Extreme Networks: Finding Treasure in Others' Trash

| About: Extreme Networks, (EXTR)
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Extreme Networks (NASDAQ:EXTR) sells stackable Ethernet switches with connection speeds ranging from 10 Megabit to 10 Gigabit, and is even scoping the new 40 – 100 Gigabit market. Why would a company focus solely on copper when fiber optics and wireless clearly offer more potential speed and flexibility?

Lets first look at why most of the network and communication device companies are dumping Ethernet despite its continued strong demand. These companies have found better margins marketing a higher priced product to the worlds largest networks, and have just about covered everything from server to location. Smaller networks like businesses, hospitals, schools, hotels, smaller telecommunication companies and government agencies have been reluctant to upgrade their internal networking gear because of the higher cost. Instead of competing with Ethernet at this level, why not just eliminate the need for it altogether; after all, storage space is not really the issue here. By handling much of the networking off site, companies like Cisco (NASDAQ:CSCO) can find even higher margins by offering complete networking and server solutions to customers.

There seems to be a disconnect between what these companies are offering and what customers are willing to commit to. According to a report from The Linley Group, which provides independent analysis in the semiconductor space from a technical and financial perspective, the 10 Gigibit Ethernet market is expected to see more than a 40% compound annual growth rate through 2014. The report also notes that the average selling price for these products will decline by such an extent as to allow only a moderate total rise in revenue despite a doubling of shipments.

The problem with the all-fiber or wireless solution right now is clearly cost. Companies would much rather spend a lot less money for very comparable speed and functionality. Cost and speed will likely be the determining factor in fibers eventual win, but how long will it take? Most of the businesses Extreme networks deals with already have huge networks and data centers built on Ethernet, so why would they want to dump all of that just yet?

Going the fiber route may be a better long-term strategy for these larger companies, but Extreme Networks clearly lacks the size and scale to compete. This means that while the company's life cycle may be approaching super nova status, there may be quite a bit of fireworks to come before it burns out completely. The company could even live on if they are able to grow big enough to compete with their larger competitors; keep in mind that they are already involved to some degree in the wireless arena. Perhaps the most realistic scenario involves Extreme Networks eventually being acquired. Either way, the potential for a significant appreciation in the stock price in a relatively short period of time exists.

It's not that companies like Cisco and Juniper Networks (NYSE:JNPR) aren't seeing growth and margin improvement from their Ethernet operations, they are. They just happen to be seeing even better improvements in growth and margins from fiber. Brocade (NASDAQ:BRCD) for example, noted a couple of quarters ago that despite growing customers in the Ethernet division, its percentage of total revenue declined as sales from data storage ramped up even faster. It's not just the Ethernet revenues that are being drowned out, but the word is fading as well. Only a tiny handful of companies still use the word in their company profile. In Alcatel-Lucent's (ALU) most recent earnings call, they mentioned that all segments are growing, but only talked about optical and wireless.

Extreme Networks' contrarian specialization has already started to pay off, and Wall Street is starting to notice the extreme short to mid-term potential. After releasing what some have called just decent quarterly results at the end of January, the stock climbed to its highest levels seen since November of 2007. Revenues have been declining year after year for the last decade from $491 million in fiscal 2001 to $309 for fiscal 2010. Since the company has shifted focus and hired some new managment, however, the last year has seen revenue growth, with sales on track to hit $340 million for 2011, and $360 million for 2012.

While Extreme Networks was losing revenue to Cisco, Juniper, Alcatel-Lucent and others, they were getting leaner, cutting expenses and improving margins. In fact, despite losing revenue, earnings turned positive in 4 out of the last five years, compared to only one out of the previous five years. The company has also been debt free for the last five years, and has decreased the number of shares outstanding from 122 million in 2005 to where they stand now at 91 million. Now, revenues are starting to increase and margins continue to expand. The company is still interested in cutting expenses as well, and announced a 5% staff cut that is reportedly centered around non-essential jobs.

Perhaps Extreme Networks' fiscal second quarter report was only seen as decent because non-GAAP earnings only increased by a penny consecutively and year over year. Looking at GAAP earnings, we may see a slightly more pleasing story. The quarter included a $4.2 million litigation award, offsetting an unusual expense of $4.15 million during the comparable quarter last year. If we remove just those two items and look at net income, we see a much more robust improvement. Q1 net income for 2011 was $2.71 million, Q2 net income was $2.77 million in 2010, and $4.73 million in 2011. This means that after unusual items, net earnings grew 75% from the previous quarter, and 71% from the comparable year ago quarter.

Extreme Networks has said that the 5% head count reduction should equate to $2 million in savings per quarter. This would seem extremely significant for future earnings growth if we look at the numbers above. The company expects to see similar revenues during the current quarter, and similar margins. Despite climbing from close to a dollar back when the market bottomed in March of 2009 to above $4.00 after the last earnings report, the stock still has an unextreme P/E of 18. The forward P/E of 12 may not include the $2 million per quarter cost savings that have recently been announced. This could add 8 cents per share to their 2012 numbers.

Everything looks great for Extreme Networks in the short to mid-term, it's the long term that is in question. The end game may not be all that bad either as shareholders could be rewarded with potential terms of a buyout that are looking more and more favorable as the company continues to expand its market share. So although the ride may be short-lived and volatile, it may be one worth taking.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.