DJ BARRON'S ONLINE: Time To Evade Brocade?
27 Mar 08:00
By Eric C. Fleming
Weekday Trader
(This item was originally published late Wednesday).
Knock, knock. Who's there? Cisco.
That's a joke that no technology firm would find remotely funny.
Especially Brocade Communications Systems, the leading vendor of the switches
and management software that form the backbone of storage networks.
Encroaching competition--from Cisco Systems and others--and soft demand have
been cutting into Brocade's sales and margins.
McData, the second-largest Fibre switching product maker (ahead of QLogic),
and other rivals are eager to steal more of Brocade's core market of switching
products.
Yet investors are still willing to pay astonishing triple-digit multiples for
the privilege of owning Brocade stock.
That's even as Brocade's market share dropped to 45% in the fourth quarter of
2002 from 49% a year earlier, according to A.G. Edwards & Sons.
In the same period, McData grew its share by two percentage points, to 39%,
and QLogic was essentially flat at 4.2%.
Ominously, Brocade`s fiscal first-quarter sales fell 20% from the previous
quarter, while McData`s sales rose 30%. First Albany analyst Mark Kelleher
views that as another sign Brocade is losing ground.
The growth in McData's share came from the rollout of its Sphereon 4500,
which can compete with nearly every product Brocade sells, and is cheaper than
Brocade's wares, says Paul Mansky, analyst at ThinkEquity Partners.
Brocade and McData make mid-range products called switches and heavy-duty
wares called directors. QLogic primarily sells lower-end embedded switches.
Switches and directors are sold as part of storage systems by big equipment
vendors like Hewlett-Packard, which accounts for about 20% of Brocade's sales.
Meanwhile, Cisco is circling.
The San Jose, Calif.-based networking giant bought what it didn't already own
of switch and director maker Andiamo Systems in a deal worth up to $2.5
billion. Cisco bought Andiamo to jumpstart its storage efforts as the market
continues to grow (albeit slowly of late), while most technology spending
remains anemic.
"Cisco sold nothing [in this area] in 2002. That won't be true in 2003," says
James Opfer, analyst at market research firm Gartner Dataquest.
While most analysts hesitate to predict Cisco's prospects in storage, "[they]
wouldn't consider themselves successful if they didn't take a quarter of the
market next year," says Mansky.
In January, IBM agreed to resell Cisco-Andiamo switches, renamed the MDS 9000
line. IBM will continue to sell Brocade and McData switches, however.
Ashok Kumar, analyst at U.S. Bancorp Piper Jaffray, expects Hewlett-Packard
and EMC to sign up for the Cisco switch by midyear.
That could spell trouble for Brocade, considering the huge chunk of sales it
gets from H-P.
Brocade officials declined to comment for this story.
Kumar, who rates Brocade Underperform, believes that Cisco's MDS wares have
features, like traffic management, that make it a better product than either
Brocade's or McData's offerings.
The stiff competition in these markets is starting to take its toll on
Brocade.
For its fiscal first quarter, ended January 25, Brocade met Wall Street's
expectations with a breakeven quarter as sales were flat.
But Brocade's gross margins slid more than six percentage points to 53.7%
from the same quarter last year, as selling prices weakened.
"[Brocade's] biggest problem is not getting [sales] volume, so their overhead
is weighing down margins," says Mansky.
Analyst Shebly Seyrafi of A.G. Edwards & Sons believes Brocade`s gross
margins will stay at about 54% as Cisco and McData chip away at its share.
To counter McData, Brocade began shipping its Silkworm 12000 director, which
costs up to $115,000, depending on the configuration. But the device may be
cannibalizing Brocade's own sales, rather than McData's, says Mansky, who rates
Brocade shares Underweight.
And with corporations tightening their belts, shelling out big bucks for the
12000 "just isn't palatable now," says Mansky.
Brocade's financial picture is also mixed. The company's cash flow from
operations dropped to $8.6 million in its fiscal first quarter from $19.7
million a year ago. Brocade has $513 million in cash and a debt-to-capital
ratio of 45%.
Yet investors unaccountably still seem starry-eyed about this stock, which
hit an all-time high of 133.72 back in the glory days of 2000.
At today's seemingly more sober 5.13, they still seem willing to pay a
ridiculous 257 times analysts' estimates for the fiscal year ending October
2003 and a still-stratospheric 51x fiscal 2004 projections.
Even next year's more modest multiple is way, way ahead of its projected
long-term annual earnings growth rate of 25% (see At a Glance), which seems
optimistic considering stiffening competition.
(Shares of Brocade rose nearly 13% in the last several sessions as rumors
swirled that Emulex was eyeing the switch maker, scuttlebutt to which Mansky
gives little credence.)
Brocade does have a large installed base of customers who use its proprietary
technology, and storage has remained, comparatively, an oasis of strength in
the technology desert.
But weak demand and growing competition make Brocade's immediate future
rather dicey. Throw in its astronomically high valuation, and it's no wonder
some investors are beginning to evade Brocade.
(END) Dow Jones Newswires
03-27-03 0800ET |
