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.
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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.
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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.
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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.