Research Associate: Anukampa Mohanty, ACA, M.Com
Editor: Kenneth Nagy
North Wacker Drive Chicago, IL 60606
Brocade Communications / (BRCDE-NASDQ) / $3.96Note: This report has substantially new material. Subsequent reports will have changes highlighted.
Reason for Report: Quarterly results for 2QFY05.
Overview
Brocade Communications Systems, Inc. (BRCDE) designs, develops, markets, sells and supports data storage networking products and services. It offers a line of intelligent storage networking switches and storage area networking (SAN) management operating system that enables companies to implement highly available, scalable, manageable and secure environments for data storage applications. The Brocade SilkWorm family of SAN switches is designed to help companies reduce the cost and complexity of managing business information within a data storage environment. Brocade products are installed worldwide at companies, institutions and other entities of all sizes, ranging from large enterprises to small businesses. Brocade products and services are marketed, sold and supported worldwide to end users through distribution partners, including original equipment manufacturers (OEMs) value-added distributors, systems integrators and value-added resellers (VARs). The company is based in San Jose, California and employs over 1,200 people.
For more information about the Company, visit its website at
Analysts have identified the following factors for evaluating investment merits of BRCDE:
Key Positive Arguments / Key Negative Arguments- As BRCDE manufactures components and has limited direct customer exposure, it has the ability to maintain high margins amid declining revenue environment by cutting down on operations
- The DOJ has joined the SEC in conducting an informal inquiry regarding the recently discovered stock based compensation improprieties and financial restatement. This may prove extensive, time consuming and costly for the company
- The company is likely to begin aggressive repurchase of its shares to offset dilution, else share count could increase in the next few weeks
- BRCDE is facing competition as Cisco is moving aggressively into the storage market and is penetrating BRCDE’s core fabric switch market. Also, MCDT’s low-cost products are gaining Brocade’s key OEM customers
- Brocade is the market leader for fiber channel switching equipment and is positioned to benefit from accelerating SAN deployments through enterprise
- The company has high customer concentration with around 80.0% revenues from eight largest OEMs. Loss of any one could cause weakness in revenues
- BRCDE is well ahead of its competitors with the new 4 Gig product cycle
- Management suffers from credibility issues among institutional investors and many sell-side analyts
- Spurred by CSCO’s initiatives and the merger of MCDTA and CMNT, Brocade is expanding its focus beyond SAN switches as it introducing new products as part of a Tapestry family of products
- Product line is exclusively fiber channel. Success of iSCSI or Infiniband could pose threat or requirethe company to invest additionally on R&D or make dilutive acquisitions to position for the future
- Brocade has delayed the filing of 10Q for 2Q05 due to which BRCD will now be trading under the ticker symbol BRCDE. They intend to apply for continued listing under Nasdaq
Among the 20 analysts rating on the stock, 4 have rated it positive, 12 neutral, while the remaining 4 have given negative ratings.
Note: The company’s fiscal year ends October 30th. All annual and quarterly references are to be construed accordingly.
Revenues
Total revenues in2Q05 were $144.8M, down 0.5% YoY, and 10.4% sequentially. Revenues were in line with revised revenue estimates of $144.7M following negative pre-announcement. BRCDE had negatively pre-announced revenue of $144.0-$145.0M versus original guidance of $155.0-$161.0M.
Management blamed soft enterprise demand in Europe and greater-than-expected seasonality for the miss, which was not totally unexpected given IBM’s slow quarter and its stumble through a new and delayed product cycle. North American business was slightly down while BRCDE experienced modest growth in Asia Pacific. Management also suggested a sequentially contracting SAN market. Cisco is believed to be starting to make headway into BRCDE’s core market with aggressive pricing actions. Few of the analysts hold the opinion that a likely QLGC OEM deal will lead even more competitive pressure this year. ASPs declined to mid single digits. It is believed increasing competitive pressures including MCDT’s new product cycle as well as Cisco, may put further pressure on prices. Sales of new entry level products did not grow and the market was flat, though the management remains positive on the ultimate growth potential of this market. The SMB space does represent an attractive market as SAN technology becomes easier and more affordable. However, many in the industry may be too optimistic about the timing of mass adoption in the low end. The channel is viewed by a few of the analysts as a key driver to making this market successful. Sales of blade switching products exhibited continued growth. With wins at the top 3 blade server OEMs, this market should provide incremental growth opportunities for BRCDE. The company’s top three customers remain HP, IBM and EMC, which represented around 70.0% of revenues in FY04.
Provided below is a summary of revenues as given by Zacks Digest:
Figures in $M / 2004A / 1QA05 / 2QA05 / 3QE05 / 4QE05 / 2005E / 2006EDigest High / $596.3 / $161.6 / $144.8 / $145.0 / $161.6 / $607.8 / $667.0
Digest Low / $596.3 / $161.6 / $144.8 / $142.0 / $142.5 / $591.3 / $598.0
Total Revenue / $596.3 / $161.6 / $144.8 / $143.4 / $149.7 / $597.9 / $632.1
For more color on individual analyst opinion please see Consensus tab of the BRCDE spreadsheet.
