By Mark Basham Extreme Networks (EXTR), which carries S&P's highest investment ranking of 5 STARS (buy), is a five-year-old company that has grown very rapidly to become an important provider of network infrastructure equipment.
Extreme's network switches are based on two dominant technologies, Ethernet and Internet Protocol. The important fact about these technologies is that they were originally used in data networks, as opposed to technologies used in primarily voice networks. S&P believes that because non-voice network traffic growth will far surpass that of voice network traffic, these technologies have a natural advantage and will capture a growing share of the total network infrastructure market.
Extreme's approach to Internet Protocol over Ethernet is to embed functions in application specific integrated circuits as opposed to software, which differs from the tack taken by the dominant network company Cisco. The advantages of hardware over software in this case are easier management of various types of traffic over the network; minimization of loss of data packets (also known as blocking); and use of common technology as the network grows larger and more complex. This approach is less expensive to purchase and to maintain.
BACK ON TRACK. Although growth in Ethernet switching sales is expected to be down in 2001, owing mainly to overall economic malaise, S&P expects the Ethernet switching market to resume to healthy growth upon the anticipated economic recovery in mid-2002. The dominant Ethernet switching technology today is known as Fast Ethernet, which transmits traffic at speeds of 100 megabits per second. Sales of Fast Ethernet are expected to peak this year at $15.8 billion, based on a forecast by industry research firm International Data Corp. At about 40% of the size of the Fast Ethernet segment, Gigabit Ethernet, with a wire speed of 1,000 megabits per second, is expected to have sales of $5.9 billion.
With Fast Ethernet likely to decline significantly over the next three years, S&P anticipates Gigabit Ethernet to more than double sales to $14.2 billion. A small portion of sales this year is expected to be captured by 10 Gigabit Ethernet, a relatively new technology, which is projected to increase six-fold to $2.8 billion in 2004.
Currently, the $22 billion Local Area Network Ethernet switch market is dominated by Cisco Systems, which has an approximate 60% market share. Extreme is in a pack of about 10 players, all with less than 10% share, based on dollar sales. However, we believe that based on ports shipped, Extreme's share is larger among this peer group, and that it is likely to gain dollar share in the future, as well.
Numerous competitors are burdened by heavy debt burdens, which leaves them with less ability to invest in next generation products after servicing that debt. Several of Extreme's competitors that also emerged in the late 1990's have we believe sacrificed product development for unsustainably high margins in the short term. The market downturn in 2001 has been particularly severe for these firms. Extreme has kept product development at high levels throughout the market downturn, and should be in better competitive position once the market rebounds.
EXTREME MEASURES. Extreme's revenues are likely to fall slightly in the fiscal year ending June 30, 2002 from the previous year, declining by approximately 2% to $481 million. Sales fell 9.3% in the September quarter, year over year, and will likely show a 21% drop year over year in the December quarter, although we expect sales to rise sequentially. December quarter of last fiscal year sales of $145 million represented the quarterly peak in sales, a level that we do not expect to be surpassed until the second quarter of fiscal 2003. For fiscal 2003, we expect revenues will increase 50%. Smoothing out the projected sales growth rate results in average growth of about 22% annually, which we think reflects a realistic growth rate for the network infrastructure market and that we expect Extreme to gain market share.
Over Extreme's five year history, it has used a combination of direct and indirect sales channels. The downturn this year has led the company to focus primarily on the indirect channel, where although average selling prices are lower, its sales and marketing expenses are also lower. This decision contributed to a large write-off of inventory and certain receivables in the September quarter.
The downturn has also enabled the company to obtain better terms with its contract manufacturers, Flextronics, Solectron and MCMS, Inc. Extreme expects to drive down manufacturing costs, with gross margins rising from 52% to 55% over the next several years, while selling costs are likely to decline due to it's decision to sell primarily through distributors. The company has adopted very conservative accounting for revenue recognition, which should avoid inventories in the channel from becoming bloated. R&D spending is targeted to remain near 12% of sales.
BRIGHTENING PICTURE. Based on the steps Extreme has taken to reduce costs, operating margins are expected to rise over the next several years to 20%. Depending on the level of cash investments Extreme has and the available return on investments, net margins will likely range from 13% to 15%. The company has $285 million in cash and investments and no debt.
Based on these assumptions, S&P projects pro forma earnings per share of just above breakeven in fiscal 2002, rising to $0.40 in 2003.
S&P relies principally on discounted free cash flow analysis as the basis for Extreme's valuation. Our assumptions include a beta of 1.2 for the stock, a risk free rate of 5.0% and an equity risk premium of 6.0%, resulting in a required return on equity of 12.2%. After a sharp jump in free cash flow in fiscal 2003, we assume gradually diminishing growth over a number of years down to 3%. Based on these assumptions, our estimate of intrinsic value for the stock is $18-$20, for an approximate 34% gain from the current stock price over the next six to 12 months.
Please note: The S&P Focus Stock feature will not be published on Nov. 19 or 26. It will return Dec. 3. Basham is an equity analyst covering small-cap and emerging growth issues for Standard & Poor's