Description

Investment Thesis:

Aerohive (HIVE) is a wireless local area network (WLAN) vendor with the education market representing 40% of sales. The stock price has collapsed by over 50% since its March 2014 which provides an opportunity today. Last week Aerohive reported the December 2014 quarter with +31% sales growth year over year, but set a low sales target for the March 2015 quarter as revenue from the K-12 education sector is deferred a few months.

Today valuation is compelling with the company trading at only 2 times cash on the balance sheet, and under 1 times sales if cash is used to reduce the enterprise value.

The $4.26 stock price could rise over 100% in the next year as sales growth strengthens due to the $1.5 Billion government funded K-12 education program to install WiFi in all schools.

WLAN Technology History

Early wireless LANs in 2001 were designed with "centralized controllers" to connect with access points such as a laptop computer. This was not an optimum architecture, but numerous bottlenecks at the time such as network speed, bandwidth and latency issues required such an architecture. Aerohive in 2008 shipped the industries first controller-less WLAN which significantly reduced the networks hardware and maintenance costs. This new controller-less network architecture can save customers 25%-65% annually depending on the networks configuration. Even with these savings market share gains in the WLAN industry can be difficult as it is much easier for a corporate enterprise to install more access points from their original WLAN supplier than to switch vendors. Nevertheless, Aerohive was able to achieve 3% market share by 2013. Exhibit #1 below shows that Cisco dominates the WLAN industry with 51% share, but has been growing at a slower pace and losing market share to other players. Aerohive only offers a controller-less product and you can see in Exhibit #1 that their $149 price point is far below the competition when they offer WLANs with controllers.

Explanation For Why Aerohive Should Be A Good Investment in 2015:

WLAN Is A Growing Market:

Gartner forecasts in Exhibit #2 that the $4.4 Billion WLAN market should grow sales at a 14% compounded rate through 2018.

Controller-less WLAN Equipment Is Growing At A 100% CAGR

Corporations have decided that the new generation of controller-less WLANs are lower cost than the WLAN equipment designed with centralized controllers 10-15 years ago. Gartner recommends to its corporate clients that they all evaluate switching to a controller-less architecture. As a result Gartner forecasts that controller-less WLANs will represent nearly all the growth in the WLAN market in the 2013-2018 time-frame. In fact Exhibit #2 shows that sales of controller-less WLANs are forecast to grow at a 100% annualized rate over this 5 year period. This is good news for Aerohive as they derive all of their sales from controller-less WLAN equipment.

Aerohive Sales Growth Expectations Are Conservative:

Aerohive management believes that they can grow sales at a 24%-30% annual rate, while the Wall Street consensus forecasts +8% sales growth to $149 million in 2015 and +21% in 2016. Clearly Aerohive will grow at a much faster rate if Gartner’s estimates are accurate, and Aerohive does not lose a lot of market share.

WLAN Equipment Sales Will Rise Over 200% In The K-12 Education Market

We assume that students have broadband internet access to do school work, but the reality is that 40 million American children do not have broadband access in their old school buildings. The situation is even worse for students from low income families that cannot go home and get broadband access at home. Thus the US government has decided to modernize our schools and provide broadband internet for all schools by 2019.

On December 11, 2014 the Federal Communications Commission (FCC) passed new regulation called

"E-Rate" that will provide $1.5 Billion per year to American schools (starting on July 1st, 2015 for five consecutive years) to install broadband WiFi infrastructure in their schools. Today the K-12 grade schools in the USA spend $500 million/year on WLAN equipment. It is estimated that 25%-55% of the $1.5 Billion E-Rate Program enhancement, or $375M - $825M will be additive to current education spending on WiFi equipment. Aerohive has a 12% share in the education market, so this E-Rate funding could add $45M - $99M in sales for the company if they maintain their market share. The Wall Street 2015 sales consensus is forecasting nearly zero benefit for Aerohive from the E-Rate program. My assumption is that E-Rate will boost Aerohive sales by 27%-60% above the Wall Street consensus starting in the June 2015 Quarter. Such stellar sales growth would certainly drive the stock price higher.

The E-Rate assumptions and their potential impact on Aerohive are presented below in Exhibit #3.

Gross Margins May Rise:

The latest generation of WiFi WLAN equipment is called 802.11ac. It represents 45% of unit sales at Aerohive and gross margins are 500 basis points higher than the prior WiFi generation called 802.11N. Thus blended gross margins will rise from the increasing mix of higher margin 802.11ac products that ship in the future.

Aerohive Technology Is Highly Rated:

In 2014 Gartner reviewed 14 WLAN equipment vendors. Aerohive was rated #2 behind Aruba. So in addition to lower prices Aerohive also has a technology solution with strong reviews.

RISKS: Sales May Be Weak Till July 2015:

The USA government is going to spend $1.5 Billion more on WLAN equipment at K-12 grade schools starting in July 1, 2015. That provides a real incentive for schools to stop spending money on WLAN right now and wait 5 months till they win the lottery. Thus many investors fear that Aerohive’s K-12 education sales (20% of total rev) will materially slow in the near future. Last week Aerohive reduced their March 2015 sales guidance as expected, but the stock did not fall. This suggests that investors are using a longer time horizon and focusing on the $7.5 Billion over the next 5 years that will be spent by the Federal government to install WiFi in all K-12 schools in the United States.

Bigger Competitors Spend Far More On R&D

Aerohive spends $26 million per year on wireless networking research and development compared to $170 million at Aruba and even more at Cisco. This makes it very difficult for Aerohive to sustain a technology edge versus its peers.

Competitors Are Introducing Controller-less WLAN equipment:

It may have been easier for Aerohive to grow when they were the only WLAN company with a controller-less solution. Now companies with a combined 70% market share do offer a controller-less solution (Cisco, Aruba, Ruckus, Ubiquiti). Their controller-less WLAN products are inferior, but this may change over time.

67% Gross Margins May Decline

Numerous WLAN firms have gross margins around 67% today, but margins for networking hardware have declined from these elevated levels in many other networking categories over time.

Aerohive Is Losing Money:

In an effort to gain market share, sales and marketing expenses at Aerohive are 66% of sales. This aggressive spending is causing Aerohive to lose money. There is no guarantee that this spending will generate sales growth and allow Aerohive to turn a profit in the future. For now the primary valuation tools show that Aerohive trades at 2 times cash on the balance sheet, and under 1x times enterprise value.

Trading Volume Is About $2 million Per Day:

Aerohive was a venture capital backed start-up and the VCs still own over half of the shares outstanding. This does increase the probability that the company will be sold, but it also leads to lower trading volume as well.

Catalyst

Aerohive sales growth will begin to grow 25% faster than Wall Street consensus beginning in the June 2015 quarter.

This more rapid sales growth is a result of the federal government E-Rate program to accelerate the installation of WiFi equipment in K-12 schools,  and bring our educational system into the 21st century. The education vertical represents about 40% of sales at Aerohive.