There's a pretty good rule of thumb that applies to swimming and diving – if you can't see the bottom, don't dive in -- and think twice about swimming there. Likewise, jumping into a stock right after a significant revision to earnings expectation can be an invitation for successive disappointments, as companies don't often miss just one time.

With Aruba Networks (Nasdaq:ARUN), that leads to some tough choices for investors. While I definitely believe that the wireless networking (WLAN) is going to grow significantly, and that Aruba is well-positioned to take more share in the small/medium-sized business (SMB) space, I also acknowledge that WLAN spending is largely discretionary and this company could see further order/revenue disappointments if IT demand doesn't rebound during the summer.

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A Miss, But Not Altogether Surprising
Aruba warned investors on May 7th that fiscal third quarter (April) results are going to come in well below prior targets. Revenue looks to have grown about 10% from the year-ago period and contracted 6% from the prior quarter – adding up to a roughly 10% shortfall relative to most sell-side expectations.

While some analysts had suggested that WLAN was a relatively safe spot in IT spending, due to its small base and the fast-growing “bring your own device” (BYOD) trend, that proved to be optimistic. Like other networking players including F5 (Nasdaq:FFIV) and Riverbed (Nasdaq:RVBD), not to mention large-cap IT players like IBM (NYSE:IBM) and Oracle (Nasdaq:ORCL), Aruba saw significant order pushouts late in the quarter.

Because the order delays apparently weren't obvious until late into the quarter, Aruba was pretty much stuck on the margin side. The company had been hiring through the quarter as a growth company would, only to see the revenue fail to materialize. Consequently, the bottom line EPS impact is disproportionate – EPS will come in about 50% lower than expected.

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Will Those Orders Come Back?
So what's actually happening in the WLAN space? Ruckus (NYSE:RKUS) recently issued a sizable warning as well, but Ruckus cited weak results in the service provider market where Aruba doesn't compete. What's more, Ruckus wasn't nearly so negative on the enterprise market that makes up Aruba's core market.

Making matters worse, Motorola (NYSE:MSI) also issued weak guidance, and the recent report from Juniper (NYSE:JNPR) (a smaller player in WLAN, but a player all the same) was hardly strong.

This sets up an unappetizing set of choices. Either WLAN market growth has significantly slowed, or Cisco (Nasdaq:CSCO), the leader with over 50% market share, has been gaining share. Cisco has been getting more aggressive with its bundling and more flexible on pricing options, neither of which is good for Aruba even if Aruba is “best of breed”.

Like as not, it's a little bit of both – I do believe the discretionary nature of WLAN spending is going to become more apparent going into (and maybe through) the summer, and I do think Cisco is gaining some share. If there's good news, it would be that Cisco may be gaining more share from the likes of Motorola and Hewlett-Packard (NYSE:HPQ) and not so much from Aruba.

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The Right Products For A Growing Market
I think there are still valid reasons to be bullish on Aruba. Even if 2013 growth disappoints, I believe the WLAN market can grow at a low-to-mid teens rate for at least a few more years. What's more, I do believe that Aruba has good technology – its “context aware” MOVE architecture and products like ClearPass and Instant that can not only offer value for smaller customers, but create significant follow-on demand for Aruba equipment and services.

The Bottom Line
The problem for Aruba investors now is in trying to run a scenario analysis on how much worse things can get relative to the long-term opportunities. If Aruba is in fact losing meaningful share to Cisco, all bets are off. Assuming that Aruba is holding its own, though, I believe investors can still look for low teens growth across the long term – suggesting a fair value in the low $20s.

If another miss likes this hits the 2013 numbers, I could see that fair value target moving down into the high teens. By the same token, if Aruba can grow its share in enterprise WLAN and develop follow-on products/technologies (always a challenge for tech companies), the upside could be well into the $20s, absent the normal overshooting that goes with successful tech stories.

On balance, then, I think there is value and opportunity in these shares. With the IT spending environment so weak, though, and investors increasingly gun-shy about the networking sector, anybody buying shares today had best be able to stomach downside risk in the $10 to $12 range.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
Tickers in this Article: ARUN, CSCO, RKUS, MSI, FFIV, RVBD, ORCL, IBM, JNPR, HPQ

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