Description

Meru Networks (COMP:MERU) - $2.65

July 2012

[Note that this write-up was substantially complete prior to Thursday’s earnings, and while it was obviously a better deal pre 60% move, given the magnitude of the mis-pricing, the idea is still very actionable, in my view (it’s also been meaningfully de-risked, IMO, given a very event-filled, treacherous FQ2 (CEO transition, new financing, macro deterioration for enterprise tech, etc.).]

Meru Networks is a long at current levels ($2.65), as the market dramatically underestimates the Company’s asset value and potential upside in a takeover.  The Company, arguably one of the worst performers from the tech IPO class of 2010 (see BSFT, QNST, RLD; to be honest SMT and MERU are in classes of their own), is now firmly in distressed tech territory.  Despite rapid (albeit now slowing relative to the recent past) growth in the enterprise WLAN market, Meru has struggled to keep up.  Recent large salesforce expansions, coupled with management turnover, have exacerbated operating losses.  The appointment of Bami Bastani and financing from Western Technology signal a turning point, in my view, and will help to stabilize the business (taken at face value, these two events (Bami + expensive, dilutive financing) are notionally bad, but there is MUCH more to them relative to what the street believes).

In my view, this type of turnaround comes in two parts; (i) stabilize the business / cash burn (perhaps you can grow a bit as well, would certainly be nice) and (ii) sell the business to a larger, tech-focused hardware company.  As to this latter part, I think we could see Meru in a sale process by the end of 2012 or early 2013 (may coincide with round 2 of WLAN deals – round 1 being 2008).

Key Stats

• Share Price – $2.65 (17.7mm shares, 11mm float)
• Market Cap – $47mm
• EnterpriseValue – $29mm (lots of moving pieces given financing / cash burn)
• ADV – 200k shares
• Short Interest – 2.4mm shares (14 days to cover / 22% of float)
• Key Holders –VC backers Clearstone, NeoCarta and DE Shaw
• Performance – shares off 36% YTD and 75% LTM

The Company, based in Sunnyvale, was founded in 2002, with initial VC backing from Clearstone & NeoCarta Ventures.  Meru produces and markets enterprise wireless local access network (WLAN (e.g. WiFi)) gear, which is distributed to VARs and then sold to business customers (anywhere from SMBs (10-100 employees), medium-sized businesses (100-500 employees) and everyone else).  Back then, we had neither the iPhone nor BYOD theme (bring your own device, just listen to five minutes of any Arubaconference call), and the WLAN market was almost non-existent.  Businesses were still ‘fully wired’, using (primarily) Cisco Ethernet switches.  A fair amount of VC was allocated towards WLAN (Aruba, perhaps the most notable, was founded in 2002 with backing from Sequoia and Matrix Partners).  Meru went on to raise several additional rounds of venture financing throughout the decade (2004, 2005, 2006, 2007, 2009 – I estimate at least $150mm of VC financing) prior to filing for an IPO in late 2009.  In between these financings, the BOD hired Ihab Abu-Hakima, a former Proxim executive, to drive further growth and professionalization in the business (Ihab left the Company in late 2011).

Meru went public in March of 2010, at $15 per share (noteArubawent public in 2007, and set good precedent in driving investor awareness of WLAN).  Shares did extremely well, for a period of time.  However, eventually, Meru’s growth engine began to stutter, as Meru’s end-markets (primarily education, healthcare and hospitality) faced headwinds.  Perhaps more importantly, the salesforce expansion was poorly managed, and operating expenses ballooned.  Meru began to miss estimates, Ihab resigned, and the stock has since fallen off the radar.  The past year has been, well, terrible for Meru, albeit for different reasons thanAruba.