Margins
Gross margin for 2Q05 was 57.1%, up marginally by 2.7% YoY, but down sequentially by 13.1%. This was in line with the guidance of 55.0%-58.0%. Gross profit declined as a result of volumes impact, and a decrease in mix of director-class solutions more than offset an increasing 4Gb/s mix during the quarter. Operating margin for the quarter was 13.7%, substantially up by 104.1% YoY, while sequentially down by 35.8%.
Long-term operating targets were reiterated. Management guided gross margin in the range of 55.0% to 58.0% for FY05. Operating margin should be in the range of 15.0% to 20.0%. Brocade’s operating expense management remains a positive. Overall operating expense of $62.8M was below the company’s guidance of $64.0-$66.0M. Operating expense management will continue to be a key focus going forward, as Brocade pointed to increased investments in new technologies and other growth initiatives, beginning October 2005. BRCDE management has done a respectable job of containing costs over the last several quarters. Increasing expenses during a time of slow revenue growth warrants caution and a majority of the analysts believe management should keep expense increases under control until revenues trends look healthier. Since BRCDE manufactures components and has little direct customer exposure, it has the ability to maintain high margins in the midst of a declining revenue environment by simply cutting down on operations which is expected to give some insulation on the downside. So far the gross marginis concerned, management expects the ramp of its new 4GB 4100 mid-range switch to positively impact gross margin over the next few quarters.
Provided below is a summary of margins as given by Zacks Digest:
2004A / 1QA05 / 2QA05 / 3QE05 / 4QE05 / 2005E / 2006EGross Margin / 56.3% / 58.9% / 57.1% / 56.5% / 57.0% / 57.4% / 56.7%
Operating Margin / 10.4% / 19.1% / 13.7% / 11.3% / 11.6% / 14.1% / 14.1%
Pretax Margin / 11.8% / 20.9% / 16.2% / 13.8% / 13.9% / 16.3% / 16.5%
Net Margin / 8.4% / 17.5% / 13.2% / 11.1% / 11.3% / 13.3% / 13.2%
For more color on individual analyst opinion please see Consensus tab of the BRCDE spreadsheet.
Earnings per Share
Net income for 2Q05 was $19.1M, up substantially by 135.8% YoY, but down 32.6% sequentially. EPS for the quarter was $0.07, up 133.3% YoY, but down 30.0% sequentially. Brocade’s 2Q05 results matched the management’s recent downward revision. EPS was below the consensus by $0.02. Despite decent results at EMC and Hewlett-Packard, two of the biggest OEMs, the company saw ‘ports shipped’ decline, a slowdown in Europe, elongated sales cycle and some director market share loss. GAAP EPS for 2Q05 were also $0.07 and included a number of adjustments including stock compensation costs and costs associated with the company’s continuing SEC review and internal investigation.
Management has guided the July quarter EPS in the range of $0.05-$0.06. Guidance was disappointing as estimates are flat to down from Q2. This is also significantly lower than the consensus of $0.08. The company blames transition from 2Gb/s to 4Gb/s and inventory build up at some of the OEMs that will probably take a couple of quarters to work off. Few analysts also blame the pricing pressure in entry level applications for affecting EPS in coming quarters. Earnings are set to decline on a sequential basis for the second straight quarter and should also continue trending downward given management’s guidance for rising expense levels. Analysts have reduced their respective July quarter estimates in line with management’s guidance and have taken a generally pessimistic outlook on BRCDE’s future business. The GAAP –Proforma variance remained tight in 2Q05, but should expand in 3Q05 due to a previously announced charge related to the Therion software acquisitions. Reversals of existing reserves helped offset the impact of charges in each of the past two quarters, but this is not expected to continue. Additional restructuring, stock-based compensation and SG&A related provisions are inevitable and have the potential to push GAAP profits down.
Provided below is a summary of EPS as provided by Zacks Digest:
2004A / 1QA05 / 2QA05 / 3QE05 / 4QE05 / 2005E / 2006EDigest High / $0.19 / $0.10 / $0.07 / $0.06 / $0.08 / $0.32 / $0.40
Digest Low / $0.19 / $0.10 / $0.07 / $0.05 / $0.04 / $0.27 / $0.21
Digest Avg. / $0.19 / $0.10 / $0.07 / $0.06 / $0.06 / $0.30 / $0.31
Zacks Consensus / $0.19 / $0.10 / $0.07 / $0.06 / $0.07 / $0.32 / $0.34
For more color on individual analyst opinion please see EPS tab of the BRCDE spreadsheet.
