Small Cap Stocks

Earlier this week, Extreme Networks (EXTR), reported earnings that missed analysts expectations. The miss was primarily caused by higher discounts and commissions for the company’s fiscal year end, rather than any indication of slackening customer demand. In fact, the report demonstrated strong demand for Extreme’s new products, and a clear indication of the coming financial benefits from the company’s restructuring efforts.

The stock, not unexpectedly, has sold off dramatically since the report, as have many other technology stocks that miss or, even meet, analysts estimates. As you may have noticed, the current environment is simply horrendous for small cap stocks, so we’re not so sure one needs to try to figure out a rational explanation for the current slide.

With $215 million in cash, $0 debt, a base sales level of about $340 million, and an Enterprise Value of a mere $220 million (EV/Sales of 0.65), the selling pressure on the stock is clearly overdone. EXTR is not going away anytime soon, and the company has ample growth opportunities given the growth in bandwith and overall demand for switching solutions. Quite simply, the stock is going down, because it’s going down.

In the end, we think investors need to wait for at least two more quarters with EXTR to render judgement. Right now, assuming you are diversified, there is absolutely no reason for panic with these shares given the pristine balance sheet and large base business. Yes, the company’s not growing much, if at all, but, since the valuation is so depressed relative to larger competitors, like JNPR or FDRY, we believe EXTR will be sold to a larger competitor, if current management does not manage to reignite growth. This significantly limits downside risk in the stock.

In sum, to date, we’ve admittingly been completely wrong on this stock, but we still think patience will prevail. If we could take one lesson away from this current bad pick, it might be to stay away from turnaround technology stocks with too many Wall Street analysts. In such instances, analysts routinely have terrible forcasting models, which creates selling pressure when the companies fail to meet the expectations of these faulty estimates. Turnarounds, like EXTR, take time, and that’s the last thing most funds have, especially in a bad market.

Please Note: We first recommended Extreme Networks (EXTR) at $4.22, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Extreme Networks (EXTR), one of our dissappointing picks this year, has finally completed its options investigation and filed up-to-date financials with the SEC. We believe that this represents a turning point for the company, as it eliminates a major uncertainty that we think has held back the shares, even as Avaya, a big partner of EXTR was scooped up by private equity at a significant premium, and Foundry (FDRY), EXTR’s  main comp, has slowly regained favor with investors after it too finally filed updated financials with the SEC.

As we have mentioned in the past, the main knock against EXTR is that it simply can’t compete against CSCO or FDRY, as evidenced by declining US revenues in the last two years. However, despite the negativity towards the company, there are still signs of hope. Specifically, there is the company’s strong growth in regions outside the US, a host of new products that appear to be gaining some traction, and a highly capable new management team that is both restructuring the sales force and cutting costs. In addition, EXTR remains free cash-flow positive, has over $200 million in cash (no debt) and has little cap-ex needs. With a cost-structure that is being repaired (see the 8-K filed yesterday), we think there is plenty of room for financial improvement at EXTR even without much sales growth.

To top it off, EXTR’s stock price clearly has already priced in all the negatives. Currently, the stock is trading at 0.7 times EV/Sales, vs. FDRY 3.0X EV/Sales. In our view, the valuation gap makes little sense, and it’s possible that FDRY could consider a buyout of EXTR at these levels. Juniper is also, at times, rumored as a suitor for EXTR. In any case, the downside in EXTR now appears minimal, especially after the refiling of up-to-date financial restatements. On the upside, with even a small improvement in sales, the stock could easily double to $8, at which level the stock would still be priced at a major discount to peers, notwithstanding the company’s solid technology reputation.

Please Note: We first recommended Extreme Networks (EXTR) at $4.22, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Last week, Extreme Network’s (EXTR) announced disappointing financial results, which prompted significant selling in the stock. Despite generating nearly $10 million in cash during the quarter, the company’s top-line remained under pressure.

However, we still believe that the new management team at Extreme is taking the right steps to turn the company around. Importantly, years of bad management, cannot be rectified in just two quarters.

We also still think our investment in Extreme has low risk, with the potential for substantial upside, given the company’s very depressed valuation and solid balance sheet (i.e. EV/Sales of 0.8X and $214 million in cash and no debt). In fact, at current prices, we are surprised that the company has not yet become an acquisition target.