Industry / Product

From a product standpoint, Meru provides virtualized, single-cell WLAN products.  Taking a step back, WLAN networks provide wi-fi access, via radio-frequency enabled routers (think of a souped-up version of the Linksys or Cisco wireless router in your home), that allow for wireless access within an enterprise.  This channel-driven market is dominated by Cisco, Aruba, and to a lesser extent, Motorola Solutions.  Most WLAN product operates on micro-cell architecture; the key difference being the ability to shift between wireless channels (within a given frequency, 2.4 GHz or 5 GHz within the 802.11 wireless standard).  Frankly, in my diligence on the topic, I don’t think that there are any MAJOR differences between single or micro, except that most of the market uses micro.  I think this is largely a function of leaders’ (Cisco & Aruba) preference to mirror the overall build-up of cellular networks (which are also micro-cell based).  Meru will pitch as to why virtual-cell is better (allows for fewer access points, given they only operate in one channel and therefore don’t have handover issues), and Aruba (primarily) will argue as to why micro-cell is better (handover issues no longer relevant, if ‘everything’ goes down within a channel on single-cell, you have issues).

Taking a step back here, WLAN product has two functional parts; controllers (the brains) and access points.  Controllers coordinate network policies and regulations, and are often located on premise (each controller can support anywhere from 30 to 1,500 access points).  To expand, controllers can sell for ~$5-8k whereas access points can sell for ~$300-600 (the averages vary dramatically, based on power / frequency / etc.).  One of the more interesting trends within WLAN has been the shift to a virtualized infrastructure, whereby the controller is managed ‘in the cloud’, by the vendor (as opposed to the customer).  As end-user (CIO) comfort with ‘the cloud’ grows, this virtualized network approach is gaining popularity.  This is a concern, as the market matures, but not overly consequential for Meru given security pricing (this was and is a big concern of mine forAruba).

Access Points, in general, are big-boy versions of the Linksys router that you have at home (with more security and power).  These products are often contract manufactured, using Atheros radio-frequency silicon, and sell for ~$300-700 each.  Each vendor integrates a certain amount of software into the AP, but, in general, they are fairly similar (at least in my view).

Why is this such a sexy area of growth?  Listen to one ofAruba’s conference calls, and you’ll hear (repeated) references to Bring Your Own Device (BYOD).  This now ubiquitous theme refers to the proliferation of clients (iPads / iPhones / Android-based phones) within the enterprise.  This pronounced trend is here to stay, and CIOs must deal, by providing secure, wireless access within the enterprise.  Gartner and Dell Oro publish relevant market data, for those wanting additional context.  Meru, with low single digit market share, participates in niche markets within WLAN (they will never go head-to-head with Cisco orArubaover 2,000+ AP deployments, within large enterprises).

Recap / Stock-Specific Information

Put yet another way, I think Meru’s products are fine and functional, however, as you can tell, Meru has major operational and financial issues.  Two principal issues stand out to me; (i) Meru has been unable to gain meaningful share outside of the core education and healthcare verticals (both faced headwinds due to budgetary constraints) and (ii) Meru’s recent sales force expansion has come at a dear price, especially in light of the muted growth profile.  Let’s discuss these in a bit more detail:

