In the world of computer networking, Cisco Systems (NASDAQ:CSCO) is the 800-pound gorilla, but Extreme Networks (NASDAQ:EXTR) is taking a step toward building its own scale to challenge its larger rivals.

Last month, Extreme Networks announced it would acquire Aerohive Networks (NYSE:HIVE) for $272 million in an all-cash deal. Once completed, this acquisition will mold the combined company into a top-three cloud networking company and greatly increase its overall scale and competitive position.

Adding products in fast-growing markets

Extreme Networks is a software company that helps enterprise customers manage networks with an end-to-end solution, from the data center to the user access point. With the proliferation of devices in the workplace and an increasingly mobile and global workforce, enterprise networks have never been more complex and greatly rely on tools to manage and secure digital assets.

Extreme Networks already has a strong position in software for managing data centers and ethernet networks. The addition of Aerohive Networks enhances the company's capabilities in wireless networking and SD-WAN, which are two of the fastest-growing segments of the networking software industry. The two companies have complementary product strengths:

Network Software Market Total Market Size Estimated Expected Growth, 2019-2022 Notes
Wireless LAN $7.0 billion 8.9% Aerohive Networks has strong capabilities.
Data center $14.2 billion 2.5% Extreme Networks has strong capabilities.
Ethernet switching & campus LAN $15.8 billion 1.5% Extreme Networks has strong capabilities.
SD-WAN $1.6 billion 18.8% Aerohive Networks has strong capabilities.
Total network software industry $38.6 billion 4.9% Aerohive and Extreme have complementary network software capabilities.

Data source: Extreme Networks investor presentation.

As one of the first companies to offer controller-less Wi-Fi and cloud network management software, Aerohive has long been a pioneer in the industry and is the No. 2 provider of cloud-managed wireless networking software by revenue. The software Aerohive sells is notable for its incorporation of artificial intelligence and machine learning to improve the efficiency of cloud network management. This software will become even more critical for enterprises as the industry transitions to a new networking standard known as Wi-Fi 6, which promises to make networks faster and increase the number of connections a Wi-Fi router can handle, but increasing the number of connections will make networks even more complicated and promote the value of using a strong network management software.

Extreme Networks' goal is to serve as an end-to-end software solution for managing enterprise networks. Extreme had a presence in cloud networking before the Aerohive acquisition, but Aerohive's capabilities in cloud networking and SD-WAN are much stronger. Therefore, this acquisition adds to Extreme Networks' product depth and brings it one step closer to being a turnkey software provider.

A person holding a tablet in one hand points with a pen to a series of interconnected avatars, indicating a network.

Image source: Getty Images.

Increasing business scale and profitability

In addition to adding product capabilities, Aerohive Networks will bring high-margin revenue. In 2018, Aerohive generated $155 million of revenue with a gross profit margin of 65.8%. However, the company produced a net loss of $18.3 million because of its inability to overcome its fixed expenses with its small revenue base. This will be easier to achieve as a part of Extreme Networks.

In comparison, Extreme Networks generated $1.0 billion of revenue in the 12 months ending on March 31, 2019. Extreme's gross profit margin on this revenue was 55.8%. Extreme also generated a modest net loss of $14.4 million; however, Extreme Network's free cash flow was positive $65.7 million. Free cash flow is often a better measure of a company's financial health than net profits due to its emphasis on actual business economics as opposed to accounting rules.

Extreme Networks' management believes the Aerohive acquisition will accelerate its "path to greater than 60% gross margins and 15% operating margins on a non-GAAP basis" by the end of the next fiscal year. This claim is credible, given Extreme Networks' track record of successfully integrating past acquisitions. Over the past few years, the company has completed four acquisitions -- of Zebra, Avaya, Brocade, and Heritage Extreme -- and it was able to boost its profit margin in each case.

Acquiring Aerohive Networks is expected to have the dual effect of growing Extreme Networks' revenue base and improving its profit margin. This is a potent combination that should by itself justify the transaction.

Still a small fish in a big pond

Even with the Aerohive Networks acquisition, Extreme Networks will continue to be a small rival to networking giants Cisco and Hewlett Packard Enterprise. To put this into perspective, Cisco boasts over $50 billion in sales and a market capitalization in excess of $200 billion, compared with Extreme Networks' $1 billion in sales and a market capitalization close to $800 million.

There are advantages to Extreme Networks' small size. The company is more nimble and will be able to grow faster through strategic moves such as the acquisition it just announced. However, larger companies like Cisco have more resources to compete in terms of funding innovation through research and development or acquiring customers with marketing.

Competing against giants like Cisco and HPE puts pressure on smaller players like Extreme Networks to find ways to scale up. Extreme Networks has had a successful acquisition strategy to date, and investors should expect the company to continue gobbling up smaller rivals as it builds scale to more effectively compete against its larger peers.

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