Interestingly, Foundry (FDRY), a company often used as the best comp for Extreme, hit a new high recently on improving results. FDRY is trading at a little over 2X EV/Sales and is sitting on nearly $900 million in cash. Perhaps Extreme (EXTR) should consider a combination with Foundry (FDRY)? Might deal activity for either of these companies accelerate once the two companies finally finish their accounting restatements?

In any case, “The Market” still remains pessimistic on EXTR, because investors believe there is no hope for EXTR against formidable competitors, like CSCO and a revived FDRY. However, we think that given the size of the end market, this line of thinking is simply way too pessimistic, and more importantly is already well reflected in the current valuation.

With a very strong cash position, exceptional technology, a solid customer base, and extensive channel partnerships, time is on the side of EXTR. Notably, share prices for depressed companies, like Extreme, can turn on a dime, once the positive personnel and strategic changes begin to show up in the financials. EXTR’s stock could also get a nice boost when the company finalizes its accounting restatements and refiles with the SEC in the coming months.

Our upside scenario for EXTR remains $8 to $10, or about 2.5 EV/Depressed Sales. With think this valuation is reasonable given the growth opportunity here and the company’s 50%+ gross margins. On the downside, we don’t see the stock going beneath $4, even under a worst-case scenario of continued lackluster growth. With 5% Downside and the Potential for 100% Upside, we think this stock remains an attractive investment gamble, even if one assigns a greater probability to the downside scenario because of the CSCO factor. The next few quarters will either vindicate or disprove our thesis.

Please Note: We first recommended Extreme Networks (EXTR) at $4.22, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

It´s always nice to get the Wall Street hype machine rallying behind our stock picks. So we were quite pleased this morning when Ryan Hutchinson, over at WR Hambrecht, upgraded Extreme Networks (EXTR) and published a 12 month price target of $6.50 per share for the stock.

Mr. Hutchinson had this to say about Extreme:

“We are upgrading EXTR shares to a Buy from a Hold rating and establishing a $6.50 price target based on 1.5x our C2007 EV/Revenue estimate. Our upgrade is based on our belief that the corporate reorganization that has been underway over the last six months is beginning to take hold. As expected, such turnarounds take time to materialize; to date, gains have been slight. However, we believe that under the new leadership of CEO Mark Canepa, the Company is at the brink of resuming a growth trajectory. Our recent meeting with CEO Mark Canepa reinforced this notion due to several actions Canepa has taken, including 1) focusing on key verticals; 2) realigning the product groups; 3) de-layering the management structure and adding key hires; and 4) reinvigorating the North American sales organization. Furthermore, with the option review nearly complete and EXTR shares trading at less than 1x our C2007 EV/Revenue estimate, we believe the risk/reward profile is compelling.”

As regards to the competitive environment that EXTR must face, Mr. Hutchinson had this very interesting piece of commentary:

“Our discussion with Canepa revealed much about his new strategy for approaching the Company’s traditional verticals-carrier and the enterprise. Within the carrier vertical, we believe the Company can ultimately compete for a sizable portion of the carrier Ethernet market, valued at $1.6B during 2007 by IDC. While the Company’s traditional carrier base has consisted of about two-thirds Tier II and one-thirds Tier I, we believe the Company will more aggressively pursue a few key Tier I accounts through OEM relationships, rather than head-on. On the enterprise front, we believe the most potential is coming from healthcare, hospitality/gaming, and education-sectors marked by transient usage populations that are well served by Extreme’s best-of-breed emerging wired/wireless platforms. Moreover, we believe the Company holds a strong competitive position in this market because it largely focuses on smaller implementations that are often overlooked by larger competitors like Cisco.”

Overall, with another analyst getting bullish on Extreme, it will probably not be long before other Wall Street firms begin upgrading shares of the company. Our view, for quite some time, has been that EXTR’s share price already reflects worst case scenarios, and with ample evidence to suggest that substantial positive business changes will be coming in the next year, the shares still have limited downside and substantial upside.

We would note, however, that we are more bullish on EXTR than Wall Street. We think that if the company continues to report improving financial results and US sales begin picking up, there is absolutely no reason why the company should trade at a substantial valuation discount to its peers. In fact, a valuation more in line with industry comps, would suggest a potential target price of $8 to $10 in the coming year, if results continue to improve. It´s also possible that the company´s large cash pile and stabilized revenue stream, will attract suitors from either larger competitors or private equity firms.