1. Growth – While Meru had been growing revenues, this growth paled in comparison to other WLAN vendors.  From what I can gather, Meru’s go-to-market strategy had been described as ‘increasingly confused’ and lacking in direction.  Their key verticals (education, healthcare & hospitality) drive ~60% of revenue, and given budgetary constraints, this has been an issue.  75% of revenue comes from existing customers, who constantly augment their existing network.  As we’ll see in the next point, they have been working to diversify and grow outside of the core verticals (and this has come at a price).
   1. General industry professionals (trade mags / consulting firms that I know through prior work on Aruba) like Meru, and regard the products as ‘fine’.  Meru cites ‘high’ win rates, but they’ve just had issues getting in front of the right people.  That said, it’s very difficult for Meru to compete head-to-head for large-scale enterprise WLAN deals againstAruba or Cisco.
   2. Educational and healthcare CIOs have universal knowledge and acceptance of Meru products, but it’s not as if there is tremendous moat (I’m not sure that moat of that sort exists in WLAN).
2. Expenses – Salesforce additions over the last year have been very costly, and have simply not yet translated into additional revenue growth. We’ve certainly seen the impact to expenses, where sales & marketing have ballooned towards 80% of revenue, but these reps take time to season.  See the below chart for ugly details (although please note the sharp improvement in FQ2 operating / financial metrics).
   1. They’ve roughly doubled the salesforce, from March 2011 to 2012.  Yet they’ve seen very little incremental revenue growth.  Why is this?  I think there are two principal reasons; (i) it takes six to nine months for salespeople to become productive and (ii) Meru’s leadership vacuum exacerbated these issues.  Consider Meru’s 70 territories (each headed with a regional sales manger), 30 of which have been added over the last year.  I’m told that existing, mature RSMs generate $2-2.25mm.  The implied contribution for everyone else is just horrifically bad.  Will this improve?  Yes, I think so, but given the lack of direction it’s unlikely to get to full productivity, at least in the near-term.  I do, however, think that we’ll see meaningful improvement given (i) normal ramps in productivity and (ii) normalized / forced attrition.
      1.                                                   i.      As to this latter point, while nothing has been announced, I’d suggest that something has to give.  I’m not sure that we need to see an overly aggressive (EXAR-ish) reduction in force, but given the ridiculously low productivity, we have levers to pull.

While perhaps broader commoditization in the WLAN market has hurt Meru’s ability to grow and win deals, this is a secondary concern to me.  As with most things in tech, revenue is a lagging indicator.  If Meru can improve on the product positioning, and fix the distribution issues, they can grow again (it may not be uber-profitable, but gross margins will have a 6-handle at least for the near / medium-term).

Recapping all of this, we’re now at a crucial stage in Meru’s (not so young anymore) corporate life.  The stock has been left for dead, the education / healthcare markets are unlikely to improve meaningfully, and life in the WLAN market is certainly not getting any easier.  So why am I spending time here?  I think Bami was brought in to ‘clean up’ the business, secure financing (now done, more on that later), and sell the business to a larger hardware vendor who wants their own product within WLAN.

So why do I think the BOD will sell?

