It was only nine days ago that investors were left speculating as to whether Aruba's (Nasdaq:ARUN) weak fiscal third quarter meant that the WLAN market was slowing or that rival Cisco (Nasdaq:CSCO) was gaining share. With Cisco's earnings in hand and Aruba management's own post-earnings comments, it's clear that Cisco now looms large as a major disruptive force.

A more aggressive (and successful) Cisco is a multi-faceted threat to Aruba, and investors aren't hanging around to see how this plays out – sending the shares down more than one-quarter Friday morning. Although I continue to believe that there's long-term value in Aruba Networks shares, investors approaching this stock today have to treat it like nitroglycerine – be gentle and have a backup plan if and when things go badly wrong.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

Third Quarter Results Confirm The Worries
Aruba shares got hammered when management warned on May 7 that third quarter revenue and earnings came in below their prior expectation. Proving that a bad situation can always get worse, management followed that up with another downward revision (to fiscal fourth quarter earnings) and confirmation that more aggressive sales tactics from Cisco loomed large in the disappointment.

Revenue rose 12% from the year-ago period, but fell 5% sequentially, fueled by product sales that rose 10% from last year, but fell 7% sequentially. That marks the first time in about four years that Aruba logged a sequential decline.

I don't want to soft-peddle the disappointment this quarter, but I would note that Aruba did a fair bit better than feared on margins. Gross margin was almost steady versus last year (and down about a point sequentially), but approximately two points better than most analysts had modeled. Likewise, the declines in operating income were distressing (down 11% and 30%), but the operating margin did beat analyst expectations by almost three points.

SEE: Understanding The Income Statement 

What Is Cisco Doing … And What Can Aruba Do About It?
Cisco made hay this quarter in enterprise WLAN by competing quite hard on price and bundling WLAN with other products – particularly data center products. There is always a price-performance trade-off in IT spending, but those evaluations become even more challenging when business confidence is low and IT budgets are under pressure, as is the case today.

So I think it's important to note that Aruba isn't losing on technology, features, or performance. Instead, Aruba is losing basically because Cisco is Cisco and can create compelling bundles for prospective WLAN customers, while Aruba is just a WLAN vendor. If there's good news, it's that Aruba's smaller rivals (in market share terms) like Hewlett-Packard (NYSE:HPQ) and Motorola Solutions (NYSE:MSI) aren't likely going to be able to compound the situation all that much with effective bundling of their own.

I also think it's worth noting one detail from Barclays analyst Ben Reitzes – according to Mr. Reitzes, Cisco's enterprise WLAN growth was in the neighborhood of 17%, but the organic growth rate was more on the order of 11-13%. If so, it doesn't sound like this was such a crushing market share swing in Cisco's favor.

Even so, I understand why investors are fleeing and why about nine analysts downgraded the stock Friday morning. Cisco's moves are going to put a great deal more pressure on Aruba to reprice their technology and compete more on price in the WLAN market than they have so far – at least until business confidence rebounds and customers are willing to pay up for better technology. Unfortunately, I'm not sure Aruba has a lot of choice – if they stay the course through this lull, Cisco is going to eat their lunch with pricing/bundling, and that share loss could be tough to reverse down the road.

The Bottom Line
I warned in my last piece that another significant revision in Aruba's outlook would likely send the fair value into the high teens, and that's what has happened. I've trimmed both my revenue and free cash flow outlook, and now expect free cash flow to grow at a slower rate than revenue (to account for more aggressive pricing and the resulting margin impacts). Even so, I'm still looking at very low teens growth for both, fueling a fair value of about $18 today.

SEE: 5 Must-Have Metrics For Value Investors

Compared to a current price of around $13, the shares look like a real bargain. Investors need to approach with caution, though. It could take another quarter (or two) for Aruba's market share to stabilize, and I'd argue that the odds favor the estimates going down again before they go up. I do believe there is a lot to like about Aruba, and the price is appealing, but buying into these sorts of situations can rack up large paper losses before the bull thesis starts to work again.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Mutual Funds & ETFs

    Build A Model Portfolio With Style Investing

    This sophisticated approach will add flair to your returns.
  2. Investing Basics

    Long-Term Investing: Hot Or Not?

    Forget the latest craze - you're more likely to succeed with a buy-and-hold strategy.
  3. Insurance

    Investing In Securitized Products

    Securitized assets are customizable and have a wide range of yields, making them an attractive asset class.
  4. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  5. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  7. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  10. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Middle Market

    Definition of middle market
  6. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How can a company execute a tax-free spin-off?

    The two commonly used methods for doing a tax-free spinoff are either to distribute shares of the spinoff company to existing ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!