Aruba Networks Still Searching For Margin Leverage

| About: Aruba Networks, (ARUN)
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Aruba beats on revenue, but posts a large miss on gross margin and adds to fears of price competition led by Cisco.

Growth in ClearPass and Instant are encouraging, as is the expectation of market growth in the low teens.

Aruba has to show that it can leverage its sizable investments into sales and marketing; without better operating margins it really isn't possible to argue for a higher share price.

It's always something with Aruba Networks (NASDAQ:ARUN) and its shares. If investors aren't worried about competitive share loss to Cisco (NASDAQ:CSCO), there are worries about smaller rivals like Meru (NASDAQ:MERU) or Aerohive (NYSE:HIVE). If competition isn't a problem, then questions about the company's ability to generate attractive long-term operating leverage come back into play. I don't mean to suggest that these aren't all relevant and important questions. My point is rather to offer some reason as to why these shares are often so volatile around earnings reports.

As it looks today, I continue to believe that Aruba is undervalued, with fair value in the low-to-mid $20s. I really would like to see more evidence of sustained operating leverage before buying in myself, but by the time that's evident the shares are likely to have already had their run.

Good Results, With A "But"

On the face of it, Aruba had a pretty strong fiscal third quarter. Revenue was better than expected and the company lifted guidance for both revenue and earnings in the next quarter. As is so often the case with Aruba, though, there was a notable "but" to the results.

Revenue rose 28%, beating the average sell-side estimate by more than 4%. Product revenue rose 28% yoy and almost 10% sequentially, while service revenue rose more than 29% and fell about 3%, respectively.

The big "but" this time was in gross margin. At 70.5%, Aruba saw almost two points of erosion from the year-ago and quarter-ago levels and likewise came in about two points lower than expected. Aruba management talked about high demand in the "value" segment of its business and a willingness to accept lower price points on AP225 to generate sales. That isn't going to help worries that Cisco's willingness to compete more fiercely on price is pressuring the business.

Aruba is also still in the midst of restructuring its sales effort. Sales and marketing spending rose 25% and 2%, a little more than expected. The net result was that despite the revenue beat, operating margin was a bit lower than expected (by about 30bp) and pro forma earnings were just in line.

The Ongoing Battle For Share And Differentiation

Aruba did report "high double-digit" bookings growth for ClearPass, the company's access and policy management offering. The company also reported 100% yoy bookings growth for Instant, its controller-less access point.

Aruba has long tried to set itself apart on the basis of its strong access policy management and security capabilities. Cisco counters with its Universal Access and Identity Services Engine. Aruba bulls contend that Aruba's offerings are meaningfully better, while the bears argue that Cisco's offerings are good enough and that enterprise customers are not going to switch over to higher-priced Aruba just for the incremental benefits.

Likewise with the issue of controllers. Aruba Instant indicates that management does realize that some customers want a controller-less option (the controller is the most expensive part). As a reminder, Cisco has been integrating WLAN controller functionality into its switches and routers, while Aerohive likewise offers a controller-less WLAN architecture. As throughput of access points has improved (as well as the capabilities of microprocessors), the ability/opportunity to distribute control functions among APs has increased and controllers have looked (at least to some) more and more like expensive bottlenecks in the system (if the controller fails, you have problems...).

The real question seems to be about performance and the price of that performance. Aruba contends that on an apples-to-apples basis its controller-less APs perform better and are more reliable, and therefore a better value. Not surprisingly, Cisco and Aerohive do not share this point of view. More recently, Aruba management has also been talking up its relationship with Microsoft and particularly the Microsoft Lync platform. To me, this is a "doesn't hurt to have," but not really a make or break partnership in the market.

Good Growth, Plenty Of Opportunity… What About Margins?

Aruba still trails well behind Cisco in the WLAN market, with a market share in the neighborhood of 11% to 14% against Cisco's consistent mid-50%'s market share. Aruba is stronger, for now, in 802.11ac, where its share appears to be closer to 20%. There is reason to believe that .11ac adoption still needs a couple of catalysts to really get going - namely multi-user MIMO features and a drop in the price of the silicon inside (the processors).

With the WLAN market growing around 12% to 14% a year, I think Aruba can handily outgrow that over the next five years (growth closer to 17%) and post long-term revenue growth that averages out to around 12%. I'll admit that's a bold prediction, particularly as Cisco has made it clear that they will not surrender WLAN without a fight (unlike what happened in the application delivery controller market, where Cisco was on the losing side of market share). Adding in opportunities from access switching and multiple device management, I believe Aruba can both gain share in WLAN and expand its addressable market over time.

Whether or not Aruba can gain share is controversial enough; whether it can do so profitably is a central argument right now. Management has significantly expanded the sales force and believes it has refined its go-to-market strategy, but ahead of real reported operating leverage those are just buzzwords. I believe that Aruba can generate free cash flow margins in the mid teens over the next three years and then expand those into the mid-to-high teens as the revenue growth better leverages those sales force investments. Interestingly, even the bearish analysts seem to largely agree (at least based upon their FCF estimates). The big downside risk here is that Aruba never sees that leverage and must continue to spend additional sales and marketing dollars to get additional dollars of revenue.

The Bottom Line

Cisco itself looks like something of a bargain today, so it's a little harder to argue that readers should take on the added risk of a smaller stock like Aruba. The compensating factor is the greater potential return, as long-term free cash flow growth of around 10% would support a fair value on Aruba shares close to $24. On the other hand, if you look at the company's near-term margins, it is much harder to argue that the shares are substantially undervalued (tech hardware EV/sales multiples generally correlate pretty well with margins, though sales growth matters too).

With this latest downturn in the shares, I admit that Aruba is more tempting to me but anybody considering the shares needs to appreciate that the company still has a lot to prove despite carving out a solid #2 position in the fast-growing WLAN market.

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.