1. Bami – For those that don’t know, Bami is the former CEO of Trident Microsystems, Anadigics, and Conexant.  Not quite what I’d call an illustrious career in tech.  But relatively competent, certainly for the task at hand (he knows everyone inSilicon Valley, is respected by boards and bankers, etc.).  Put yet another way, given the context (Bami’s age and historical career experience, industry inflection point, investment life cycle for long-time VC backers), I find it unlikely that Bami was brought in to effect a wholesale operational turnaround (e.g. let’s go after Aruba as stand-alone company).  Discussions with industry professionals suggest that Bami should be viewed in this light.
   1. Consider Bami has 600k options (strike @ $4.62, share price on the date of his appointment) and 100k RSUs.  In my view, Bami is much more likely to listen to make his money ‘righting the ship’ as opposed to driving 20% yoy growth for a healthy company.  Once this has been cleaned up, I’d expect the BOD to sell.
2. Insiders – Insiders (BOD members and the new divisional head) have purchased $755k of stock at an average price of $3.15 during 2012.  This is notable for three reasons; (i) this is the first time that insiders have bought since the 2010 IPO, (ii) $750k represents almost 1.5% of Meru’s stock, and (iii) the purchases came as the stock was making new 52 week lows (e.g. insiders very bullish as investors yawn (or short Meru)).  Insiders can certainly be wrong, but given the situational dynamics, I think these signals are meaningful.
   1. I’d also note these purchases came at a time of extreme pessimism for enterprise tech, and specifically enterprise WLAN (again, look atAruba– insiders are bailing every day).
      1. Relating to this point, Meru recently hired Manish Rai, former head of Product Solutions @ Aruba.  Manish is not a C-level employee, so we don’t know his compensation package, but I view the hire as notable.  Manish, a WLAN veteran, was formerly Director of Product Marketing @ Symbol (prior to Motorola’s acquisition).  He then spent the last few years @Aruba.  The move fromArubato Meru parallels a move from Apple to Nokia (roughly), and gets me excited about the growth prospects here.  It also speaks volumes as to the legitimacy of virtual-cell technology (givenAruba’s constant dismissal of virtual-cell as a technology).
3. Industry Positioning – While Meru has done a poor job as a public company, to date, this says nothing of the possibility to be layered onto an existing hardware vendor.  Meru’s biggest issue, arguably, is the lack of scale, coupled with an expensive salesforce.  It makes no sense, to me, as to why Meru is not much more valuable (and sale-able) when sold alongside other products.   A strategic buyer would get several things in a deal; (a) installed base of ~6,600 customers (still growing, added 280 in Q1 and 400 in Q2), (b) some embedded, proprietary IP (not much, but come on, Aruba has like four patents and had $2.5bn EV), (c) the brand name.  Let’s ignore NOLs, for now (if Meru can maintain equity value, these can be VERY meaningful in the context of $47mm market cap).  I see several likely acquirors:
   1. DELL – The most likely acquirer, in my view, given they lack an internal WLAN product, but sell Aruba OEM’d product (largely through the Force 10 sales force).  They are not doing meaningful volume withAruba(and think they can get out at any time).  Meru would be (smaller than) a bite-sized acquisition for Dell.
   2. EXTR – Extreme, with a $365mm market cap and $265mm EV, is a very logical acquirer, given the mid-sized installed base of networking gear (wired Ethernet switches, some re-selling of WLAN, bunch of other middling stuff).  Would certainly be a reversal of fortunes given Extreme is largely viewed as ‘low-growth, un-exciting’ tech (and Meru was, just two years ago, a very hot IPO).
   3. BRCD –Lacks an internal OEM product, but resells MSI product through a three year old partnership.  I need to dig in more detail as to the historical relationship here (BRCD used to OEM MERU products, but moved away a few years ago).  Brocade is no longer in sell-mode, but unquestionably, the WLAN market has better growth characteristics than just about anything in their product set.  CEO is a ‘deal guy’, who I think would love to pick off Meru on the cheap.
   4. I think there are plenty of others that would consider an acquisition of Meru (certainly at the right price).
   5. Recapping this, I’m far from a bull on the WLAN space.  And admittedly, there is not much resident IP or product differentiation here (ultimately, these are all contract-manufactured products, that use the same Atheros chipsets).  But unquestionably, Meru is much more valuable once put on top of a larger platform (given potential revenue growth acceleration and reductions in opex).
   6. Timing is also important; Clearstone & NeoCarta have invested meaningful capital, and are likely nearing the end of their respective fund lives.  Both Clearstone and NeoCarta sit on the BOD, and would be unable to sell such large stakes in the open market (not that they would, see the large, recent insider purchases).

Let’s talk about the risks.

