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Extreme Networks Rides the Wave
In business, turnaround stories are very rare. It's difficult to take a company on the brink of extinction through a revival that ultimately ends with that company roaring back to be a power. That's because there are typically issues in the company's structure or market conditions that prevent such a come-back. However, it does still happen. Apple and Microsoft are two companies that come to mind that have been able to catch a wave and ride it to regain their glory.
In the networking space, it's even more difficult, as that market has been dominated so long by Cisco that it's left very little room for anyone else to establish itself as a major vendor. Sure, many have tried, but names like 3Com, Foundry, Force10, Meru and others have tried only to ultimately face irrelevance.
This is what makes Extreme Networks' story so fascinating. Five years ago, the company was nothing more than a niche vendor with a handful of loyal customers that were waiting for the doors to close. If I brought up Extreme to a customer or investor they would either laugh or say, "Are they still around?" The company tried to do something about it in 2013 by merging with Enterasys Networks, but as the saying goes, if you tie two people together, each with one broken leg, they still can't walk. The management team at the time completely bungled the acquisition and irked both customer bases. Instead of using Enterasys to turn around Extreme's business, it actually drove customers away.
Then along came the dynamic duo -- Ed Meyercord, CEO and president, and Norman Rice, chief marketing, development and product officer -- who have proven to be the Belichick and Brady of the networking world. When they took the helm, I thought their mission was to slash and cut the workforce and sell the company off in some sort of fire sale. Instead, the company took a different approach. It looked for good products that were lost in larger organizations that didn't fully understand networking and then acquired those assets for a fraction of their value. This included the Wi-Fi business from Zebra Technologies (point of sale), campus networking business from Avaya (UC/CC) and data center products from Brocade (data center).
The result is a network vendor that is knocking on the door of $1 billion in annual revenue. Extreme has also improved its position in the Gartner Magic Quadrants for Data Center and Wired and Wireless LAN, and now has the ability to cross-sell products from its various portfolios into the different installed bases. For example, a large retailer is currently a (Zebra) Wi-Fi customer and is now evaluating campus (Avaya) and data center (Brocade) products. The combined company is now the number three enterprise networking vendor and has the opportunity to challenge HP and Cisco in many larger accounts.
But It's Not All Smooth Sailing
Over the past few quarters though, Extreme has hit some rough surf, making one wonder if the opportunity for Extreme is real, or if it's just smoke and mirrors.
Last week, the company announced its Q4 and FY2018 financial results, and both revenue and margins were at the low end of guidance. One miss is fine, but this is the third quarter in a row after reporting a "beat and raise" for 13 consecutive quarters. Also, the miss (within guidance but the street likes it to be at least at midpoint) was on a revenue bar that was reset the quarter before. Looking ahead to Q1 FY19, Extreme guided to a number that was lower than expectations, indicating another reset of the bar.
The numbers tell a grim story, but I believe what the company is experiencing is growing pains. The bet that Extreme made on the enterprise opportunity is still very real. In fact, Arista's campus switch announcement and recent acquisition of Mojo Networks supports the thesis that the enterprise is where the future of networking is, and Extreme is certainly well ahead of that curve. The missed revenue relative to expectations has more to do with Extreme needing to fix lingering issues with the companies it acquired.
Holes in the Boat
If you've followed my posts, you're aware that I felt the Avaya Fabric solution was highly differentiated and something Avaya should have been able to use to establish itself as a real network vendor. The issue was that Avaya sales and marketing were so tightly tied to its bread and butter, that UC, contact center, and networking almost became features of those initiatives. There were a few individuals such as Nidal Abou-Litaf who understood how to sell the "full stack," but many ignored networking. If they sold it, it was often at a hefty (sometimes 90%) discount just to get the product in the door.
When Extreme took over Avaya's networking business, the systems were not tied together and the Avaya back-end provided very little visibility into the breakdown of business. For example, if a deal was registered as $1 million, there was no indicator as to whether that was 50% UC and 50% networking or 95% UC and 5% networking. Assumptions were made by the sales teams, but those wound up being way off and, as a result, the number Extreme forecast was off on revenue and on margin, because of the discounting.
Over the past few quarters, Extreme has worked to correct what is deemed as bad behavior by the Avaya sales team, and those that get it and have changed are still at the company. Those that haven't changed are systematically being replaced.
Brocade is a different issue that had a similar result. Brocade's data center business came from the acquisition of Foundry, which had a reputation of being customer-driven with code. Its willingness to create almost custom code was what leading-edge customers liked about Brocade on the networking side. Brocade had many service providers and high-end data center businesses that wanted new features fast. A good analogy for this is that I'm part of the Apple beta program for iPhones. I download the OS early and have access to new features, but the price I pay is its buggy. I'm willing to make that trade, as were Brocade customers.
But now Extreme is selling to mainstream enterprises and that "buggy" approach needs to change and be more disciplined with software. There were a couple of other issues related to discounting that held back the business. The net result was that the original forecast for the Brocade business was $230 million and Extreme has knocked that down by about $50 million to where the business is. Extreme also made a leadership change to manage the Brocade business. The team now reports into Bob Gault, chief revenue and services officer at Extreme. And he is about as good as they come, so I expect a much more smoothly run business.
Some of the challenges have been people-related, and that was tough to predict given the way Extreme inherited Avaya and Brocade employees. With Avaya, Extreme was given a list of names and it checked boxes to keep or not keep, but didn't have that much time to do due diligence so it was a bit of a crap shoot. Extreme followed a similar process with Brocade, but the company was broken up into 11 pieces prior to the Broadcom acquisition and Extreme was one of the last to get employees. The good news is that Extreme is willing to swap out underperformers, or people that don't fit, to ensure they have everyone on the same page.
Sealing the Leaks, Sailing Ahead
The business wasn't all doom and gloom, though, and this leads me to believe what Extreme is facing isn't market or competition related; rather, it's internal and can be fixed. Highlights from this quarter are:
- Year over year growth of 56%
- Core business grew 5%, the fifth consecutive quarter of organic growth
- Gross margins in the mid 50% range
- Avaya gross margins are now 55%, up from 45% at acquisition time
- Zebra is now in 50% of the Fortune 50
- Cross-sell deals were $23 million, with almost $100 million in the pipeline
- 20 deals of $1 million or more
- Record quarter for software at $11 million
The plan for the new Extreme is sound. The combination of Meyercord and Rice have put the company on a trajectory it hasn't seen since the late '90s. If a mistake was made, it was in underestimating the difficulty in integrating Avaya networking and Brocade data center businesses into the company at the same time. This would have been a challenge if the acquired companies were well-run, but Avaya was entering bankruptcy and Brocade was being chopped up and those businesses were a bit of a mess.
Customers, resellers, and partners of Extreme should feel confident in the long-term outlook for the company, but it's taking a bit longer for it to get there as it wants to run the business the right way and not take short-term money at the expense of long-term health.
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