Brocade's Quarterly Results:  How Bad Were They?
    August 31, 2010  PSW Staff
    Brocade Communications (BRCD) has been on the hot seat lately due to a lack of revenue
    growth relative to their perceived peers.  Revenues grew just 2% year over year, while
    heavyweight, Cisco (CSCO), posted 27% growth.  A company more Brocade's size, Qlogic
    (QLGC), which has a similar market cap but only a quarter of the revenues, saw 16% year
    over year quarterly revenue growth.  Data Storage Devices as a whole saw 18% revenue
    growth.  Brocade's operating margins have been slipping as well, below CSCO, QLGC and a
    few others, but are still above the industry average.

    It is hard to make direct comparisons in these particular industries, however, as each
    company offers their own line of unique solutions in an ever evolving space.  This has
    caused results and outlooks for the data storage industry to be all over the map lately.  Signs
    of firms increasing IT spending earlier in the year and some good projections for technology
    spending here and there have been met by pessimism, with Cisco recently saying that they
    see some uncertainly among their customers.

    Looking at Brocade's results by themselves without any distractions, however, we do see
    several positive signs.  The company's revenues are derived 75% from data storage, and
    25% from the Ethernet space thanks to their acquisition of Foundry Networks in 2008.  Non-
    Gaap numbers are significantly better, with the difference mainly due to leftover costs from
    the acquisition.  The Ethernet division has been growing customers with a slight acceleration
    during this most recent quarter, and it has been growing in terms of percentage of revenues
    for BRCD as well.  This is where it get's interesting.  The percentage of revenue from the
    Ethernet division dropped in the most recent quarter despite growing customers faster.  This
    was mostly due to better than expected results from data storage.  The bigger division grew
    sequentially, which is unusual given that the quarter is seasonally quite a bit weaker than the
    previous one.

    Brocade has been mentioned as a potential buyout target with M&A activity in the space
    expected to accelerate this year and next.  Some names that have been thrown around as
    potential suitors are Dell, (DELL), IBM (IBM) and Oracle (ORCL).  These and other big
    companies may be looking for something a little different, however, as the recent bidding war
    for data storage company 3Par (PAR) may prove.  3Par is a pure data storage play, and it is
    also ensconced in the exciting, so called 'cloud computing' phenomena.  Cloud computing is
    internet based computing where shared resources and information are provided on demand
    through central storage locations.  The concept is actually decades old, but in the data
    storage industry, it has recently emerged as a very cost effective way for customers to store
    data, and many see the industry headed that way quickly.  Cloud computing does not
    substantially decrease the overall amount of data that has to be stored, however, but it may
    increase efficiency.  From Brocades standpoint, they will need to increase new products and
    customers in the central data storage arena faster than they lose smaller customers who are
    switching.  So far, they have been able to do that, and it is likely that many of their big
    customers will never switch.

    Despite being a lot more boring than 3Par, Brocade could offer a lot less risk to any potential
    buyer.  Both have a market cap of around $2 billion, but Brocade is selling at book value,
    while 3Par is selling at 14 times book value.  Brocade is also selling right at sales per share,
    while 3Par is at almost 10 times sales.  For the same price, Brocade gives you $2 billion in
    consistent annual revenues, while 3Par gives you $200 million in annual revenues.  3Par
    would clearly be an easier assimilation, however, with no debt on their balance sheet and
    only 60 million shares outstanding, while Brocade has $1 billion in debt and half a billion
    shares.  It will be interesting to see where Dell turns next, as most believe Hewlett Packard
    (HPQ) has the upper hand in the 3Par struggle.

    Brocade's stock has seen sideways action between $5 and $10 dollars for around eight
    years now.  The stock saw a high of around $120 in 2000, and a low of near $2 in March of
    2009.  Upside for the stock in coming years is certainly in question, as low balance sheet
    valuations are currently being trumped by a fairly high P/E, and revenues are not expected to
    do anything spectacular.  What may not be in question however, is the downside for BRCD.  
    Over the past year, analysts have downgraded the stock, and most have lowered their target
    prices.  None have gone below five dollars, however, and with book value close to that level,
    shorts may not be very interested.  In fact, shares held short as of Aug 13 were 18.5 million
    compared to 22.4 million the prior month, although their most recent results were not
    announced until August 18.  It seems that the bar has been set extremely low for Brocade,
    and it could provide a nice hedge against some of the hotter names.
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