Earnings Concerns Rock Internet-Equipment Darling Extreme

An analyst's in-line guidance knocked the momentum stock down 25% in a sector where investors want expectations to be exceeded.
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SAN FRANCISCO -- It had to happen: After months of loving, momentum investors have shunned one of the white-hot Internet-equipment stocks.

Extreme Networks

(EXTR) - Get Report

, which closed Monday at 94 1/4, slipped as low as 65 Tuesday before closing at 70 1/4. That was still 25% down for the day. The bombshell came from analyst Chris DePuy of Extreme underwriter

Morgan Stanley Dean Witter

, who wrote, "We simply expect little to no upside for the quarter."

Translated, that means Extreme might only meet -- and not beat -- DePuy's forecast of a $4.7 million profit in the December quarter, compared with a loss of $1.2 million a year earlier. That's 9 cents a share, compared with a year-ago loss of 3 cents a share. Rudely jarred from its bacchanal, Wall Street took the opportunity to rethink what it had been paying for Extreme, and the unease did spread to related Internet-equipment stocks.

Foundry Networks

traded down 10 1/16 to 208 1/2,

Sycamore Networks

(SCMR)

fell 13 1/8 to 233 15/16 and

Juniper Networks

(JNPR) - Get Report

was off 9 7/8 at 294.

"You have to exceed expectations," says Erik Gustafson, manager of the

Stein Roe

(SAIAX)

Young Investor fund. His fund has no position in Extreme, but holds shares of Foundry and Sycamore.

Money managers like Gustafson are more eager to defend the sector than they are to defend Extreme, which has become a show-me stock. In its core business, Extreme has claimed a small share of a competitive market long ruled by

Cisco

(CSCO) - Get Report

-- building fast electronic switches for corporations. In a recent interview, CEO Gordon Stitt said Extreme has managed this by developing sophisticated hardware and software, and also by selling at lower prices than Cisco. It has sustained gross margins of 52%, compared to Cisco's 65% margins.

Investors prefer companies such as Foundry, with gross margins of 56%. They even prefer a less-established company like Sycamore if it has a groundbreaking technology. Sycamore helps carriers and ISPs handle higher volumes of phone and data signals by giving them a new way to control the passage of light through fiber-optic lines. Extreme boasts highly efficient switches, but peers such as Sycamore have been viewed as more groundbreaking.

Extreme still has fans. Analyst Paul Johnson at

Robertson Stephens

, an underwriter of Extreme's initial public offering in April, said Tuesday the stock represents the sector's "most interesting way to make money." Johnson says that after investing in R&D more heavily than its peers, Extreme is about to ship products that will fuel surprisingly strong sales to carriers and ISPs in 2000.

So Extreme must prove the success of its new products. Until then, says Chris Bonavico, manager of the

TransAmerica

(TPAGX)

Premier Aggressive Growth and

(TPSCX)

Small Company funds, its R&D expenditures will remain high. And meanwhile Bonavico will stick with Sycamore.

Extreme accounted for 8% of sales of the so-called "layer-three Ethernet switch" market in the September quarter, less than Cisco and

Cabletron

(CS) - Get Report

, according to the research firm

Dell'Oro Group

(Dell'Oro declined to disclose its client relationships.)

It did woo many corporations with its low-priced products, and according to Dell'Oro, shipped more "ports" (separate network connections) than any rival. To broaden its growth, Extreme is unveiling a Summit 7i switch that will help ISPs manage vast repositories of data. Extreme has about a six-month lead.

"You can fully expect that other vendors will follow," says Esmeralda Silva, analyst with the researcher

IDC

. Her firm has no business ties to the companies discussed in this story.

Extreme is now valued at $3.6 billion, or 27 times revenue for the trailing four quarters -- far less than Foundry, valued at $11.9 billion or 136 times revenue. Unlike Extreme, so far Foundry hasn't crossed the momentum crowd.

If it does, look out. Stein Roe's Gustafson wryly notes that investors tend to hold a grudge with these names. "They'd rather pay 280 on the way up than 80 on the way down," he says.