In addition to reporting unsurprising fiscal first-quarter earnings, Extreme Networks(NASDAQ:EXTR) management confirmed the goal of improving the company's operating margin to 15% by the end of its fiscal year in June 2020. Yet even if the network vendor reaches this ambitious target, it will need stronger results to stay competitive.

Third-quarter results held no surprises

In the last three months, the company's revenue increased to $255.5 million, up 7% year over year and landing at the midpoint of management's guidance range of $250 million to $260 million. Non-GAAP (adjusted) gross margin of 59.9% almost reached the top-end guidance of 60.1%. And non-GAAP net income of $0.08 per share even exceeded the guidance range of $0.01 to $0.05.

These encouraging results are due to the strength of the recently acquired Wi-Fi vendor Aerohive, since its $25 million revenue far exceeded management's expectation of $15 million. And Aerohive's gross margin of 64% boosted Extreme's historically lower gross margin. Also, the double-digit revenue from Extreme's edge switches -- network devices that connect computers to the enterprise network -- contributed to the strong performance.

Yet excluding revenue from the Aerohive acquisition, Extreme's revenue dropped to $230 million, down 4.1% year over year. Management justified this weak performance with the macroeconomic weakness in Germany and a one-time delay from a single large customer. Thus, over the next quarters, investors should keep an eye on Extreme's revenue excluding the contribution from Aerohive to verify that the company's organic (i.e. non-acquired) revenue decline isn't structural.

Wi-fi sign on digital background.

Image source: Getty Images.

An ambitious target for the near future

Beyond the short-term results, management confirmed its goal of increasing the company's operating margin to 15% by the end of the fiscal year. That means the operating margin must quickly increase in a significant way from the 6.2% level notched during the first quarter.

Extreme Networks is integrating Aerohive, which will bring synergies and cross-sell opportunities since both companies sell complementary network solutions for the same markets. But this activity also includes risks, and bringing the operating margin to 15% in less than one year will require flawless execution. Investors should remain prudent, though. Over the last several years, some of Extreme's acquisitions have led to disappointing results.

More improvements needed

Extreme Networks will still need to fine-tune its business beyond its short-term operating margin goal. The company's non-GAAP operating margin excludes many expenses such as share-based compensation (SBC) and exceptional items, which is a common practice for tech stocks. But many of these costs are real expenses to shareholders. For instance, SBC has the effect of diluting current shareholders. Also, management excludes restructuring charges and acquisition and integration costs from its non-GAAP metrics. Yet the company has reported such costs in the range of $8.5 million to $62.0 million every year between fiscal 2015 and 2019.

Extreme's strategy of acquiring companies to build a comprehensive network portfolio and gain scale led to these extra costs. Add to this a rising stock compensation cost over the last few years: SBC reached $8.8 million during the last quarter, up from $6.8 million one year ago.

As a result, during the last quarter, Extreme's GAAP operating margin was negative 12.6%, which represents a significant difference from its non-GAAP operating margin of 6.2%. Thus, even if the company's non-GAAP operating margin improves to 15%, Extreme Networks will report a much lower GAAP margin. 

Investors should also note that Extreme competes against stronger companies. At the end of the last quarter, Extreme's net debt increased to $218.9 million because of its Aerohive acquisition. Given the company's low operating margin, the debt load may become risky if Extreme doesn't increase its margins. The high debt load limits Extreme's ability to acquire companies and enhance its portfolio. In contrast, competitors such as Cisco, Arista, and Juniper all maintain a strong positive cash balance, which gives them more flexibility to acquire companies, pay a dividend, or buy back shares.

Finally, even with its Aerohive acquisition, Extreme lacks scale. With annual revenue in the range of $1 billion, the company's research & development (R&D) and sales & marketing investments remain modest compared to its competitors. Extreme spent 21.6% of its revenue for its R&D over the last 12 months, which is higher than Juniper's and Cisco's R&D expenses at 21.4% and 12.7% of their respective revenue, so its priorities are in the right place. But given their larger scale, Juniper's and Cisco's R&D of $947.3 million and $6.6 billion, respectively, dwarfed Extreme's $218.0 million R&D spending. Since these network vendors compete over the same markets, Extreme's smaller scale represents a competitive disadvantage.

Looking forward

You should consider Extreme's goal of a non-GAAP 15% operating margin a modest one only. And given the company's challenges, prudent investors should stay on the sidelines until Extreme improves its GAAP operating margin and generates organic revenue growth.