Analyst Tugs on Loose Thread in Brocade
By Adam Lashinsky
Silicon Valley Columnist
8/22/00 7:00 AM ET
thestreet.com
Unless you're a zealot, it's probably best to stay out of a religious war. That is precisely what's being fought between Brocade Communications (BRCD:Nasdaq - news - boards) and a Wall Street analyst who follows the company, Ashok Kumar of U.S. Bancorp Piper Jaffray.
To boil down a very complex story, Brocade is the leading supplier of switches that connect storage devices such as disk drives to powerful server computers through storage area networks, or SANs. Brocade's switches use a technology called "fiber channel," the only system currently being used by major manufacturers in storage networks. As such, the young company -- which just reported fiscal third-quarter income of $20 million, or 16 cents per share, on $92 million of sales -- is worth almost $26 billion at Monday's closing price of 210 9/16. To put that into perspective, the stock trades for about 175 times Wall Street's projections for calendar 2001 earnings; shares of storage industry leader EMC (EMC:NYSE - news - boards) trade for about 93 times estimates for the same period.
Brocade's rich valuation is the result of rapid growth (revenue in the year-earlier quarter was $20 million) and nearly universal support on Wall Street. The dissenter is Piper's Kumar, who argues that fiber-channel technology in storage networks will be replaced in short order by Internet Protocol, or Ethernet, technology, the same stuff on which the Internet runs. Kumar's also not crazy about Brocade's astronomical valuation. In his most recent broadside against the San Jose, Calif.-based company, published before the market opened Monday, he argued that "while the fiber channel business will degrade slowly, we believe valuations will not degrade gracefully."
Kumar didn't respond to phone calls about his open distaste for Brocade. His challenges are particularly strident because of the many fans the company has won on the Street. But his commentary speaks for itself -- and investors should ignore it at their own risk. He calls Brocade "the last man standing in an unhealthy industry" and suggests the company's "quarter-over-quarter revenue momentum [will] start slowing beginning [in] the January quarter." Kumar goes on to argue that the Ethernet/IP storage threat is "much bigger than Brocade makes it out to be," basically arguing that when companies like Cisco (CSCO:Nasdaq - news - boards) figure out how to deliver storage connections over IP-based networks, Brocade competitors like QLogic (QLGC: Nasdaq - news - boards) and McDATA (MCDT:Nasdaq - news - boards), as well as Brocade, will be toast.
Whether or not Kumar is right about that, he certainly has a point about Brocade's lofty valuation. The strongest part of Kumar's argument, of course, is the valuation argument. No company maintains a multiple of more than seven times its earnings growth rate for very long. Even shares of mighty Cisco stalled at around three times their growth rate.
Kumar has his tacit supporters. Steven Milunovich, the senior heavy-iron analyst at Merrill Lynch, acknowledges that fiber channel could find itself endangered in the next two to five years. However, a Merrill survey of information-technology managers showed that more than half planned to develop SANs in the next 18 months, reports Milunovich, who does not follow Brocade. That means huge incremental upside in the near term for Brocade.
Chase H&Q analyst William Lewis is even more forceful in his defense of fiber channel in general and Brocade in particular. "Fiber Channel will be the leading technology for enterprise SANs for the visible future," he wrote in a recent industry overview. He maintains a buy rating on the stock "for high-growth, high-momentum technology investors." Neither Piper nor Chase H&Q has been an underwriter for Brocade.
For Kumar's influence, the ultimate tell, of course, is the market's reaction. Despite past instances when Kumar hurt Brocade's stock with a slam, the market paid no attention Monday. The shares moved up a half point on trading volume far below the recent average. But let his lone-wolf opposition serve as a warning. James J. Cramer, a Brocade fan, has cautioned that the red-hot storage industry shows the classic signs of a tech-stock bubble. The run-up in shares of EMC, its spinoff McDATA, Network Appliance (NTAP:Nasdaq - news - boards) and even mature tangential player Sun Microsystems (SUNW:Nasdaq - news - boards) are evidence of the momentum-driven surge.
Do you have the conviction to remain in the middle of this religious war, with the understanding that years and years of Brocade's future profits are built in the stock? Very few companies hold up under such scenarios. That includes companies where there isn't even one analyst warning of cataclysmic problems just around the corner.
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Didn't mention Nishan either.
Jack |
