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.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

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.

SEE: Understanding The Income Statement

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).

SEE: 5 Must-Have Metrics For Value Investors

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.

Related Articles
  1. Mutual Funds & ETFs

    Reinvesting Capital Gains In Leveraged Portfolios

    Don't get forced into action. Learn how to plan properly to avoid making rash decisions.
  2. Investing Basics

    7 Investing Mistakes And How To Avoid Them

    No investor is flawless. Here are some common investing fallacies and a step-by-step guide on how to avoid them.
  3. Bonds & Fixed Income

    Long-Term Investing With Equity Index CDs

    Equity Index CDs are perfect for investors who don't mind hanging in for the long term.
  4. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  5. Investing

    Redefining the Stop-Loss

    Using Stop-losses for trading doesn’t mean ‘losing money’, but instead think about the money you'll start saving once you learn how they work.
  6. Fundamental Analysis

    10 Major Companies Tied to the Apple Supply Chain

    Apple has one of the best supply-chain models. Here are some of the top businesses involved, and the benefits and challenges for all.
  7. Term

    What are Non-GAAP Earnings?

    Non-GAAP earnings are a company’s earnings that are not reported according to Generally Accepted Accounting Principles.
  8. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  9. Investing Basics

    A Primer On Investing In The Tech Industry

    The tech sector can provide fantastic returns for investors with a little know-how in the field.
  10. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Middle Market

    Definition of middle market
  6. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  5. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  6. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!