Please do not repost. This is Kumar today. He's trying to kill us along with BRCD. Any comments on this? KJ?
Equity Research Notes
Brocade Communications Systems, Inc. (BRCD – 210 1/16) August 21, 2000
Ashok Kumar, CFA, 650-233-2289, akumar@pjc.com; Amir Ahari, 650-233-2271, aahari@pjc.com;
Paul H. Mansky, 612-303-6474, pmansky@pjc.com
Brocade’ s Masada? Adjusting FY00 And FY01 Sales And EPS
Estimates.
Rating: Neutral, Aggressive (#)
Highlights
· Brocade is the last man standing in an increasingly unhealthy industry
· Enterprise OEMs – SUN (SUNW), EMC (EMC), HP (HWP), and IBM (IBM) – have yet to embrace FC SAN connectivity fully
· Ethernet/IP SAN solutions for MAN/WAN should begin rolling out in six months
· Expect Q/Q revenue momentum to start slowing beginning January quarter
· Inflated valuations discounting flawless execution and exponential market growth
Brocade has finally begun to do many of the things it needs to. It is educating the industry participants, it is working to build strong
partnerships with noncompeting companies in the industry, and is allocating resources into interoperability testing.
However, on a tactical note, it appears to be lacking direct sales intelligence. While it talks about being named as the standard SAN
switch for Storage service providers like StorageNetworks (STOR), it does not have a direct relationship with them. In other words,
Brocade does not determine its own destiny in the market through its own sales organization. The reasons for this are not clear. It
might be trying to keep its gross margins up by keeping the cost of sales down, and/or it might be afraid of losing OEM customers if
it competes head to head with them in some way. They may also be afraid of compatibility problems between its own Brocade
products and those offered by an OEM that might contain customized functionality. Whatever the reason, it is dangerous for Brocade
not to have more direct knowledge about what is happening at customer sites.
Brocade Communications Systems, Inc.
August 21, 2000 – Page 2 of 2
What is happening is that FC has fallen well short of expectations. It has become the victim of dueling standards efforts that have
fractured the promise of interoperability and hampered deployment of SANs. A recent poll by eWeek (7/31) indicated that 85% of
the companies surveyed have not deployed SANs and about 80% of the respondents either do not intend to or do not know if they
will deploy SANs within the next year.
The Ancor (ANCR #)/QLogic (QLGC-#) business with Sun was not discussed by management during last Thursday’s earnings call.
We believe Sun’s professional services organization has been installing Brocade at some sites. It takes a long time for a company
like Sun to get going, but it is making some headway. If Sun ever gets behind a competitive product with its own OEM version, this
will force storage suppliers to step up their sales of “SUN-compatible” switches – meaning non-Brocade. As the single largest
market for noncaptive disk subsystems, the Sun server storage opportunity is one of the largest. Brocade’s lack of OEM products at
Sun today is an exposure.
OEM sales represented 75% of channel mix with the top 10 OEMs representing 80% of the Company’s revenues. Compaq (CPQ-#),
a company that lacks any storage strategy, is the largest OEM for Brocade. Brocade faces the loss of revenue tailwind without
sponsorship at Sun, the largest OEM opportunity, and the potential that the other OEM programs could be still born due to
competitive technology offerings by 1H01.
The Ethernet/IP storage threat is much bigger than Brocade makes it out to be. Brocade likes to talk about WDM in the MAN and IP
in the WAN. The real issue is IP everywhere. Why shouldn’t storage be IP also?
While Brocade’s execution appears to be fairly good, its market is not healthy. It claims a growing percentage of the market, which
is indicative of its own progress, but is also indicative of the state of the fibre channel industry, which is not growing as quickly.
Brocade likes to believe it is like Cisco (CSCO), the king of IP, but the industry reality is that it is much more like IBM, the proud
king of Token Ring - a standard that no longer has any standard group working on it.
This industry needs to separate the storage subsystems from the core technology providers (Brocade, Gadzoox [ZOOX], QLogic,
Agilent [A], LSI [LSI]). When one includes the major subsystem vendors (EMC and IBM), the FC market looks pretty solid.
However, if one takes them out of the mix and assigns them to competitive technology, such as Ethernet/IP storage, the equation
changes rapidly. This is Brocade’s and QLogics Achilles heels.
Brocade’s valuation – 34X C01 P/S, 7.3x CY01 PEG, and 182x CY01 P/E - discounts flawless execution and exponential market
growth. Most network technology companies trade at 15x-25x CY01 P/S. With the imminent slowdown in OEM sales due to lack of
sponsorship at Sun and the rollout of competitive technologies, the best is behind. While the FC business will degrade slowly, we
believe valuations will not degrade gracefully. |
