Commentary
3/4/2003
02:07 PM
William Schaff
William Schaff
Commentary

Taking Stock: Enterasys: Fallen Angel That May Still Fly

Economic benefits of new products won't be realized until 2004



To keep readers awake, I like to throw in something a little different from time to time, so I scanned my "fallen angel" list. These are tech stocks investors used to love that are now struggling to survive. The list is quite long, so I picked an easy one, Enterasys Networks Inc., a provider of local-area network infrastructure equipment for the enterprise. Its products are primarily Layer 3 and Layer 4 to 7 switches and routers, as well as wireless LAN equipment.

The company just reported first-quarter revenue of $104.5 million, a 14% sequential decline from the previous quarter, and loss per share of 5 cents. Not exactly overwhelming. However, as investors, we have to look beyond today's news to decide whether an investment makes sense. Tomorrow looks a lot better.

The company is on a significant new-product binge, and almost all of its legacy products have been improved. The first new products came out recently, such as the Matrix N Layer 3 switches, a highly scalable multilayer-switching solution. One of the exciting developments is an application-specific integrated circuit called Entera ASIC. New-product launches will extend to high-end switching and routing and to wireless systems. This will be done slowly over the course of the year so the economic benefit of the products likely won't be fully realized until 2004.

Risks remain. During the first quarter, the company saw a substantial drop in its service revenue, the mainstay of IT companies in a weak market. Not surprisingly, legacy product service-contract renewal rates were weak. Service revenue fell to $30 million during the first quarter, down 13% sequentially from the prior quarter. As the company markets its new products, investors can expect sales and marketing costs will increase, cutting into operating and profit margins over the next couple of quarters. Potential customers also may be wary of dealing with the company given its tumultuous recent past. It won't help that costs will increase associated with its SAP implementation (let's hope that goes smoothly!). Should we mention the Securities and Exchange Commission investigation into the company's aggressive revenue recognition, or inflation of revenue, which was settled in February? And the fact that the management team is relatively new? But let's give new CEO Bill O'Brien et alia the benefit of the doubt.

Typical of many IT-related companies these days, Enterasys didn't give any revenue and earnings forecasts. But we can crunch some numbers anyway. Cash on the balance sheet was $236.6 million, or roughly $1.17 per share. Not bad for a $2.33 per share stock price (roughly 50% of the stock price is represented by cash on the balance sheet). The company, despite losing money on an earnings-per-share basis in the first quarter, had positive cash flow from operations of about $16 million. It might break even on an EPS basis in 2004 based on revenue estimates of $460 million.

Understand that many stocks at these prices have a strong tendency to go down further as they find few buyers among large investors. Also, if you have to spend 10 cents per share to purchase a share of stock, the stock price has to appreciate almost 10% to justify the trading costs (both in and out) based on the current price of $2.33 per share. Don't you long for the good old days of 1998-1999?

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected].

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