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.

SEE: 3 Secrets Of Successful Companies
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.

Related Articles
  1. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  2. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  3. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. Internet Of Things

    A network comprised of physical objects capable of gathering ...
  5. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  6. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... 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. 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 >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... 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!