Please Note: We first recommended Extreme Networks (EXTR) at $4.22, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Late last week, Extreme Networks (EXTR) reported quarterly results, which continue to support our investment thesis, that EXTR has limited downside risk at current prices, and substantial upside potential, assuming new management continues to drive positive change at the company.

The most important positives from the quarterly results were:

Balance Sheet Remains Pristine Limiting Downside Risk

During the quarter, Extreme Networks (EXTR), paid down all of its debt and exited the quarter with nearly $205 million in cash. This large cash cushion implies that there is little to no financial risk at the company and investors can remain comfortable holding the shares as the turnaround progresses.

Book-To-Bill Signals Healthy Business Growth

During the conference call, management of Extreme highlighted that the company’s Book-to-Bill ratio was greater than one, due to higher than anticipated demand for the new Summit X450 stackable switch. The book-to-bill ration is the ratio of business “booked” (orders taken) to business “billed” (products shipped and bills sent). A book-to-bill ratio higher than one (1) is encouraging.

On the negative side:

US Sales Remain Disappointing

The most glaring negative of the quarter was the continued weakness in the company’s US sales. Management indicated, though, that they continue to restructure and re-train the US salesforce, and they expect to see positive results from these efforts in the coming quarters.

Options Investigation Still An Issue

In addition, Extreme, like many other high-tech companies, is still undergoing investigation related to past option practices. While we don’t view this investigation as important from a business perspective, it’s probably the case that this may limit demand for the shares in the interim, as some investors will shy away from the stock until the company files updated financials.

Valuation Remains Depressed and Already Reflects All the Negatives

Despite evidence of improving results, Extreme’s stock price remains depressed as evidenced by an Enterprise Value (EV) to Revenue ratio of less than 1, with competitors such as Foundry Networks (FDRY) sporting EV/Sales ratios of 3X+. The discounted valuation reflects years of underperformance by the company from both a business and shareholder perspective.

Underperformance Indicates Substantial Upside Opportunity

However, despite past underperformance, the company appears to be undergoing significant changes under a new management team and as current results suggest there is ample room for continued upside surprises in the year ahead.

In general, in these types of turnaround situations, most analysts on Wall Street prefer to wait for several quarters of improving results until they become more positive on the company. In fact, out of the eight analyst reports we have read on EXTR, only two analysts are positive on the company, and only moderately so. Clearly, in the case of EXTR, the negatives are already well understood and priced in by the Market.

Our view, howver, is that since EXTR’s share price pretty much already reflects worst case scenarios, and there is ample evidence to suggest that substantial positive business changes will be coming in the next year, you have no need to wait here. In sum, at current prices, there is little to lose and much to gain, the perfect investment combination.

We would note, in the case of EXTR, that if the company continues to report improving financial results and US sales begin picking up, there is absolutely no reason why the company should trade at a substantial valuation discount to its peers. In fact, a valuation more in line with industry comps, would suggest a potential target price of $8 to $10 in the coming year, if results continue to improve.

Please Note: We first recommended Extreme Networks (EXTR) at $4.22, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Last evening Ericsson announced an agreement to acquire Redback Networks (RBAK) for $2.1 billion in cash or about $25 per share. This allows us to lock in a 150%+ gain on our original Redback investment, the first pick we made on this site back in October 2005.

More importantly, though, are the repercussions that the Redback deal will have on the entire networking industry and specifically for our latest pick: Extreme Networks (EXTR). As regards to the industry, the Redback deal highlights a growing need among service providers to upgrade their networks to accommodate the huge growth in bandwidth demands, particularly for consumer downloads and in addition the increasing need to deliver that content to mobile devices.

As regards to Extreme:
While Redback and Extreme are focused on different product areas (i.e. Redback makes “edge” routers, while Extreme makes L3 switches) and have a somewhat different market focus (i.e. Redback is carrier-focused, while Extreme appears to be more enteprise-focused), the valuation afforded to Redback (8X EV/R) can and will be used to analyze others companies in the sector, such as Extreme. At less than 1X EV/revenue, EXTR appears dramatically undervalued.

