This week's Barrons on Brocade:
A Question of Value
Is Brocade the next Cisco or merely an overpriced stock?
By Neil A. Martin
Like many technology outfits, Brocade Communications Systems has seen
its share price pummeled lately. But the company's business-and growth
prospects-remain strong. And fans think that, over the long haul, Brocade can
put up numbers that will justify its still lofty stock-market valuation. Along
with EMC, Network Appliance and Veritas, Brocade is one of the four
horsemen of computer-data storage. The company ended its business year
October 31 with record sales and earnings, a 4% increase in its market share
and profit margins near 60%. And unlike other Silicon Valley firms that were
being forced to lay off workers because of a slump in computer sales and a
slowdown in the economy, Brocade added 10-20 new workers a month to
its payroll, which now stands at 750, compared with 120 a year ago.
Brocade's stock was also one of the hottest on Wall Street last year. The
common tripled in value through the first 10 months of 2000, hitting a
split-adjusted high of $133.72 on October 23. And even after the recent slide
in the tech sector shoved the shares down 20% in December, the company's
stock still is wafting through rarefied air.
Brocade closed Thursday at $95.48, up 116% on the year, while shares of
Veritas were up slightly by 0.02% in the same span, and those of EMC and
Network Appliance were up by 25.5% and 74%, respectively. In fact, since
Brocade's stock started its meteoric rise on initial listing on May 25, 1999, it
proved to be the only one of the few equities that not only managed to hold
on to its 1999 gains in 2000 but also improve on them. From its '99 debut
through Thursday, the shares of the San Jose outfit jumped more than
3,000%.
Naturally, against a backdrop of earnings warnings by many of Brocade's
biggest customers, which include many of the big personal-computer
manufacturers, investors are nervously trying to determine whether the
company can continue its rapid expansion. Earnings have grown nicely
through the past nine reported quarters, galloping ahead at a 40%-plus annual
pace over the past four. That has elevated Brocade's price/earnings ratio.
Based on recent quotes in the mid-90's, the shares now change hands around
144 times estimated fiscal 2001 earnings.
"Brocade is facing the same
question other fast-growing,
highly-valued companies
confront today, which is whether
it can maintain past levels of
growth amidst a slowing
economy," says Chris McHugh,
lead manager of Turner Midcap
Growth fund. "At some point in
the future, it won't be able to
continue to grow at those kind of
numbers." But McHugh doesn't
believe that unhappy day will
arrive soon. In fact, the stock's
December swoon inspired him to add to his already substantial position in
Brocade of 475,000 shares. "It is definitely attractive at current prices," he
says.
While the market's gyrations have made investors wary of just about any
high-tech firm, a number of other fund managers and most analysts who track
Brocade remain upbeat about its near-term prospects. Of the more than a
dozen analysts who follow the company, nearly all rate Brocade a Buy or
Accumulate.
Analyst Shebly Seyrafi, who follows Brocade for A.G. Edwards, recently
lowered his 12-month target price for the stock to $100, way below the
$162 he was dreaming of last October, "to reflect a lower technology market
and general economic concerns." But he still rates it a buy. "Brocade has a
dominant position in its specific market and none of its competitors can match
its earnings momentum," he maintains.
When he reported fourth-quarter earnings on November 29, Brocade's
president, Gregg Reyes, expressed strong confidence about the pace of
business this fiscal year, predicting that revenues would rise more than 150%,
to $830 million, from $329 million in fiscal 2000. "We have an incredibly
strong outlook and our best backlog ever going into the next quarter," Reyes
declared. Two months into the new quarter, and despite a stream of
downward earnings revisions by many of his key customers, Reyes is still
upbeat about the 2001 outlook. "We certainly aren't recession-proof, but we
continue to see very, very robust growth in our segment of the storage
market," the CEO maintains.
In some ways, belt-tightening by Corporate America is helping Brocade, as
companies invest less in adding computer power and more in safeguarding
their existing data-storage systems. And Brocade's fiber-channel switches
and technology allow companies to network these systems so that information
can be recovered and managed more easily, quickly and cheaply.
