The curious saga of Brocade (Nasdaq:BRCD) is about to take another interesting turn. The company's long-suffering Ethernet business looked quite strong this quarter, and new fabric products and the opportunities in software-defined networking could be significant longer-term contributors. More significantly, though, Brocade will soon have new leadership and with that, perhaps a new chance at living up to what seems like unfulfilled potential.
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Solid Results in a Tough Environment
Although plenty of tech stocks are struggling these days, and Brocade's guidance was cautious, the company did pretty well in the fiscal third quarter. Revenue rose 10% from last year and 2% from the fiscal Q2, with a big sequential improvement in Ethernet. While storage revenue was up nicely from last year (17% growth), the business contracted 6% sequentially. On the flip side, Ethernet rose 5% from last year and 29% from the prior quarter.
Margins came in pretty solidly, at least relative to expectations. Gross margin did weaken sequentially (by about 110 basis points with non-GAAP or 80 basis with GAAP). Likewise, product gross margin did erode sequentially - due in part to the greater contribution of Ethernet in the sales mix and its substantially lower margins. Operating income also improved - up 23% sequentially by GAAP and 7% by non-GAAP accounting.
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Time for New Leadership
The sentiment around Brocade has often been pretty negative for much of the time I've paid attention to the company; investors and analysts have long seemed frustrated with the company's inability to marry its solid technological capabilities with an effective sales effort. Perhaps that will soon change.
Not only did the head of sales leave the company relatively recently, but now CEO Michael Klayko has announced his intention to resign once a successor can be found. While I do understand investor frustration with this company, I think Klayko sometimes gets a bum wrap. The deal for McDATA was a successful one, and though the Foundry acquisition has been much less impressive thus far, I think he's done at least a reasonable job as CEO. Nevertheless, this CEO search process is a chance for the company to revitalize itself, and I would be surprised if the company selects someone without strong experience and demonstrated success in go-to-market strategies and translating good technology into good sales.
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Things Can Still Go Right
There's no doubt that Brocade has chopped around for years - though the stock has done well over the last year. Along the way, it seems like a consensus has developed that the company just cannot compete effectively with companies like Cisco (Nasdaq:CSCO), Juniper (NYSE:JNPR) and F5 (Nasdaq:FFIV) in Ethernet and ADC, nor penetrate markets like data centers. I'm all too aware of the dangers of "it's different this time" thinking, but I'm cautiously optimistic on this name. Fabric is still a small component of sales, and new fabric products should give the company another crack at making this a more significant contributor. According to the company, these new products offer the ability to "flatten" the network and significantly lower hardware and operating costs. Likewise, the rise of software-defined networking (SDN) could be another sales opportunity for Brocade, though I imagine there will be skepticism about Brocade's ability to outmaneuver companies like Cisco or VMware (NYSE:VMW) here.
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The Bottom Line
I do worry that I'm too optimistic about this company and too willing to assume that business execution will get better. After all, Alcatel Lucent (NYSE:ALU) amply demonstrates that companies with good technology can botch their sales execution for extended lengths of time. Nevertheless, even conservative estimates point to interesting opportunity.
On the basis of mid-to-low single-digit revenue growth and frankly no improvement in free cash flow conversion (though no deterioration either...), I can see this company growing free cash flow at about a 3% clip over the next decade. That's low growth, but enough to generate a fair value target in the $7 to $9 range. I'm well aware that value-priced tech stocks don't outperform without some reason for optimism regarding revenue growth or capital returns to shareholders, and this stock has already enjoyed a good rally, but I still find the potential at Brocade to be interesting enough to keep watching.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.