Extreme’s discounted valuation of course reflects dissappointing recent growth and heavy competitive pressure. However, we believe these negative factors will be mitigated in the coming year as restructuring efforts begin to pay off. In addition, as regards to the Cisco risk, it is important to note that RBAK too faced intense competiion from Cisco, with Cisco controlling greater than 50% of the market in which RBAK competes. As such, it’s hard to argue for a substantial “Cisco competitive ” discount after the RBAK deal.

Overall, the valuation afforded to RBAK clearly shows the potential upside for EXTR should the company succeed in stabilizing revenue, returning to profitability, and communicating a solid plan for future growth. In any event, Extreme (EXTR) too is a likely acquisition candidate sooner rather than later. The possible suitor: Avaya (AV). Avaya is already Extreme’s most important channel partner and the company could easily swallow a company of EXTR’s size.

Investment Thesis

Investment Summary

If you’ve been following our picks for some time, you know that the first stock we mentioned on this site was Redback Networks (RBAK). Despite a huge amount of volatility, RBAK has been a very profitable investment for us, having more than doubled since we first wrote about it fourteen months ago. The success of the RBAK investment has had as scouring for more network-related “bubble stocks” that have fallen on hard times and yet appear to offer good odds of turning around. Extreme Networks (EXTR) definitely fits the bill and we believe the shares could appreciate significantly in the next 12 to 18 months.

Extreme designs, builds, and installs metro Ethernet infrastructure based on its proprietary switching product lines. We think that as management begins to implement certain operational changes at the company over the next year, Extreme’s profitability and competitive position will improve. This greater investor certainty with regards to the company’s long-term competitive position, particularly versus Cisco (CSCO), and better visibility as to Extreme’s growth prospects over the next 3 to 5 years, may lead to significantly higher prices for the company’s shares, especially considering their current depressed valuation.

Importantly, downside risk in Extreme’s stock appears limited at current prices. With approximately $200 million in cash (no debt), a stable base revenue stream, attractive technology portfolio/alliances, and a very low relative valuation, one can feel comfortable holding these shares as the turnaround materializes and/or averaging down on any non-business related weakness. In addition, it seems likely that if Extreme can’t turn things around, that the company would be a prime acquisition candidate for a larger competitor.

Note: We own shares in Extreme Networks (EXTR). As we finished this report the stock was trading at about $4.22 per share. It is important to mention that Extreme, like many other high-tech companies, is still being investigated for possible option irregularities and as such the company has yet to file up-to-date financials. Should the company be delisted due to a failure to file updated SEC filings, it is possible that Extreme’s stock could sell-off dramatically. We would view this type of sell-off as a buying opportunity.

The Business and Opportunity

Basic Capitalization Statistics

As of 7/2/2006, the last time financials were made available for Extreme, the company had about 120 million shares outstanding on a fully diluted basis following recent share buybacks. The company also has nearly $200 million in cash and no debt. Note that in December 2006 the company paid off roughly $200 million in convertible debt with excess cash. Trailing 12 month sales (TTM) are about $360 million, with $295 million in product sales and roughly $64 million in service revenue. We believe that the company is currently operating at a cash-flow positive level, and it is important to note that the company generated operating cash-flow in 2003, 2004, 2005, and 2006. Notably, the company generated nearly $20 million in free cash-flow in fiscal 2006, based on unaudited financials.

Taking the above, we calculate that at the current price of $4.25, Extreme has an enterprise value (EV) of about $310 million for an EV/Sales ratio of 0.86. This ratio is a significant discount to the company’s closest peer, Foundry Networks (FDRY), which sports an EV/Sales ratio of 3.3.

Business Description

Extreme designs, builds, and installs metro Ethernet infrastructure based on its proprietary switching product lines. For a detailed discussion on the Ethernet market we recommend these entries at Wikipedia: http://en.wikipedia.org/wiki/Ethernet and, http://en.wikipedia.org/wiki/Metro_Ethernet

Below we have summarized some of the more relevant background information. “Ethernet has been a well known technology for decades. Ethernet is a large and diverse family of frame-based computer networking technologies for local area networks (LANs). A Metro Ethernet is a computer network based on the Ethernet standard covering a metropolitan area. It is commonly used as a metropolitan access network to connect subscribers and businesses to a Wide Area Network, such as the Internet. Large businesses can also use Metro Ethernet to connect branch offices to their Intranet.