"In the past, when money was not a consideration and a company ran out of
storage, it would just buy another server," Reyes says. "But in today's
business environment, with tighter budgets, they are finding it more
cost-effective and efficient to network their data in a storage area network,
which is the market we dominate," he adds. (Brocade claims to have nearly
60% of the U.S. storage area network, or SAN, market. That share jumped
by four percentage points in its fourth quarter.)
Reyes, who prides himself on beating Wall Street estimates, is "comfortable"
with consensus estimates that call for 63 cents per share in the year ending
next October 31, which would be more than double last year's 28 cents.
Beating earnings estimates may prove less of a problem than keeping the
stock out of Wall Street's doghouse if the rout in the rest of the tech market
continues. Guilt by association has hammered some high-flying but solid
stocks like Brocade. Direct competitors like McData, Network Appliance,
EMC, Qlogic, Veritas and Gadzook Networks recently have been trading
near their 52-week lows. Brocade, in contrast, is about 36% under its
12-month high.
Like Brocade itself, many of its rivals sport P/Es that might make a value
investor weep. Network Appliances, EMC and Veritas recently have been
trading, respectively, at multiples of 139.7, 67.2 and 123.9 times next year's
expected profits. Many analysts contend that P/E ratios are irrelevant when
trying to evaluate a fast-growing outfit like Brocade. But carrying a lower
multiple than many of its competitors certainly isn't a disadvantage whenever
the market gets queasy.
"Which do you value more -- a company like Brocade that is trading at 100
times earnings, but is expected to grow over 100% year-on-year, or another
company that trades at 35 times earnings, but will struggle to get 10% growth
over the next 12 months?" asks H. Clinton Vaughan, who covers Brocade for
Salomon Smith Barney and rates it a Buy, with a 12-month price target of
$130. "You expect to pay a premium for growth unless you want to watch
from the sidelines."A far better measure to evaluate high-growth companies in
new industries, Vaughan argues, is price-to-earnings growth or price-to-sales
growth. In terms of next year's earnings growth, he says, Brocade currently
trades at the lower range of the higher-growth tech companies at 1.5,
compared with Veritas at 3.7, Network Appliance at 2.8 and EMC at 2.5.
On a price-to-sales basis, Brocade lately has been trading around 26.1 times
forward revenues, compared with EMC's 12.8, Veritas' 24.1 and Network
Appliance's 17.1.
"Brocade's valuation is driven on the fact that it is a market-leading company
in an emerging market," says Thomas W. Coler, an analyst with Dain
Rauscher Wessels. "So if you go back in time and look at Cisco Systems'
performance over the course of its history, you'll find that the market cap has
always doubled or tripled the size of the actual market opportunity the
company was attacking," he says. Okay, but given the rapid changes in the
ever-evolving storage industry, how long can Brocade maintain its current
torrid growth pace? While a 150% revenue gain, like that expected to be
reported for fiscal 2001, might not be in the cards for fiscal '02, most
consensus estimates place Brocade's five-year average earnings growth rate
at 50%.
"If we continued to grow 40%-plus a quarter
sequentially, we'd soon become the size of GM,"
laughs Michael Byrd, Brocade's financial VP. "The truth is that no one,
including us, really knows just how fast our market is growing. We only know
that we are in the middle of an incredibly explosive market with a dominant
share and don't see any dynamics that would threaten that position anytime
soon," he explains. In fact, he adds, "we believe we are in a period of great
growth this year, and my greatest challenge with investors will be to manage
expectations."
Reyes says he worries about managing his company's future. "The one thing
that really keeps me up at night is not just how to use our critical mass to an
advantage but also to make sure that we do whatever is necessary to prevent
us from imploding under our own weight," he says. Founded in 1995,
Brocade currently controls more than 90% of the market for fabric switches
-- a storage networking device. It also enjoys a 59% share of the overall
market for SAN networking equipment, which includes hubs, switches and
host bus adapters, and supplies products and software to nearly all of the
world's top computer makers, including IBM, Dell and Compaq.
