Extreme Networks (EXTR): Competitive With Pricing Power, But Wait For Supply Chain Update

The one-year price performance of Extreme Networks (NASDAQ:NASDAQ:EXTR), a leader in cloud networking, contrasts sharply with the tech-heavy Invesco QQQ Trust (NASDAQ:QQQ) as shown in the blue chart below and is due to its favorable growth and profitability metrics as this thesis will elaborate upon, with the second quarter fiscal year 2023 results to be announced on January 25.

Moreover, looking into the products portfolio, they can simplify the management of network endpoints across customers’ IT infrastructures and are appealing for cybersecurity purposes too. However, far from bragging about their merits, the aim of this thesis is instead to highlight how these can improve operating efficiency for customers, and this, in an economic context where the cost of doing business has increased substantially due to inflationary pressures.

Also, taking into consideration the competition, I will also assess whether the company can increase pricing to absorb supply chain overheads in a dash to sustain profitability, especially in light of China’s rapidly easing Covid lockdown measures.

I start with how the company has positioned its products.

Product positioning and Revenue Growth

The way the company has developed its portfolio, either organically or through M&As shows that it has positioned itself at the edge of the corporate network, namely through products like Fabric Connect and Extreme Fabric Attach as pictured below.

In fact, the edge is where its clients, which come from many industry verticals interact with their customers. These interactions can take the form of mobile transactions, IoT device communications, or simply employees accessing the corporate network for remote work. As such, the edge is also synonymous with vulnerability in terms of cyber threats.

This diversity of user endpoints, or points at which they access the corporate network also implies that IT departments experience considerable challenges in administering these.

To address the challenges, Extreme’s Smart OmniEdge networking solution provides a unified Wi-Fi and wired infrastructure equipped with AI technologies that cater to both cloud and on-premises scenarios. This is all accessible through a centralized management console. Noteworthily, in contrast to a dispersed structure, a centralized organization, for administrating the network can prove to be speedy for decision-making, especially for IT functions where failure to take timely actions can result in millions of dollars of losses in downtime or loss of data.

Another advantage of centralization is the ease of enforcement of standards, whether it is for improving performance or compliance purposes. There are also advantages in terms of the number of employees who have to be employed, especially if some of the repetitive tasks like checking logs are automated using AI-driven applications.

Thus, for Extreme, applying automation features, not only makes management nimbler and scaling of the infrastructure easier in terms of services, users, and devices but, also optimizes TCO (Total Cost of Ownership) for customers. Also, as seen by the quarterly year-on-year acceleration in revenue growth to 20% in the March 2021 quarter (table below), after four consecutive quarters of regression, Extreme’s products were rapidly adopted by companies migrating their IT workloads to the cloud as part of Covid-led digital transformation projects.

Talking specifics, the company was able to bag contracts as it adapted its network architectures to a cloud-first paradigm away from conventional hardware appliances.

However, there has been a deceleration in the rate of growth, to 11.2% in the third quarter of 2022, while the cost of revenues has increased by 16.9%. This is due to higher supply chain-related expenses, without any corresponding increase in product pricing, probably because of the competition.

The Competition and Supply Chain

Extreme designs and manufactures both wired and wireless network infrastructure equipment. It also develops software for network management, analytics, and security. This signifies that it competes with bigger companies like Juniper Networks (JNPR), Cienna Corporation (CIEN), and Cisco Systems (NASDAQ:CSCO) as shown in the table below.

First, a comparison of the revenue growth shows that except for Juniper, Extreme is growing faster than its peers. Second, Juniper is ahead of everyone else among network manufacturers as it is also cloud-centric, and has included a high dose of software-defined networking and AI in its product lines as I detailed in a previous thesis. This also explains its pole position in Gartner’s Leaders Magic Quadrant as pictured below.

However, Extreme is close behind and it also forms part of the leadership pack.

Still, despite its significant level of differentiation, Extreme still faces competition and this is the reason why it proceeded to “a very modest and targeted price increase” which became effective on October 1. This resulted in customers reducing bookings, but it was much less than in 2022 when Extreme resorted to a 12% price hike. This was done in the footsteps of Cisco incrementing prices.

As a result, Extreme should benefit from an increase in revenues in the second quarter of fiscal 2023 which ends in December 2022. At the same time, it has qualified more component (electronics and semiconductors) suppliers from China and Taiwan from whom it purchases parts for eventually assembling its networking equipment. This diversification in sourcing parts can result in a lower cost of revenues, with the management also anticipating a reduction in expedited fees incurred as freight costs for components sourced from East Asia reach its main hub in El Paso, Texas.

Discussion and Key Takeaways

Therefore a combination of factors ranging from higher product pricing, a more diversified component sourcing strategy, and fewer shipping expenses could see an increase in non-GAAP gross margins, possibly above 60% for the second half of its fiscal year, lasting from January to June 2023.

This compares to 57.6% in the first quarter of fiscal 2023 (Q1) which ended in September 2022. This was up by 0.6% from the June quarter and was attributed to an improvement in the supply chain and a reduction in freight costs, which was slightly offset by changes in the products/services mix.

However, this trend in supply-side improvement could be put in jeopardy, as with China rapidly easing its Covid zero policy, there has been news about 60K death with hospitals and healthcare systems being overwhelmed. Now, this may also cause some disruption in industrial activities in case workers did not have access to components factories, in turn preventing the fulfillment of overseas orders for the second quarter (Q2).

As a result, the company could face a shortage of raw materials resulting in lower production volumes which can impact its growth forecast of 10%-15% for fiscal 2023. Alternatively, Extreme could reach growth targets but at the expense of gross margins in case it has to incur higher costs to source chips from pricier Taiwanese companies or suffer from exceptionally high supply chain costs as a result of Covid hampering economic activities in China. In this case, the stock could suffer from volatility in case the management downgrades its guidance for the current fiscal year.

This is the reason why it is better to wait for an update from the management during Q2’s earnings call on January 25 before making an investment decision. Also, with a valuation grade of “C“, Extreme is overvalued with respect to the IT sector based on most metrics and does not represent an opportunistic buy for the time being.

Finally, with the progress made in component supplier diversification and together with some level of pricing power, this is more of a stock to be put on your watchlist. Also, with the latest record backlog figures amounting to $555 million, or about two quarters of sales, this implies that once supply chain issues are resolved, there are longer-term growth prospects.