A typical service provider Metro Ethernet network is a collection of Layer 2 or 3 switches or routers connected through optical fiber. A router acts as a junction between two or more networks to transfer data packets among them. A router is different from a switch. A switch connects devices to form a local area network (LAN).

One easy illustration for the different functions of routers and switches is to think of switches as neighborhood streets, and the router as the intersections with the street signs. Each house on the street has an address within a range on the block. In the same way, a switch connects various devices each with their own IP address(es) on a LAN.

The bandwidth advantages, the slightly better isolation of devices from each other and the elimination of the chaining limits inherent in non-switched Ethernet have made switched Ethernet the dominant network technology.”

Extreme Networks was founded in 1996 to market a new type of Layer 3 Switching solution which addressed the issues caused by slow and expensive legacy networks. The company’s innovation was to replace complex software-based routers with simple, fast, highly intelligent, hardware-based network switches based upon custom-designed semiconductors (or ASICs). The resulting Layer 3 switch was faster than the software implementations used in many competing products. In addition, Extreme’s switches by utilizing proprietary ASIC’s and operating systems, were less expensive than software-based routers.

The broad acceptance of Extreme’s innovative and simplified approach to networking enabled Extreme to grow from $0 in revenue in 1996 to nearly $500 million by 2001. With the popping of the Telecom bubble in 2001, though, the company’s sales have slowly declined, reaching a bottom of $351 million in 2004.

Since the telecom bust, demand for bandwidth-intensive applications that integrate voice, video and data over IP networks still continues to grow dramatically. The steady rise in application sophistication and the associated bandwidth load demands a fast, flexible and scalable network infrastructure.

We believe that continued increases in bandwith demand will fuel continued and growing demand for sophisticated IP networking gear over the coming years, particularly in the Enterprise metro-Ethernet market as more and more businesses, governments, educational institutions, health care enterprises and other organizations become highly dependent on their internal networks and the Internet as their central communications infrastructure.

This overall macro-environment will benefit Extreme Networks, particularly as new management strives to refocus the company in 2007 on niche markets with good growth potential. We note that the market in which Extreme competes is a $12 billion sub-segment of the Ethernet market. So there is clearly plenty of potential for the company to recover to its peak sales of nearly $500 million by concentrating on the right vertical markets within the metro Ethernet market.

The People

Proven Technology Executive Now at the Helm

In late August 2006, Extreme hired Mark Canepa as the new president and chief executive officer. Prior to joining Extreme Networks, Mr. Canepa was with Sun Microsystems where he managed a $4 billion division of Sun (roughly 10X the size of Extreme’s current top-line), while serving as executive vice president of the Network Storage Products Group. Before Sun, Mr. Canepa worked in several general manager positions at Hewlett-Packard Company, including development and marketing of the firm’s workstation products. Mr. Canepa’s educational background includes both a B.S. and M.S. in electrical engineering from Carnegie Mellon University, and he has also completed the University of Pennsylvania’s Advanced Management Program at the Wharton School.

Mr. Canepa was granted a one-time option to acquire 850,000 shares of Extreme’s Common Stock at $3.65 per share. One-fourth of these shares shall vest one year after the commencement of Mr. Canepa’s employment with Extreme, and the remaining shares will vest monthly over the following three years at a rate of 1/48th of the entire option each month, subject to Mr. Canepa’s continued employment . Mr. Canepa also received a one-time grant of 100,000 restricted stock units (the “RSU”) that will vest at the rate of 50% on August 15, 2008, and one-fourth of the remaining balance each six months thereafter, subject to Mr. Canepa’s continued employment with Extreme. The vesting of the shares subject to the Option and the RSU may be accelerated upon a change of control.

In reviewing Mr. Canepa’s background and listening to him at recent investor conferences, we came away with the impression that Mr. Canepa is more of an operational leader, rather than a entrepreneurial visionary. We view this as a very important positive given that Extreme is no longer a start-up. In addition, we are pleased by Mr. Canepa’s desire to move Extreme towards a more solutions-focused company. A greater emphasis on services, as opposed to products, should provide the company with better revenue visibility, which in turn should lead to improved profitability.

You can read some good interviews with Mr. Canepa by using the links below: http://www.itweek.co.uk/itweek/analysis/2169189/interview-extreme-view-network http://www.itp.net/features/details.php?id=5716&category= http://telephonyonline.com/mag/telecom_canepa_sets_extreme/

What Went Wrong At Extreme?

