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Extreme Surprise

Light Reading
News Analysis
Light Reading
10/24/2003

After several quarters of losses, Extreme Networks Inc. (Nasdaq: EXTR) reported it has finally returned to profitability in the first quarter of fiscal 2004 (see Extreme Returns to Profitability in Q1). And it’s done it ahead of schedule. The news sent Extreme’s stock soaring, despite reporting lower than expected revenues.

The company’s stock was trading up $1.14 (16.16%) to $8.21 per share.

Its operating income was $1.2 million and earnings per share $0.02 for the first quarter. This compared to an operating loss of $14.0 million and a loss per share of $1.44 in the fourth quarter of fiscal 2003. That fourth-quarter loss included a non-cash tax-related charge of $154 million.

During the company’s last conference call, CEO Gordon Stitt predicted the company would reach profitability by the end of fiscal 2004 (see Extreme Optimism Boosts Stock).

Revenue for the quarter remained almost flat, with sales coming in at $87.4 million compared to revenues of $87.3 million in the fourth quarter of fiscal 2003 (see Extreme Losses Dwarf Revenues). Although Stitt had given no formal guidance in the prior quarter, analysts had expected the company to generate about $90 million in sales.

Stitt also announced a new chief financial officer. Bill Slakey, formerly CFO of wireless handheld device maker, Handspring Inc., will come on board in the middle of November. The company has been without a CFO since Hal Covert resigned in July (see Extreme's CFO Checks Out).

The company's gross margin levels improved to 51.4 percent from 39.5 percent last quarter. Some of this increase was due to one-time items.

The company has struggled over the past several quarters to raise margins, while its closest competitor, Foundry Networks Inc. (Nasdaq: FDRY), has seen healthy margin improvement. Earlier this week, Foundry reported gross margins of 67 percent for the September quarter, a slight improvement from margins of 63.8 in the June quarter (see Foundry Revenues Are Up).

Extreme also improved service margins, which had been negative in the previous quarter and were at positive 15 percent in the first quarter. Stitt attributed overall margin improvement to better operational execution.

Stitt expects gross margins to remain around 50 percent over the long term, but he would not give specific short-term targets.

“We will continue to focus on improving operational savings," he said. "But we will see some impact due to Mariner. It’s a pretty minor part of the business, and it’ll have only a small impact on margins.”

What about Stitt’s prediction that Extreme will hit $400 million in revenue for the entire year? Despite the company’s lackluster performance in the first quarter, he said the company is still on target. This means that the company will have to bring in, on average, $104.2 million in each of the following quarters.

“We have a plan, and I am confident in that plan,” he said.

Stitt's optimism hangs on the success of the company’s new line of products (see Analysts Chart Extreme Comeback). During the quarter, the company shipped the Summit 300 wireless switch (see Extreme Ships Wireless LAN Kit). It’s also begun upgrading networks with its new Triumph ASIC products (see Extreme Enhances Alpine Switch and Extreme Goes GigE With Triumph). This migration is expected to take place over the next four quarters, which should help increase sales and gross margins, as the Triumph chipset provides more density on a per port basis.

The company also expects to ship its 10-Gbit/s Ethernet Mariner switch this quarter (see Extreme Intros 10-GigE Platform). The product is currently beta testing. While Stitt said he doesn’t expect it to be a big contributor right away, he seems confident that the high-ticket item will contribute more significantly later in the fiscal year.

Steve Kamman, an analyst with CIBC World Markets, says as long as the company remains profitable, missing revenue targets will have little impact on investors. He currently predicts Extreme to generate $370 million for the year. He has rated the stock Underperform, and his firm currently has no banking business with Extreme, nor does he own any shares in the company.

“Missing $30 million in revenue for the year won’t change the outlook of the company’s financials,” he says. “Investors are getting a lot more money for the margins. That’s what they’re looking at right now.”

Meanwhile, Foundry is improving margins and increasing revenues. In the September quarter, the company reported it had increased revenues to $101.7 million from $95.7 million the previous quarter.

Today, Foundry is trading down $0.31 (1.32%) to $23.25.

— Marguerite Reardon, Senior Editor, Light Reading

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