When Cisco (Nasdaq:CSCO) decides that your particular market is an important one to its long-term goals, you're in for some challenging times (unless you're one of the companies that Cisco chooses to acquire). That's the reality that Aruba Networks (Nasdaq:ARUN) is facing right now, and it has consequences for the bottom line. While I continue to believe that Aruba has the technology and product quality to be a strong #2 in the growing WLAN market, the need to spend more on marketing and sacrifice margins to shore up growth adds another headwind for the stock.
Ending The Year With Some Positive Developments
Aruba did not have a great fiscal fourth quarter, and Cisco certainly reported better growth from its wireless business, but it was at least a decent quarter relative to Street expectations. Management's guidance wasn't bad, but it's seems pretty clear that this is going to be a long and hard-fought battle for the company.
Revenue rose 10% this quarter, with product revenue growth of 7%, and that was good enough for a slight beat compared to sell-side estimates. Gross margin declined about a point from last year, but ticked up a bit sequentially and came in around a half-point better than analysts expected. Operating income was down sharply (down 26% on a non-GAAP basis), but again a little better than expected. 
Still A Tough Market, And Aruba Is Going To Spend More
Relatively speaking, Aruba still has a lot to do to rebuild its credibility as a growth hardware stock. Cisco reported nearly 29% growth from its wireless business (albeit not exactly an apples-to-apples comparison) and Ruckus (Nasdaq:RKUS) saw nearly 31% year on year revenue growth, while Meru (Nasdaq:MERU) reported growth more in line with Aruba's performance.
The key for Aruba remains addressing the serious competitive challenges from Cisco. This large networking company has focused a significant amount of attention on WLAN and while Aruba may arguably have technological and price-performance advantages, Cisco's bundling capabilities and integration of WLAN controller functions into switches and routers makes it a formidable rival.

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Aruba is taking a familiar approach to the problem – allocating more money into sales and marketing. Better clarifying the advantages of Aruba's gear and translating it into actual dollars and performance metrics should help, but it will definitely compress margins in the short term. To that end, management did boost revenue guidance a bit, but the net effect of the margin changes was a slightly lower bottom-line forecast.
Can Aruba Catch A Tailwind?
One positive that could work in Aruba's favor is improving sentiment in the networking space, both among enterprise customers and investors. Companies like F5 (Nasdaq:FFIV) and Juniper (Nasdaq:JNPR) seem to think that we've seen the worst of the downturn in spending and it looks like investors are returning to these stocks.
It also doesn't hurt that the WLAN market is expected to be a double-digit grower for several years to come – making it one of the fastest-growing hardware markets of any real size. So Aruba is looking at a mix (potentially, at any rate) of strong underlying demand growth, increasing enterprise customer confidence, higher marketing spend, and improving tech investor sentiment. Although Aruba shares are down post-earnings as of this writing, that combination could give some support to the stock through the end of the year.
The Bottom Line
I want to like Aruba shares, but the valuation is challenging. A long-term revenue growth estimate of 11% and free cash flow margins in the high teens only gets the fair value to about $20. Boosting the free cash flow margin into the low 20%'s would drive the target into the mid-$20s and wouldn't be inconsistent with what companies like F5 and Riverbed (Nasdaq:RVBD) have achieved in other markets, but that sort of performance in the face of competition from Cisco could be difficult to achieve. On the other hand, Aruba's EV/sales ratio isn't that high if they can rebuild sales growth.
Valuation is never anything like an exact science, and I don't think it's controversial to suggest that the stock will do fine if and when revenue growth improves (assuming it doesn't come at too high of a margin cost). To that end, I'm favorably inclined on these shares even if the valuation doesn't make a completely compelling case to buy today.
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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