Aruba Networks Posts Strong Revenues But Margins Struggle

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By Thomas Copeland on May 30, 2014 Technology & Software

It was the same story for Aruba in the fiscal third quarter—strong revenue upside was not able to produce the elusive operating leverage the bulls have been expecting, and EPS were only in line with consensus. Unlike last quarter, however, when higher spending was the culprit, this quarter gross margin was the issue, driven mainly by the discounting of premium 802.11ac access points (AP 225) in the value segment of the WLAN market, where Aruba’s lower-cost access point (AP 205) was not yet shipping. This was a surprise to us, especially as our VAR discussions centered on strong demand, backlog build, and share gains for Aruba, which we believe played out in the quarter.

Nonetheless, we strongly believe this margin hiccup is temporary, and we do not believe it should overshadow an otherwise strong third-quarter performance and a guidance raise for the fourth quarter (which still looks conservative). Overall, we expect Street consensus estimates to rise modestly for both the fourth quarter and fiscal 2015, and we expect improved leverage with management reiterating its 20% operating margin target for the fourth quarter (up from 17% in the third quarter).

The sizable dip in product gross margin (from 71.6% in the prior quarter, to 69.4%) was attributed to two main factors: 1) the 11ac product mismatch in the value segment of the WLAN market (which includes K-12 and state and local government) and 2) a higher mix of switch sales, which carry lower gross margins (in the 50%-60% range). Management noted that the lower-cost AP 205 will ship this quarter, which will eliminate this mismatch problem and return gross margin to the target 71%-73% range in the fourth quarter and beyond. Management chose to go after this business despite the temporary margin hit due to the importance of share gains during major technology transitions like the one that is occurring with 11ac.

Recapping the third quarter, revenue of $189 million topped consensus by roughly $8 million while non-GAAP EPS of $0.20 were in line with the Street target. Once again, topline strength was broad based, with both sequential and year-over-year growth across all geographies, as well as continued order strength for 11ac, ClearPass (up high double digits) and Aruba Instant (up more than 100%). Management pointed to greater-thanexpected switching revenue being a function of the all-wireless office concept taking off, diminishing the advantage of incumbent switching and routing vendors (like Cisco [CSCO $24.38; Outperform]and Juniper [JNPR $24.70; Outperform]), which has been a key part of our secular growth thesis for Aruba.

Revenue guidance for the fiscal fourth quarter was convincingly ahead of consensus at the midpoint ($192 million to $196 million versus Street at $188 million) and translates into 25%-28% revenue growth year-over-year. In addition to a return to the low-70s gross margin, management reiterated its expectation of reaching 20% operating margins for the fiscal fourth quarter. Non-GAAP EPS guidance of $0.22 to $0.23 was slightly higher than the $0.22 consensus estimate, as higher revenue should bring stronger operating leverage on previous sales-and-marketing investments.