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6/25/2004
04:40 PM
William Schaff
William Schaff
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Taking Stock: Enterasys Still Has Much Work To Do

Sales must pick up and costs must come down for a solid investment.

Remember Fox In Socks by Dr. Seuss? Fox shows Knox how to rhyme. "Fox in socks. Knox in box. Fox in socks on Knox in box." If you recall, Knox's head starts spinning as he can't keep up with Fox. My head was doing likewise when I started researching Enterasys Networks because of the many changes at the company. Ever the bargain hunter, I started sniffing around Enterasys to see its value. What caught my interest was the $201.9 million in cash on its balance sheet. This amounts to about half the company's total market cap. So let's see if the stock represents a true bargain.

Enterasys focuses on providing secure networks for its customers, and designs and builds networking equipment aimed primarily at large implementations such as Fortune 500 companies and government agencies. Its product portfolio includes the Matrix line of switches, the X-Pedition line of routers, and various Dragon Intrusion Defense System security products, among others.

The company's trouble began in February 2002 with the disclosure that it had found irregularities in its Asia-Pacific subsidiary. Soon the Securities and Exchange Commission was investigating. Irregularities appeared across the company and were mainly related to aggressive revenue recognition and channel stuffing. The CEO, chief operating officer, and executive VP of marketing got the boot, and the company announced a restructuring, with a 30% cut in the workforce.

Enterasys has been in restructuring mode ever since, but the new management team has been working hard. The company reached a settlement with the SEC and paid $50 million to settle several class-action lawsuits. Meanwhile, management has had to contend with a bloated cost structure and sliding sales. During the latest quarter, revenue was down 16.5% from the same quarter a year ago. The poor performance was blamed on two factors: poor sales execution, which cost the head of sales his job, and competitive pressures on the low end from Hewlett-Packard and 3Com and on the high end from Cisco Systems and Foundry Networks.

It appears to me that Enterasys isn't participating in the resurgence of spending on networking equipment. Several new senior sales executives have joined the company in the last couple of months, and Enterasys has established an alliance with Lucent Technologies as a reseller, so there may be an end in sight to declining product sales.

But I believe the company still has a bloated cost structure. While gross margins are fine at 50.2% in the last quarter, R&D and selling, general, and administrative expenses overwhelm any gross profits generated, leading to a negative operating margin. I suspect that more cost cuts may appear in the future. Despite all the cash, I would wait on investing in Enterasys until product sales start ticking up again and operating expenses have been reduced further. It could very well be a while before the company gets back to a significantly higher revenue level, given the tough competitive environment. For now, this fox will take his socks and look for ideas under different blocks.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.

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