Description

If you like really beaten up technology companies this might be the idea for you.  Extreme Networks (EXTR) is a situation where you have a solid product line, good customers, some growth in its end markets, but management that has been absolutely horrible in execution.  After several quarters of disappointing results, now may be a safe time to invest in the company as estimates and expecations are VERY low.  The valuation is compelling, trading at a mere 40% of sales for a company with 55% gross margins.  A take out valuation (yes it could happen) could be 3X the current stock price. My target for the stock is $5/share, 100% upside.

Brief Description of Company

EXTR is a leading provider of wired and wireless network infrastructure equipment.  Its end markets include corporate, government, healthcare, education  and hospitality enterprises throughout the world.  Its products include ethernet switches, wireless networking and management software. 

Recent History

To understand how Extreme got into the position where its stock price is so low, it is worth going back in history a little bit.  Prior to 2013, EXTR was muddling along as a network switching company competing against the likes of Cisco, HP and Juniper.  It did about $300mm in sales and was known as a company with good products, a good balance sheet but struggled to grow due to lack of critical mass with an organized sales force.  Its sales execution was poor.  In 2013, EXTR acquired Enterasys for $180mm which is a provider of wireless network equipment and associated software management systems.  By combining with Enteraysis, EXTR doubled the size of revenues and added a significant product line that can be sold in conjunction with its existing network switching products.  In addition, there were estimated to be about $30mm of synergies.  The net cash balance of $200mm went into a net debt position of about $20mm.  EXTR stock ran up to about $8/share based on all the excitement and the prospect of earning nearly 80 cents in EPS in the future.

Over the next several quarters, the company has failed to execute on its strategy to integrate the salesforce.  This was also exacerbated by a rising dollar causing foreign sales to slip, and a government program for technology spending in schools being postponed for calendar 2014.  This has caused the company to miss sales guidance 4 of the past 5 quarters.  In September of this year, EXTR brought in a senior executive from Cisco.  He was charged with organizing a dysfunctional sales force and driving higher sales through existing and new sales channels.  On April 6th, in conjunction with another miss of revenue guidance it was announced that Jeff White is leaving the company after only about 6 months.

Major Products and Markets

Ethernet Switching

EXTR sells into the ethernet switching market which has a total addressable market of about $23 billion.  In particular EXTR addresses a subset of this market which includes data center, large and small enterprises in various vertical industries.  Cisco has the largest market share of over 50% followed by HP, Juniper and Alcatel Lucent.  This market overall is growing at 1% with some subsegments growing fast (Data Centers) while others not growing (large enterprise).  Approximately 80% of EXTR's revenue comes from selling into the ethernet switch market.  Gross Margins are in 50+%.

Wireless Local Area Networks

Approximately 20% of EXTR's sales comes from selling wireless internet infrastructure products.  The wireless local area network industry is made of  large competitors such as Aruba (Now HP), Meru, Ruckus.  This market is about $5 billion but is growing at about 10-15%.  EXTR products include wireless endpoints for Wifi networks and management software called Purview that manages the network.  EXTR often sells switches in conjunction with a wireless deal.  EXTR has been very successful in setting up wireless internet in large dense environments such as at sporting events (NFL) and college campus' and hospitals. 

Financials/Estimates

With their fiscal year ended in June, an investor should really be looking at 2016.  I have estimated that they will do $600mm in sales or about 10% YOY.  There are two reasons why I believe this:  1) E-Rate is a government sponsored program which enables K-12 schools subsidies for purchasing IT equipment.  A large portion of this equipment is apportioned to Wifi.  Last year there was no program but a new program is starting again and it could contribute as much as $50mm to revenues.  In 2013, this program contributed about $30mm in revenue for the combined companies.  This year the program is larger and EXTR has actually been focused on selling a switch/wifi package to schools. 2) The proforma revenue for both companies for the 12 months ended June 2014 was $612mm.  The $600mm of sales is even less than what it did 2 years ago in a less robust environment for Wifi.

Other upsides to numbers include a potential partnership with an OEM on wireless products.  The acquisition of Aruba by HP has created many new opportunities for EXTR to expand customer relationships from former customers of Aruba.

Extreme has a partnership with Lenovo which has not beared any fruit.  Lenovo just acquired IBM's server business which does about $5 billion in revenue.  Lenovo would like over time to sell Extreme's switches to this installed base as it does not have full

Valuation

I believe that EXTR should trade at a multiple of revenue at approximately 80% of sales which is an enormous discount to comps.  ARUN acquired at 3X, RKUS trading at 3X, JNPR at 2X, ANET at 7X, CSCO at 2X, ATEN 1X, HIVE 1X.   Granted, EXTR should be trading at a discount but at 40% of sales, and 8x EBIT (with an NOL) it is too cheap. 

An acquirer would be able to take out about $40mm of synergies and be left with an adjusted operating profit of $67mm, on a market cap of $240 with no net debt.

Risks

Chuck Berger is still the CEO and has shown no ability to execute nor has he shown the ability to hire someone to execute.  The company, despite its strong product portfolio, might still see senior level defections leading to further poor execution.

Customers may start to get nervous dealing with Extreme given the stock price and turnover in sales.

The Board of Directors has not been  good stewards to shareholders.  This may continue.

DISCLAIMER

This is not a recommendation to buy or sell shares.  The views expressed above are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this recommendation.  The information above is from various public sources.  The author has not independently verified this information and makes no representations as to the accuracy or correctness of any such information.  Any forecasts made in this writeup are estimates and may not come to fruition.  The author takes no obligation to update any opinions or information above which may change in any way at  any time.   

Catalyst

The next few quarters may actually come in better than expected due to E-Rate and deferred orders coming in.

Fallout from HP acquiring Aruba creating potential new customer opportunities for EXTR.  There are customers of Aruba who now do not want to buy from HP because they are a competitor (namely Dell).  You could see EXTR picking up share in this market shakeup.

Lenovo finally getting their act together and starting to focus on selling EXTR's product. 

Acquisition from Strategic.  It is very reasonable to forsee EXTR being an acquisition target by Lenovo.  Lenovo wants to be a force in enterprise sales.  First it acquired the PC business from IBM and this has been viewed as a success.  Now they acquired the server business from IBM and they are working for it to be a success although the progress has been slow to date.  Over time Lenovo will look to continue to fill out their product portfolio through accretive acquisitions.  From an economic perspective,  acquiring EXTR would be accretive for Lenovo as it would be able to leverage its sales force and capture the 55% gross margin that EXTR currently receives.  From a strategic standpoint, Lenovo doesn't have a strong network switch product line, and it does not have a wireless product line which is highly desirable so both would be highly complementary to Lenovo.  In addition, EXTR has experienced engineering personnel in the US to further progress product development.  In a takeout scenario I would put EXTR at $7.50/share representing about 1.1X EV/sales, a modest valuation still.

Acquisition from Financial Buyer.  The Board of EXTR has shown that they don't know what they are doing and may chose to put the company up for sale.  A financial buyer would pay about $3.50/share in my opinion which is about 60% of sales.