It's always something with Brocade (Nasdaq:BRCD). Although takeover speculation gave a little life to the stock, the ongoing problems in the ethernet business and the sluggishness of the underlying storage market have sapped a lot of that momentum. Although Brocade remains a tech stock that could deliver substantial returns if it got all of its ducks in a row, progress towards that goal seems inconsistent at best.
SEE: Trademarks Of A Takeover Target.
Second Quarter Results Beat Slightly, but will Anyone Really Notice?
Relative to published sell-side estimates, Brocade delivered a pretty good second quarter. Unfortunately, ongoing issues in the ethernet business and disappointing guidance are likely to limit the enthusiasm over the quarter.
This quarter revenue did surpass estimates by a few million dollars, but nevertheless declined 1% from last year and 3% from the fourth quarter. Within product revenue, storage product revenue rose 4% from last year and fell 2% sequentially, while ethernet business revenue fell 10% year over year.
Brocade did do well on its margins. Gross margin improved on both an annual (up two points) and sequential (up half a point) comparison and was about two points ahead of where many sell-side analysts had modeled for the company. The company basically held that outperformance through its operating items, and operating income rose 13% from last year, while falling one quarter sequentially.
SEE: Analyzing Operating Margins.
A Little Added Color Doesn't Brighten the Story Much
Repeating what has become an unfortunately common theme, Brocade continues to struggle to build up its ethernet business. The company didn't appear to gain on Cisco (Nasdaq:CSCO), and Juniper (NYSE:JNPR) saw year-on-year growth where Brocade was down by double-digits. Uptake of the VDX line and 100GbE products has been good, which just highlights how weak the legacy business has become - even with the support of companies like EMC (NYSE:EMC).
On the storage side, the company's leadership in 16Gb continues to be a major factor in pushing the company forward. Unfortunately, this means that Brocade is weak where most investors see the most growth potential and strongest where most investors see a slowing (although not declining) legacy market.
The Bottom Line
Brocade deserves credit for maintaining such strong share in the SAN market, especially against a company like Cisco. Unfortunately, the ethernet business has never delivered on its potential, and investors have had to listen to a series of excuses, explanations and pledges for future improvements. With the SAN market offering a lot less growth than ADCs ((dominated by F5 (Nasdaq:FFIV)) or even WAN optimization ((where Riverbed (Nasdaq:RVBD) makes its home)), investors just aren't willing to pay much for this stock.
I honestly don't know what Brocade can do to improve the ethernet business, but I'm not confident they can do it all on their own, and I'm not sure that a small or medium-sized tuck-in deal is going to fix the situation either. Maybe Hewlett-Packard (NYSE:HPQ) or Dell (Nasdaq:DELL) could prove vulnerable, but some investors may have given up on Brocade's prospects in ethernet.
Buyout rumors keep popping up around Brocade, with Dell being a frequently named buyer. I have my doubts about that. Brocade's high-end market sales are tied to OEMs like IBM (NYSE:IBM), EMC and NetApp (Nasdaq:NTAP) that aren't likely to stick around if rival Dell buys Brocade.
SEE: Understanding Leveraged Buyouts.
That said, Brocade's valuation is undemanding. Even just 3% compound free cash flow growth and a higher-than-market discount rate points to a target price more than 50% above today's price. With nobody, yet, predicting actual declines in the SAN market, that seems like pretty modest expectations even with the ongoing ethernet struggles. Although tech stocks usually need revenue growth to really work, this may yet be a name to watch for value-oriented investors.
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