CEO Interview: Brocade
[BRIEFING.COM - Gregory A. Jones] Fibre channel switches. They just
sound cool. And for a while, that was probably enough in this market. But
now, companies have to put up numbers, and Brocade Communications
(BRCD) is doing that too. Big time. That's our take-away from the Q2
earnings report and follow-up interview with CEO Greg Reyes last night.
Yesterday's FQ2 earnings report was a blow-out in every regard. Earnings
of $0.11 a share beat both the consensus of $0.08 and the whisper of
$0.09. Revenues of $62.1 mln were up a staggering 45% sequentially and
exceeded even the most optimistic whispers of about $60 mln. And finally,
gross margin rose to 58.0% from 53.0% in the prior quarter, also better
than expected.
Bottom line -- the Q2 report was immaculate. Instead of spending all our
time on the specifics of this report, however, it is more interesting to focus
on the big picture. When a company has a P/E on next year's earnings of
230, the key is not to get caught up in the details of the past, but to focus
on the potential for the future. After all, that 230 P/E suggests a lot of
potential.
In discussing a company with a 230 P/E ratio, we must determine the
ultimate potential of its market, its share of that market, and the operating
margins that it hopes to achieve. In the Brocade conference call and in an
interview with the CEO, we were able to put many of these pieces
together.
Market Size
First, it is critically important to understand that the storage area network
(SAN) market generally and fibre channel switch market specifically are
new markets. Estimating their size is only slightly better than a dart toss.
But the story here is compelling. The Internet has produced an explosion in
e-business for both dot-coms and traditional corporations, and e-business
results in tremendous amounts of data. Data requires storage capacity.
The fibre channel protocol has introduced speed and reliability into data
storage.
IDC recently doubled its forecast for the fibre channel switch market to
$3.0 bln from $1.5 bln. CEO Greg Reyes believes that this revised number
is still too small. He argues that IDC's numbers are based on surveys of
the market for new SAN equipment and ignores the huge market for
upgrades of legacy equipment that is just now developing. Reyes sees the
market going from its current homogeneous phase to a new heterogeneous
phase that might be 10 times larger.
The homogeneous phase has been characterized by discreet deployments
of all-new equipment. The heterogeneous phase can also be seen as the
upgrade phase. In this phase, existing storage networks will be upgraded
and merged with fibre channel networks, as companies seek to protect
their investment in legacy equipment. This phase will be much larger and
will demand interoperability, something which is currently lacking in the
fibre channel market. With its extensive OEM agreements (Brocade's
OEM partners account for 90% of the storage market) and dominant
market share, Brocade is in an excellent position to set the standards for its
industry and benefit tremendously from phase 2.
Market Share
Brocade currently controls a stunning 90% share of the fibre channel
switch market. Reyes acknowledges that this 90% share is unhealthy for
the industry and will not last. While not willing to offer a specific target, he
notes that anything north of 50% long term is fantastic.
One of Brocade's few competitors, Ancor Communications (ANCR), has
agreed to be acquired by QLogic (QLGC), a maker of Fibre Channel host
bus adapters and a supplier to Brocade. Not surprisingly, this pending
merger was a source of several questions during the conference call, both
because of the new competitive threat and the changing supplier
relationship with QLGC.
Reyes acknowledged that the combined QLogic/Ancor team would be a
more formidable competitor due to the stronger management brought in by
the QLogic team. But he argued that this was good for the switch market,
as it would speed adoption of the technology even as Brocade's market
share slips. While it would be easy to write this off as a rosy view from the
CEO, it is probably true that Brocade has more to gain from increasing the
size of the market than it has to lose from shedding a bit of market share.
Though its supplier relationship with QLGC will change in some ways, it
will not end. And in any case, Brocade does have other options for host
bus adapters such as Emulex (EMLX) and JNI (JNIC).
Brocade's market share won't hold at 90% forever, but it will quite likely
exceed 50% for quite some time. And as a conservative estimate, we'll
use that 50% figure in determining the company's long term potential.
The Market Share Risk
Lest we give the impression that there is no risk to Brocade's position, we
must note a key long term threat. For Brocade, the risk is not so much in
the market size as it is in the competitive landscape. The QLogic/Ancor
combination is a threat, but not the threat. The more significant risk is that
a dominant player in the enterprise networking industry that is not currently
in the fibre channel switch business arises and steals substantially more
market share from Brocade.
The name Cisco (CSCO) naturally comes to mind. On its earnings
conference call, Cisco discussed the possibility that it will make its Catalyst
6000 line interoperate with fibre channel. Reyes expressed confidence that
this did not indicate that Cisco is working on a competitive product.
Instead, he thinks that Cisco will partner to achieve its goals, and who
better to partner with than the company that has 90% of the market --
Brocade.
Is this optimistic thinking? Maybe. But for now, there is no reason to
believe it isn't true, and Reyes probably knows more about Cisco's plans
than we do. But in determining a long term value for Brocade, interested
investors had better keep a wary eye on Cisco.
Operating Margins
Moving on to margins -- in Q2, gross margin jumped to 58.0% from 53.0%
and operating margin rose to 25.2% from 18.9% sequentially. Furthermore,
Brocade gave higher guidance on both numbers for Q3. Even while
reducing average selling prices by 20% for the quarter, margins soared.
The improvement in margins was a result of several factors. First,
Brocade introduced its new 2000 product line, which had higher margins.
Second, sales through systems integrators (SIs) jumped from 15% to 25%
of total revenues. Gross margins on sales through SIs are "double digit"
percentage points higher than sales through OEMs, according to Reyes.
Though the SI/OEM mix might stall this quarter due to mounting sales via
recently added OEM partner EMC (EMC), the SI percentage should
improve longer term, helping to improve margins. Increasing software
sales should also boost gross margin.
Can Brocade sustain these margins? For the foreseeable future, yes. They
indicated that margins for the remainder of fiscal 2000 will actually
increase. And longer term, its market dominance and improving brand
visibility should sustain gross margins in excess of 50% and operating
margins of about 25%.
The Math
Of our three key issues -- market size, market share, and margins -- the
size of the fibre channel switch market is the most difficult to determine.
Consultants' projections of such nascent industries are often off by several
orders of magnitude. That is already becoming evident for this market. The
IDC forecast of $3 bln by 2003 looks too conservative, perhaps by a large
margin. For our purposes, we are going to assume a $5 bln market, though
even that might be too pessimistic. With a 50% market share and 25%
operating margin, Brocade could earn $625 mln in 2003 (its annual run-rate
on Q2 net income was $53 mln) before taxes and about $388 mln after
taxes.
If you run a discounted cash flow model on numbers like that and assume
healthy but slower growth in the years thereafter, it's not hard at all to
justify the current price of about $122/share (BRCD rallied sharply in after
hours from its 114 15/16 daytime close). In fact, prices of double that level
can be justified given these assumptions.
Part of this exercise is to avoid the pitfalls of thinking that a P/E of 7 is
cheap when a company is headed down the tubes, or a P/E of 230 is
expensive on a company that is dominating a huge market that is just being
born. Brocade is a good example of the latter. Its Q2 results are just a hint
of what might lie ahead. And given the positive response by analysts on
the call, you can expect a slew of reiterations and maybe even an upgrade
on Tuesday. |
