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Aruba Networks Seems Cheap But Is There Value?

Richard Saintvilus

NEW YORK ( TheStreet) -- Warren Buffett famously said "Price is what you pay. Value is what you get." Investors who struggle with making this distinction between price and value might find it difficult to avoid a stock like Aruba Networks that has recently fallen by as much as 44% over the past several weeks after reporting a brutal fiscal third-quarter report.

Although the stock has rebounded 20% from its $12.38 low, fears about the overall health of the wireless local-area-network (WLAN) market continue to add pressure on Aruba's near-term prospects, which caused the panic selling. Making matters worse, network giant Cisco , which owns more than half of the WLAN market has shown no such weaknesses.

What's more, given Cisco's recent comments regarding WLANs and what seems like CEO John Chambers' renewed commitment to growing that part of the business, current Aruba investors should consider that the worst might not be over. Even more disappointing, was that Aruba blamed Cisco's aggressiveness, which included pricing discounts, for Aruba's disappointing third-quarter results. But is Cisco really to blame?

As much as I've always liked Aruba, one of my major concerns has been the competition. I've never felt that Aruba's management addressed the company's leverage well enough. And it seems that it's precisely this deficiency that has now come home to roost.

Still, Aruba's earnings results were not that all surprising -- as bad as they were. Management had already issued a warning to investors a couple of weeks prior that the results were going to be below estimates. Plus, given the fact that Aruba relies so heavily on government contracts, the issues regarding the government sequestration didn't help matters.

To that end, Cisco, which also relies on government spending as well as large corporate customers, saw an opportunity to close some deals (with or without discounts). Unfortunately, Cisco's leverage was used to squeeze out Aruba, which reported an 8% drop in earnings-per-share, when excluding items.

Relative to sell-side estimates, that was not a complete disaster. The company missed EPS estimates by just one penny. This is while postingg 12% revenue growth that was in-line with expectations. But as is often the case, it's not so much about what is reported, the stock reacted to what Aruba is now expected to report.

Management guided fourth-quarter EPS to come in at 11 cents on revenue of $149 million -- both below expectations. Analysts were looking for 17 cents per share (excluding items) on revenue of $157.1 million. There are a couple of ways to play this guidance, though.

Essentially management is calling for 38% year-over-year drop in earnings per share after the company earned 18 cents per share in the year-ago quarter. Likewise, revenue is expected to grow at only 7%, which would represent decelerated year-over-year growth of 15% and 5% sequentially. These numbers presume (relatively) no growth for the coming quarter.

It's entirely possible that management has created a worst case scenario and tossed everything out, including the kitchen sink, which can be brilliant, by the way. For example this is precisely what Apple has done with its third-quarter guidance. For Aruba, though, I don't believe that the WLAN situation is this dire.

While I won't begrudge investors for having bailed on the stock, whether to lock gains or to cut their losses, this may prove later to have been an erratic move. For new investors, though, that are looking to "test Aruba's waters," the question to ask is, how much of Aruba's struggles has more to do with poor sales execution vs. the idea Aruba might be losing both market share and its "best of class" status.

In that regard, there are two major factors that investors have to consider. First, it's still unclear when enterprise IT spending will fully rebound. Although analysts are projecting a possible recovery in the second half of the year, recent earnings and/or a combination of earnings and guidance from enterprise players like IBM and Oracle suggests that corporate leaders aren't feeling as optimistic.

The other issue is, even if the optimism were there and enterprise IT spending does rebound faster-than-expected, will WLAN be an important IT priority to the extent that interest in the bring-your-own-device (BYOD) market comprises of a meaningful enough portion of the expense budgets to matter to Aruba? The good news is that Cisco seems to thinks Cisco's efforts to build its WiFi capabilities.

I do wonder, though, why Cisco has not yet picked off Aruba, especially since Aruba has opted to not drop its prices. It would make sense for Cisco to acquire Aruba's best-of-class WiFi assets while also capitalizing on Aruba's strong margins. At that point, Cisco wouldn't need to sacrifice its own margins with aggressive discounting. With Aruba's stock trading at such depressed levels this is a situation that bears watching.

I'm not advising diving in head first in Aruba. But I believe there is considerable amount of value to be had -- despite the competitive pressures. In the meantime, though, there is urgency for Aruba's management to differentiate the business. And I think a focus on security and/or a combination of security and software will add tremendous long-term value while the WLAN market recovers.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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