|Shares Out. (in M):||18||P/E||0.0x||0.0x|
|Market Cap (in $M):||47||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-18||EBIT||0||0|
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Meru Networks (COMP:MERU) - $2.65
[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).
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:
|Support & Services||2.2||2.7||2.6||3.1||3.1||3.1||3.2||3.5||3.6||4.2|
|Ratable Products & Services||3.7||2.9||2.6||2.1||1.6||1.1||0.5||0.1||0.1||0.0|
|Less Sales & Marketing||(7.4)||(8.1)||(8.7)||(9.3)||(9.6)||(10.5)||(12.9)||(14.8)||(15.6)||(15.0)|
|yoy product revenue growth||12%||24%||20%||13%||2%||7%|
|yoy services revenue growth||46%||15%||23%||16%||13%||33%|
|yoy revenue growth||3%||11%||9%||3%||(4%)||5%|
|S&M as % of Rev||38%||39%||40%||41%||48%||45%||54%||63%||80%||61%|
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?
Let’s talk about the risks.
From a valuation perspective, well, this is admittedly tricky.
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