EXTR - Extreme Networks: The Market May Be Too Pessimistic

2023-11-19 23:56:28 ET

Summary

• Extreme Networks has revised its growth expectations for fiscal year 2024, anticipating mid-to-high single-digit growth instead of mid-double-digit growth.
• EXTR is facing challenges with existing orders and inventory, as well as macroeconomic conditions in the EMEA region.
• Despite the slowdown in growth, there is still potential for margin expansion through supply chain normalization and the transition to the Universal platform.

Thesis

Extreme Networks, Inc. ( EXTR ) has a diverse portfolio that effectively meets customer needs and offers strong solutions in campus switching and cloud-managed wireless products. Additionally, EXTR holds a unique position in customer verticals that align with government and education spending, which helps the company remain resilient even during fluctuations in Enterprise IT spending. However, Extreme has significantly reduced its growth expectations for the fiscal year 2024, now anticipating mid to high single-digit growth, a significant drop from its previous forecast of mid-double-digit growth. The company is facing challenges with its customers and partners working through existing orders and inventory amidst a challenging macro environment. Although the growth has slowed down, the company's margin improvement story keeps me positive on the stock, especially given it is now trading at an attractive valuation of 19x forward PE.

Q1 2024 Review and Outlook

The market was not pleased with EXTR's weak forward guidance for the next quarter. The management has revised the FY24 guidance, lowering previous expectations of achieving growth rates in the mid-double digits to mid-to-high single-digit growth. This adjustment is primarily driven by two factors: first, customers and channel partners are working through existing orders and inventory, and second, there are ongoing macroeconomic challenges, particularly in the EMEA region. These revised expectations are attributed to a combination of supply chain issues accounting for 40% of the impact and macroeconomic conditions responsible for the remaining 60%. Additionally, EXTR is implementing changes to its go-to-market organization with the aim of enhancing sales productivity.

EXTR's technology advantage is evident in various significant growth metrics, including a subscription increase of over 30% YoY. This surge is coupled with an increase in both the quantity and size of opportunities, leading to enhanced win rates and an influx of new customers. Notably, there has been a 17% rise in average deal size, with 85% of partners now offering a comprehensive suite of services. Additionally, there's a double-digit rise in new opportunities, over 10% growth in million-dollar deals in the pipeline, and an impressive addition of over 800 active new partners in 2023 alone, alongside a 19% increase in new customer logos. The company is also experiencing a significant channel expansion with the addition of larger networking Value-Added Resellers, Managed Security Service Providers, telecom VARs, and federal channels, underscoring the robust outlook for Extreme's business.

I believe that the stock currently may be oversold and that there is a compelling narrative for significant margin expansion, which is not necessarily dependent on the growth rate. While the company's revenue prospects have diminished, at least for the time being, it's important to note that there is still a substantial opportunity for margin expansion. This can be achieved through the normalization of the supply chain, resulting in improved gross margins and the transition to the Universal platform, which could bring about a 300-400 basis point increase in margins.

Well-Positioned in the Campus Market

Extreme is in a favorable position to offer customers comprehensive solutions that encompass data center switching, campus switching, and wireless LAN products for their IT infrastructure needs, which sets it apart from competitors who specialize in only one aspect of the network. This makes Extreme an ideal choice for providing solutions and is the preferred choice of channel partners, particularly for smaller to medium-sized deployments. Furthermore, Extreme holds a leadership position in customer verticals aligned with the education sector, as well as a strong presence in public sector projects and federal and state government IT initiatives. This positions the company to benefit from countercyclical spending trends, as a significant portion of its portfolio is less affected by broader fluctuations in Enterprise IT spending.

Strong Product Momentum

Extreme has a robust lineup of new products that are expected to contribute to its growth and enhance operating margins. At the core of these innovations is the Universal Platform, which allows Extreme to utilize its software across its existing customer base, encouraging product upgrades and delivering substantial software value to customers. The Universal Platform serves as a gateway, enabling various operating platforms from multiple acquisitions to transition to Extreme's AI cloud and advanced network fabric. It effectively connects customers to Extreme's superior software, including WiFi Edge and SD-WAN capabilities, leading to an anticipated strong wave of upgrades. Moreover, the Universal Platform boasts higher gross margins and significantly streamlines production costs and supply chain complexities.

Valuation

Extreme has significantly lowered its guidance for the fiscal year 2024, now anticipating mid-to-high single-digit growth compared to its earlier projection of mid-double-digit growth. This downward adjustment is attributed to factors such as customer and channel adaptation periods and prevailing macroeconomic challenges. However, the company is shifting towards cloud-delivered products, integrating its entire product line encompassing hardware and software, emphasizing subscription-based models, expanding its distribution network, and enhancing its sales strategies. Furthermore, the company has managed to maintain resilient growth relative to the industry, partly due to substantial market share gains. Although the revenue growth has slowed down, I believe the company can continue to improve margins by the end of 2025, driven by three key factors: supply chain cost normalization, the transition to the Universal platform, and the growth in Software/SaaS subscriptions. Trading at a forward PE of 11.7x, as per Capital IQ estimates, the stock is trading below the sector median and large-cap peers like JNPR and CSCO despite outpacing the industry and its peers in terms of growth. Although the revenue growth story has been unwounded for now, the valuation discount is unwarranted in my view as the margin expansion opportunity is still intact. The risk/reward remains attractive from current levels, and I use the forward earnings estimate of $1.38 and a forward PE multiple of 18x, which is more in line with the sector average and the company's own historical multiple to arrive at a target price of $24 for the stock.

Investment Risks

Extreme could encounter challenges when it comes to integrating the businesses it has acquired. These challenges might include difficulties in retaining customers and achieving the expected profit margins. Furthermore, any merger carries the inherent risk of cultural clashes, resistance from employees who may not fully embrace the merged company's vision, or disruptions in sales efforts. However, I believe that employees from both companies are likely to recognize the benefits of being part of a more robust and capable entity following the merger. Moreover, in the rapidly evolving switch market, there are software-based players that enable the use of bare metal switches and private/white-label switches. Given Extreme's smaller market share and limited exposure to the public cloud, I am not overly concerned that this will have a significant impact on its business in the coming years.

Conclusion

Extreme Networks excels in delivering comprehensive solutions to its customers, spanning data center switching, campus switching, and wireless LAN products. Furthermore, the company holds a prominent position in customer segments aligned with the education sector and maintains a strong presence in public sector projects, including federal and state government IT initiatives. Although EXTR has reduced its growth expectations, I remain positive about the company's margin expansion potential. Given the company is trading at an attractive valuation currently, I assign a buy rating to the stock.

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