The networking equipment industry has been a tough one to navigate this past year. Investors who have been following this market should have noticed several major trends by now – a heavy dependence on government, telecom and enterprise spending, a brutal pricing war, and a revelation that in tough times, leaner businesses fare better. It’s often difficult for these companies, which offer a wide variety of products, such as switches, routers, wireless LAN equipment, application delivery controllers and network security equipment, to outmaneuver each other, since relative size and pricing power can easily allow larger companies such as Cisco Systems, Inc. (NASDAQ:CSCO) to crush the competition.
In this article, I’ll examine three names in the networking field – Aruba Networks, Inc. (NASDAQ:ARUN), Palo Alto Networks Inc (NYSE:PANW) and Ciena Corporation (NASDAQ:CIEN) – which respectively represent weak, mixed and strong players in this cutthroat industry.
Aruba Networks, Inc. (NASDAQ:ARUN)
Aruba Networks, Inc. (NASDAQ:ARUN) Networks’ primary business is wireless LAN (WLAN) equipment focused on the enterprise market. It specializes in wireless access points, mobility controllers and network management software. The Sunnyvale, Calif.-based company is currently the second largest WLAN equipment manufacturer in the world, with a 10.6% market share in 2012, which only trails Cisco Systems, Inc. (NASDAQ:CSCO)’s 50.7%. Over the past five years, Aruba Networks, Inc. (NASDAQ:ARUN)’s top and bottom lines have risen 58.6% and 75.7%, respectively, fueled by strong demand for increased wireless connections in the workplace.
That growth, however, came to a grinding halt after the company reported disappointing third quarter earnings on May 16. Aruba Networks, Inc. (NASDAQ:ARUN) posted a net loss of $0.18 per share, or $20.2 million, an alarming decline from the profit of $0.05 per share, or $6.0 million, it reported in the prior year quarter. Adjusting for one-time charges, the company earned $0.11 per share, which still missed the consensus estimate by a penny. Revenue climbed 12% to $147.1 million, topping analyst forecasts.
The primary reason for this disconnect between Aruba’s top and bottom-line growth was its loss of pricing power. During the quarter, Cisco started bundling WLAN products together with its routers and data centers at steep discounts, sacrificing margins with the goal of capturing more market share from Aruba, Hewlett-Packard Company (NYSE:HPQ) and Ruckus Wireless Inc (NYSE:RKUS). As a result, the government, telecom and enterprise sectors which Aruba heavily relies on flocked to Cisco instead, since Cisco could bundle WLAN equipment with other networking products that Aruba was unable to offer.
Last quarter, Cisco reported 5.4% and 14.5% increase in its top and bottom lines, respectively, indicating that not only is the company’s pricing strategy working, but it also hasn’t hurt its profitability. For now, it seems like Aruba has given up on fighting Cisco, and provided weak guidance for the fourth quarter that missed analyst estimates by a wide margin.
Palo Alto Networks Inc (NYSE:PANW)
Another recent loser in the networking industry is Palo Alto Networks Inc (NYSE:PANW), which specializes in high-level network security systems. Although the Santa Barbara, Calif.-based company only went public last July, it has been around since 2005, and grown on robust enterprise demand for strong protection from increasingly dangerous hacking attacks. The business model appeared to have high growth potential, since its core business of firewalls was a much higher-margin business than traditional network equipment, such as routers, switches or WLAN equipment. For a while, investors agreed, bidding shares up 69% from its IPO price of $42 to $71 by last September.
However, the stock, which now trades at 112 times forward earnings, couldn’t escape fundamental gravity forever. For its third quarter, the company reported a net loss of $0.10 per share, or $7.3 million, on revenue of $101.3 million – missing analyst estimates on both top and bottom- line growth. Although revenue rose 54% year-on-year, sales and marketing expenses climbed 5.1% and now account for 51.1% of the company’s total revenue. In other words, Palo Alto Networks Inc (NYSE:PANW) spent too heavily to expand its customer base.
To make matters worse, the company issued a warning for its third quarter, stating that revenue would come in lower than the $113.7 million that analysts were expecting. It stated that weakness in Europe and spending cuts in the U.S. government would exacerbate its losses in the near term. Europe accounts for 20-25% of the company’s top line, while the U.S. government comprises 10%.
Although Palo Alto Networks Inc (NYSE:PANW) might have some solid growth potential in the future by capitalizing on the growing need for network security in both the public and private sectors, the stock’s feverish fundamentals indicate that it will probably cool down considerably.
Ciena Corporation (NASDAQ:CIEN)
Last but not least, network equipment maker Ciena Corporation (NASDAQ:CIEN) proves that sometimes less is more in the industry. The Hanover, Maryland-based company recently reported a second quarter loss of $0.27 per share, or $27.1 million, a slight improvement from the loss of $0.28 per share, or $27.8 million, it reported in the prior year quarter. Adjusted earnings dropped year-on-year from $0.04 to $0.02. Revenue rose 6.3% to $507.7 million.
While Ciena Corporation (NASDAQ:CIEN)’s top and bottom-line growth seem fairly meager, shares surged 17% on June 6. What happened?
Improved sales of Ciena Corporation (NASDAQ:CIEN)’s optical network switches and broadband access products, which drive Internet traffic around the world, was the primary reason. As a result, product sales rose 7.2% to $413.2 million, while services revenue climbed 1.7% to $94.5 million. Ciena also reported increased purchases from Tier 1 U.S. telecom companies, such as AT&T Inc. (NYSE:T) and Verizon Communications Inc. (NYSE:VZ), which are currently expanding their 4G services. Therefore, optical network products, which can transport data faster than traditional networking equipment from rivals such as Cisco, should remain in high demand.
The rising adoption of mobile devices and the growing demand for cloud-based computing are expected to fuel long-term demand for higher-speed 100G connections to increase nationwide machine-to-machine connections. Market research firm Frost & Sullivan estimates that the global 100G market will rise from $892 million in 2012 to $4.8 billion by 2016.
Wells Fargo analyst Jess Hubert forecast that Ciena’s sales volume and margins could further improve over the next few quarters, since its higher-margin converged packet optical and carrier Ethernet solutions, currently in the trial phase, could soon be released commercially.
The Foolish bottom line
A lesson we can learn from a comparison of these three companies is simple – networking companies need to realign their businesses rapidly to address the shifting demands of the market.
Those that offer no discernible advantages over their larger rivals, such as Aruba Networks, will eventually be crushed. Companies that spread their resources too thin and spend too heavily, such as Palo Alto Networks, will eventually sink into unprofitability. Lastly, companies that have a longer-term view of the Internet and the simpler, higher-volume components it needs to continue growing at an exponential rate, such as Ciena and Cisco, will thrive.
Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems (NASDAQ:CSCO)
The article Two Losers and One Winner in the Networking Industry originally appeared on Fool.com and is written by Leo Sun.
Leo is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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