While Extreme was incredibly successful in capturing a nice chunk of the L3 Ethernet switching market early on, the company has had a very rough time navigating the changed marketplace following the collapse of the telecom bubble in 2001. It appears that since the telecom slowdown, the company lost its focus and failed to develop new marketing and sales initiatives to attack the changed market landscape.

Continued leadership by the entrepreneurial founder, is probably the main reason for the company’s inability to adapt as the company’s end markets matured and competition increased. As is usually the case, entrepreneurial strategies which helped a new company grow dramatically in the initial start-up phase, are generally not the tactics that will help the company achieve sustainable and profitable growth once there are no longer any low-hanging fruit.

As execution issues plagued the company, competitors, especially industry behemoth Cisco (CSCO) and key rival Foundry Networks (FDRY), have made good progress in the ethernet switching market over the last several years, stealing key market share from Extreme.

What Has Changed?

Understanding that the company needed proven operational talent, rather than entrepreneurial skills, the board has replaced the founder of Extreme, Gordon Stitt, with Mark Canepa, a high-tech executive with proven experience managing much larger tech enterprises in more mature markets.

According to Mr. Canepa, the new CEO of Extreme, investors can look forward to following changes under his leadership:

• Sharper Focus

Extreme has become too horizontally focused, with alot of small revenue streams. In the coming year management will force the company to focus on those vertical areas where Extreme can be #1 and/or #2 from a competitive standpoint. Other non-core revenue streams will be discontinued.

• Better Supply Chain Management

Since the company is no longer in start-up mode and there is no rush to market, there are seemingly a lot of cost savings that can be realized thru better management of the supply chain.

• Greater Emphasis on the Service Market Opportunity

Since the problems for Extreme’s customer are becoming more and more complex, Extreme sees services as another avenue to grow revenues and profitability. It is seeing growing demand from its customers for help in designing, deploying, consulting and integration, yet most of its services revenues are still from basic maintenance and support. Extreme plans to separate the services business into its own business unit, headed by a full Vice President and General Manager. The company recently created a solutions marketing organization to develop and market new services offerings. In addition to these higher-value add professional services, Extreme also sees opportunities to up-sell its installed base with services such as 4-hour response, rather than 24-hour response.

Risk Analysis

Cisco Constantly Lurking and Stealing Market Share

Extreme faces several risks, but we think that the most important one to focus on is the competitive threat, particularly from Cisco (CSCO). Recently released market data suggest that CSCO’s Ethernet switch sales continue to grow at over 17% Q/Q to over $3.1B, boosting its market share to 73%, the highest in 2 years. If Extreme is not able to counter market threats from Cisco (CSCO) and other competitors, such as Foundry (FDRY), the company will have a very difficult time maintaining the current sales level, let alone increasing it to a level that will ensure sustained profitability.

The Cisco threat is usually enough to convince most investors to run from Extreme as fast as possible, but we think that if management is successful in repositioning the company along several niche vertical markets and focusing sales efforts on solutions, as opposed to products, the Cisco threat will become less meaningful to Extreme investors over the long-term. In addition, we think that the current valuation of Extreme more than prices in the current competitive risks that Extreme faces.

Return Analysis Basically, if the company is successful in implementing the above-mentioned operational changes, we don’t think it is unreasonable to expect sales to climb back to the $400 million level in a few years time. With better cost controls, the increased sales level could lead to significant cash-flow growth well above current levels.

Valuation: Downside and Upside Scenarios

We don’t see much downside in Extreme at current prices. Assuming a base sales level of $330 million per year, the stock is trading at an Enterprise Value (EV) to sales of less than 1X, versus FDRY’s valuation of over 3X. This valuation of Extreme assumes continued loss of market share vs. Cisco and Foundry and an inability of management to reignite sustainable growth at the company. In the worst case, we’ll use $3.50 as the downside here.

On the upside, if new management can reinvigorate the company, and achieve a base sales level of $380 million, it’s conceivable that the company would be valued at 2X Enterprise Value to sales, implying a valuation of about $8.00 per share. Giving each scenario 50% odds implies an expected value of about $5.75 per share, implying that the shares are about 35% undervalued at current levels.