Fabric switches are the fastest-growing category in the computer storage
market, which is expected to nearly double in size over the next three years to
$72.3 billion. According to estimates by Dataquest, the fiber channel segment
of this market could expand at a 68% compound annual rate between 1999
and 2003, to reach at least $7 billion. But some analysts believe this estimate
is conservative, saying the market could top $10 billion by 2004 if all goes
well.
"We don't look at those as final numbers or even believe the market will stop
growing," says Reyes. "Rather we look upon them as simply a validation of
the growth of this industry and the huge upside potential." What's driving the
industry is the explosively widening demand for more data storage, generated
by the Internet and a host of new information technologies.
According to a recent poll by InformationWeek magazine, corporate
information technology managers say their companies' storage needs are
expanding, on average, about 50% annually. Other reports put the figure as
high as 80%. Whatever the number, it will keep getting a boost from firms
and individuals using voice and speech recognition products, digital language
translation and photography devices, MP3 music and MPEG video, desktop
video conferencing and set-top boxes/web television.
"The importance of data and information has increased exponentially," says
Salomon Smith Barney's Vaughan. "The ability to move, backup, manage and
access greater amounts of data in more ways and more often has led to the
necessity to network storage, thereby enabling better resource utilization and
management," he adds. "Storage networking is the next big paradigm shift in
computing, and it is just beginning to unfold," he says. By utilizing SANs, a
company can connect its servers to storage devices, which in turn can
communicate with other storage devices, providing a fast, efficient, reliable,
diversified and cost-effective method for parking data and providing backups
for it.
"Companies need to network what they have and we can help," notes Reyes.
"So our current business really isn't about switches or fiber-channel
technology; rather, it is about networking that is already out there."
Some industry analysts predict that more than 80% of the world's external
storage will be based on SAN infrastructure by 2004, driven by exploding
growth in the amount of data and the need for continuous access anywhere,
anytime.
Right now, storage area networks -- relatively new kids on the block
--represent only about 3% of the $40 billion storage market. And they face
competition from technologies that, some critics contend, could hurt Brocade
down the road.
"Brocade is the last man standing in an increasingly unhealthy industry,"
asserts Ashok Kumar, who tracks the company for Piper Jaffray. "Fiber
channel was the first major new technology used in storage area networking
and although it established an early market lead, fiber channel's success in the
long run against entrenched networking competitors such as Ethernet and
Internet-based protocols is highly questionable," he adds, arguing that fiber
channel appears to be headed for the mothballs.
But Brocade officials -- and many other analysts -- dismiss Kumar's gloomy
assessment.
"Whether Ethernet or fiber channel will dominate the world of enterprise
storage is not the point," says Reyes. "The truth of the matter is that this is an
incredibly complex issue involving many different applications and
technologies. The one thing we think most people can agree on is that there is
really no viable, competing alternative to fiber channel as it exists today and
won't be for another three to six years."
That's a lifetime in the world of high tech, but even if Brocade is correct, it
knows it can't rest on its laurels. Consequently, it's striving to consolidate its
position in its core market, while seeking to develop new products and to
bolster relationships with customers and even with some competitors.
Brocade recently agreed with Cisco, which is also moving into the storage
business, to jointly develop a standardized interface that will allow fiber
channel switches to connect to Internet protocol-based networks. If
successful, this could convince more companies to adopt fiber channel-based
networks for their storage needs.
"You'd have to believe that these guys are asleep at the controls to think they
will allow their company to lose its dominant position," comments Paul
Johnson, an analyst with FleetBoston Robertson Stephens. "They will devote
the time and money to develop new technologies, acquire the best technical
personnel, invest in other companies, or do whatever it takes to keep ahead
of the curve."
In this sense, Brocade officials like to compare themselves to Cisco.
"Brocade will be to storage area networking what Cisco is to the Internet,"
Reyes contends. "I don't want to imply that Brocade is the next Cisco," he
adds, "but we certainly have the opportunity to be the Cisco of storage." And
that's precisely what investors who have kept Brocade's stock price flying
high are betting will happen someday. |
