUN also has a strategic relationship with Microsoft, which began in June 2005. Microsoft chose ARUN's products for a worldwide company deployment in Asia, North America and Europe. Sales to Microsoft have totaled $3.5 million. In addition ARUN will essentially 'gift' MSFT approximately 400,000 shares of ARUN stock on ipo. Essentially MSFT is getting either free equipment or free ARUN shares from ARUN for choosing ARUN products.

ARUN's products have been sold to over 200 end customers. Flextronics (NASDAQ:FLEX) handles the majority of ARUN's manufacturing.

Financials

$1 per share in cash post-ipo, no debt.

Revenues have been growing steadily if not rapidly. For the past 5 quarters ending 1/31/07, ARUN's revenues were (in millions): $20.1, $20.1, $24, $24.5, $26.6. Operating expenses have also grown steadily in the past 5 quarters. In fact, ARUN's operating expense growth has kept pace dollar for dollar pretty much with revenue growth.This really isn't what you want to see in a young growing company.

The past 5 quarters of ARUN's operating expenses ending with the 1/31/07 quarter (in million): $12.4, $12.6, $14.7, $14.8, $16.4. the % of operating expenses to revenues the past 5 quarters are 62%, 63%, 61%, 60%, 62%. 5 quarters of solid revenue growth, yet ARUN is no closer to lowering its operating expense ratio.

ARUN's fiscal year ends 7/31 annually. FY '07 then will end 7/31/07. Through the first 6 months, ARUN's revenues are on pace for approximately $105-$110 million. This would represent a 48% increase over FY '06. Keep in mind ARUN was essentially in start-up revenue stage as recently as FY '04. Also at that revenue run rate, ARUN will be selling a hefty 9 X's 2007 estimated revenues.

Gross margins appear on track for the 60% ballpark. As noted above, operating expense levels are where ARUN runs into trouble. By growing its operating expenses in the ballpark of dollar for dollar, ARUN is not shifting close to profitability even with the increased revenue growth. This is a very competitive niche and it appears ARUN is plowing a substantial amount of expense money into sales and markets to compete with Cisco. The result is that ARUN will actually lose more money in FY '07 than in FY '06 even with the 44% revenue growth.

Assuming the fully diluted 98 million shares outstanding, ARUN lost $0.12 in FY '06 (ending 7/31/06) and appear on pace to lose $0.20-$0.25 in FY '07. Until ARUN is able to reduce its operating expense ratio significantly, it will not be able to turn a profit. Thus far ARUN has not been able to lower that ratio much at all.

Conclusion - ARUN appears more than fully valued when all those option/warrant/employee incentive shares are factored in. These are shares that will be exercised over the next 1-2 years, so you've got to include them in the initial market cap. ARUN to me does not look anything like a $1 billion market cap company should look. We've seen a number of good tech ipos the past 6 months, ARUN at this initial market cap is not one of them. There just isn't remotely enough here under the hood to justify a a nearly $1 billion dollar cap on pricing.

Source: IPO Analysis: Aruba Networks Doesn't Have Enough Under The Hood