As Brocade (Nasdaq:BRCD) struggles to go anywhere, new management realizes that the company can't simply operate as it always has. But a new direction isn't particularly helpful if it is the wrong one, and I have real doubts about the company doubling-down and looking to compete with Cisco (Nasdaq:CSCO) in markets like data centers. While expectations for Brocade are shockingly low, it's hard to see this stock going anywhere without a real improvement in sales growth.
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Fiscal Q2 Results Disappoint As Expected
Brocade had warned investors that fiscal second quarter results were going to come in below the expectations at the time, and that's what happened as the company suffers from the wider IT hardware malaise that has hurt so many other stocks in the space.
Revenue fell 1% from the year-ago level and 8% from the prior quarter, as product revenue declined 10% sequentially. Both SAN and Ethernet declined; the former by 12% and the latter by 6%. Even so, the gross margin improved slightly from last year (by 30bp) and fell only 90bp from the prior quarter. Operating income rose 8% from last year, but fell 30% sequentially.
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A New Direction, But Will It Lead To A Better Destination?
Details are still coming out in bits and pieces, but it is increasingly clear that Brocade's (relatively) new CEO wants to streamline this company's operations. First, management intends to strip out $100 million in annual costs by early calendar 2014, largely through narrowing the product portfolio and refining its marketing approach.
That leads to a bigger, vaguer, new direction as well. It looks like Brocade is going to intensify its focus on a smaller number of markets that management believes hold higher potential. On the surface, this makes a great deal of sense – continuing to compete in markets where the company holds only scant market share costs money and doesn't generate particularly attractive revenue growth or economic return prospects.
The key, though, is what markets the company picks. Management specifically mentioned data centers and federal markets in its earnings press release. This is not really surprising, given that the company has been focusing on opportunities like fibre channel over ethernet and virtual cluster switching for data centers for some time now.
While this is a popular (not to mention large and growing) market, it's also a market that companies like Cisco and Juniper (Nasdaq:JNPR) have explicitly targeted. Perhaps Brocade can piggyback on the efforts of its SAN partners like EMC (NYSE:EMC), but Cisco's recent success in this market (at a time when so many rivals are struggling) is not encouraging for Brocade, particularly as recent head-to-head battles between Cisco and Brocade have not gone in Brocade's favor.
Tough Times Likely To Continue A Bit Longer
Consistent with what storage companies like IBM (NYSE:IBM), EMC, Dell (Nasdaq:DELL), and Hewlett-Packard (NYSE:HPQ) have been saying recently (not to mention networking companies like Juniper), the near-term outlook is not very good at Brocade. Against an average Wall Street estimate of $556 million for the July quarter, the midpoint of management's guidance falls at $520 million. That sort of revision (even in a weak market) is going to do nothing to change the minds of Brocade skeptics. I also do wonder how much Cisco may impact Brocade in the near-term with its long-awaited 16G storage switching product.
Along similar lines, the apparent opportunities at Brocade have to be set against some real risks. The company has struggled in the ethernet switching business for so long now, and holds little overall market share. While a narrower focus on particular markets that could benefit from (and embrace) Brocade's technology could help, it's hard to be all that optimistic. Likewise, while Brocade through its hat into the software-defined networking (SDN) ring, it's tough to see them shoving aside the likes of Cisco and VMware (NYSE:VMware), particularly when Cisco can leverage its huge product line into bundled deals.
The Bottom Line
The saving grace to Brocade has long been the company's relative strength in storage networking and the rock-bottom expectations built into its valuation. Still, the long-term charts are pretty ugly, so those positives only go so far.
Projecting just 2% long-term revenue growth and 2% annual long-term free cash flow *contraction* points to a fair value in the $7 range, against a going price of about $5.50. It's not too often that you see a company where the stock seems to incorporate free cash flow contraction, but that's how poor the sentiment is here (while the trailing EV/EBITDA below 6x and trailing EV/revenue of nearly 1 also point to significant bearishness).
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Is Brocade a value or a value-trap? Absent a clearer presentation of the company's new long-term strategy, I'm leaning toward the latter. I do believe that Brocade has nearly been written off and that any real growth upside could ignite the shares, but I could also see a very frustrating (if not infinite) wait for that to occur.
At the time of writing, Stephen D. Simpson owned shares of EMC.