While the frothy world of speculative excess bubbles up in social-media IPOs, Tesla, and Bitcoin, the same cannot be said for the old-school networking business, where hardware margins and deal premiums are shrinking.
Case in point: Extreme Networks (EXTR), whose shares have spent the better part of a decade going absolutely nowhere — until recently. Extreme recently closed on the deal announced in September in which it bought Enterasys Networks for $180 million. Enterays Networks had trailing twelve months revenue of $330 million, making the revenue on that deal a paltry .54.
Extreme’s deal was a shocker, because the price was low and it represented yet more consolidation in what has been a challenging network hardware market. Extreme may now actually leapfrog Dell, Brocade, IBM and DLink in the market share rankings with the Enterasys acquisition, according to Dell’Oro research quoted in a recent Jim Duffy article.
But from Extreme’s perspective, the deal was received well by the market. The stock has more than doubled since the deal was announced. You could have picked it up for under $3 this summer and it’s now trading North of $6. The reason? The acquired a lot of revenue and assets for a bargain price. Extreme’s revenues, around $300 million per year prior to the deal, had been shrinking for years. It has now quickly doubled its size.
This deal had many tongues a wagging, not only for the chutzpah Extreme had in gobbling up a company that was roughly the same in revenue terms, but for the price it paid.
“That deal tells you all you need to know about how people are valuing hardware,” says a source of mine in Silicon Valley, a former executive at a big public networking company.
It’s true. That’s the kind of revenue multiple you would see on a rust-belt tire manufacturer. The market now views networking hardware companies as has-been plays not worthy of deal premiums. Cisco’s (CSCO) valuation is now at trailing price/earnings ratio of 10 and a price/sales ratio of 2.33. And those ratios have been compressing. Can they compress further? Sure.
As you look at the big networking trends of virtualization, cloud services, and software defined networking (SDN), it’s clear that the value in the “networking stack” — as those networking geeks like to call it — has climbed up high above the hardware into the networking applications you can build on top of the boxes. Enterasys was coveted by Extreme because its network management software is well-regarded.
And if these trends are long-term, and everybody says they are, you can expect further compression and multiples in the old-line networking companies selling proprietary hardware and software. All of those talk of SDN — which ultimately entails running more open software on anybody’s hardware box — means companies such as Cisco, Juniper (JNPR), Extreme, and F5 Networks (FFIV) are going to have a harder time defending their tightly integrated hardware and software platforms.
(Disclosure: No positions in stocks mentions. The author previously disclosed being short F5 Networks, but he recently covered the trade for a small gain.)