• Cash Burn – While Meru’s cash burn / operating cycle is seasonal (always highest in Q1, given lowest sales), this is undoubtedly THEissue with Meru.  Their expenses (many semi-variable (sales) or fixed (R&D / G&A)) are too high, and revenues too low.  Meru has burned $25mm of cash over the LTM period, with burn spiking to $9.7mm in Q1 and $11mm in Q2 (although $6mm was NWC-driven).  There are certain steps that are being taken to address this burn, specifically focused on (i) reallocation of marketing spend, (ii) reallocation of certain sales functions & processes and (iii) the inevitable flow-off of one-time restructuring expenses (taken over the last two quarters).    Management sees $3mm of quarterly cash burn as a near-term target.
  • In the context of the cash burn, one thing that had weighed heavily on investors was Meru’s precarious capital position.  Yes they had $31mm of net cash, but the burn had been increasing at an alarming rate, the SVB credit facility was expiring and they were / are EBITDA negative.  Rather than doing a horrible equity deal, they recently struck a deal with Western Technology Investors, for a $12mm term loan.  This loan, with a 12% annual coupon, 2015 maturity, and forty monthly amortization payments, is expensive, but downright cheap relative to the cost of $1.60 equity.  WTI also got 470k warrants at $2.05.
    • Perhaps, most importantly, the WTI loan has no covenants, nor prepayment penalties, and a ‘success fee’.  This $2mm success fee is payable upon the earlier of (i) 2015 maturity or (ii) a change of control.  Given the situational dynamics, it’s fair to say that WTI understands the end game.
• End Market Exposure – Meru’s heavy reliance on the education market is an unambiguous headwind.  We’ve already been hit by these headwinds, but there is no reason to suggest that they will get better.  That said, everyone else in WLAN is growing rapidly, and even budget-constrained colleges and high-schools are switching to wireless.  The cost of going wireless is not all that large in the context of school IT budgets, and it’s still a growth area.
• Increasing Commoditization within WLAN – This one is easy; at the end of the day WLAN product is primarily hardware-based, and I do expect longer-term industry gross margins to gravitate towards 60% (Aruba is 70% right now).  Margins will compress as controllers go away (into the cloud), and competitive dynamics intensify.  An investment in Meru is far from a bullish WLAN bet.

From a valuation perspective, well, this is admittedly tricky.

• There are 18mm shares so at say $2.65 that's $47mm market cap, less $30mm of cash, plus $11mm of debt (no covenants, btw debt tells you what they will be doing down the line) - so $21mm EV.  Let's say they burn $10mm in cash through year end (I think this guidance is appropriately conservative given the dynamics, as it makes no sense to overpromise and under deliver), so $31mm adjusted EV at year-end.  They should finish the year at something like $95-100mm of revenues, and if they can drive growth beyond that (either via driving virtual-cell product awareness, or even just growing alongside the market), that's great.  Either way, call it 0.3x EV / Sales.
  • I'm not arguing that Meru should trade whereArubadoes, at 2.3x EV / Sales, but 0.3x is not the right level.
    • Consider another tech hardware name, NETGEAR (a very tough business, with 30% gross margins that carry meaningful prospective risk) which trades at 0.7x EV / Sales.  Yes, NETGEAR is profitable (11% operating margin), but with those gross margins, and that growth profile, the business carries meaningful risk.  I’d also argue that no one will touch NETGEAR from an M&A perspective.
    • Consider Extreme Networks (EXTR), another low-growth tech company (and potential buyer here, IMO).  Extreme trades @ 0.5x EV / Sales, and yes they do have 3% EBIT margins, but the business has meaningful prospective risk.  And while MERU lost $4mm of EBITDA this last quarter, I see this turning positive over the next few quarters (driven by sales growth and continued opex reductions).
    • For now, let’s use 0.75x EV / Sales as a starting point.  On my 2012E numbers, we have $72mm in EV and $80mm in equity value.  This gets us to a share price of $4.52, or up 70% from here.
      • Obviously, the prospective returns are lower relative to where they were pre Q2 print.  But the turnaround is more advanced than expected, and we now have reasonable scope to accelerate growth and lower the cash burn.  Ultimately, if / when Meru sells, acquirors may look to gross profit as a pricing metric.  I’m happy to discuss in Q&A, as this may be getting ahead of ourselves, but there is scope to see a $7-10 stock price in a takeout (if acquirors view Meru in anything approaching the same light as Big Band (Arris), Isilon (NetApp), 3Par (Dell), Data Domain (EMC)).  The latter may be stretches given differences between storage and networking, but still, the comparisons are valid given the value in layering a good product on top of a larger tech platform.
    • One last point on valuation; most, if not all of the prospective acquirors are full cash tax-payers, and would not mind having access to Meru’s $127mm+ of federal NOLs.  Sure, you’re going to get hit with 382 limitations, but if Meru does not fall off the face of the earth and file (a la Trident , but as we all know there were some very unique issues at play), and maintains any meaningful ($50mm / $100mm) equity value, the NOLs have significant additional value.

Catalyst