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Extreme Networks (EXTR): An Attractive Turnaround in the Networking Sector

Posted on December 18, 2006

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.

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