Target Price/Valuation
The average Digest price target is $5.25. Prices range from $3.00 (Technology Research) to $6.00 (AG Edwards, American Technology, Lehman, and R W. Baird). Most of the analysts have used the P/E methodology for the purpose of valuation. Other valuation techniques used by analysts include DCF, P/S and EV basis.
The analyst (Technology Research) quoting the minimum price target of $3.00 bases his calculation on a multiple of 1.2x FY2006 revenue. The analyst uses revenue estimate for the purpose of price target calculationas they have minimal confidence in forward earnings estimate and expect the bottomline to fall below breakeven level at some time in 2H05 or FY06. After a 42.0% decline year to date, the shares are still believed to have considerable downside risk.
One analyst (AG Edwards) quoting the maximum price target of $6.00 uses a P/E multiple of 19x CY06 EPS for the purpose of calculation. The current P/E represents a discount to an overall storage peer group 2005 multiple and the analyst believes the multiple could expand modestly as they expect Brocade’s product cycle and competitive position to remain healthy.
The table below shows details regarding valuation:
Rating DistributionPositive / 20.0%
Neutral / 60.0%
Negative / 20.0%
Average Price Target / $5.25
Maximum Price Target / $6.00
Minimum Price Target / $3.00
Price quoted by most analysts / $6.00
Number of analysts / 20
For more color on individual analyst opinion please see Valuation tab of the BRCDE spreadsheet.
Long-Term Growth
Long-term growth rates for the company range from 3.0%(RBC Cap.) to 12.0%(AG Edwards, JMP Sec., Piper Jaffray), with an average of 8.2%.
Spurred by CSCO’s initiatives and the merger of MCDTA and CMNT, BRCDE is expanding its focus beyond SAN switches. Brocade has numerous hardware, software and services announcements designed to differentiate the company from its competition. On the hardware side, the two biggest announcements were a 4Gb/s 256-port director called the Silkworm 48000 and a 4Gb/s entry level ‘ports-on-demand’ product called Silkworm 200E. Also, the company talked about a blade for the Silkworm24000 that would increase the bandwidthand a 4Gb/s switching blade partnership with Intel. Many of the analysts think that Brocade will be able to create a need for 4Gb/s products where no need currently exists. Strong marketing and low pricing should be enough to stem any market share erosion and may even help to get a portion of the lost share back. On the software side, Brocade introduced two storage applications. The first is Application Resource Management, which is simply automated provisioning of storage and servers. This is an outcome of buying back Therion. Brocade acquired Therion Software for approximately $9.3M in cash. As a result, the company indicated several new product development programs underway. The second application is the wide area file systems. This product is the result of an investment in a small private company called Tacit Networks. BRCD announced a strategic partnership with Tacit Networks to deliver WAFS to the enterprise. Brocade will invest up to $7.5M in Tacit and become the exclusive distributor of Tacit solutions to OEMs. The companies also entered into a joint development agreement. Together these two products mark the beginning of a product suite called Tapestry. Management is hopeful of launching several more applications over the next 12 months. Finally, BRCDE talked about a new services framework where consultants are put on project-based jobs commissioned by end users either through the OEMs or through the company directly. Available immediately and with about 15 contracts already, these new solutions include services in design, installation, and support for increasingly complex storage infrastructure.
Other Discussion/ Corporate Governance/ Capital Structure
- BRCDE announced on May 11 that it would restate its accounts for FY2001-04 due to the company’s non-adherence to the guidelines regarding stock option granting practices for stock options granted from August 2003 through November 2004. As a result, the company expects to record additional non-cash expenses of $12.0-$26.0M in FY01, $19.0-$23.0M in FY02, $0.2-$0.8M in FY03 and $0.8-$2.8M in FY04.
- The DOJ is working with SEC in a joint investigation regarding BRCDE’s stock option granting practices. The company is also facing class action lawsuits for providing misleading financial information.
- Analysts believe Brocade could begin to actively repurchase shares over the next few weeks, following the filing of its restated financials with the SEC. CFO Tony Canova reiterated his long-term focus of spending approximately 20.0% of the company’s operating cash flow on share repurchase going forward. The company repurchased 1.15M shares at an average price of $6.13 during 2Q05.
- The company repurchased $66.5M ($69.2M face value) of its convertible bonds duringthe second quarter. The bonds mature in January 2007, and a conversion price of $43.75 makes it a near certainty that BRCD will be forced to repay the principal.
- Accounts receivable declined 20.0% sequentially to $87.3M. DSOs declined 4 days to 54 days. This is within management’s goal of 50-60 days. Inventory was up $4.9M sequentially, representing an increase of 71.0% sequentially. The company mentioned that channel inventories would decline over the next several quarters as its 2 Gbps products are phased out. Deferred revenue was flat sequentially.
- The balance sheet is solvent, despite a noticeable reduction in liquidity over the past year. Accruals associated with employee compensation and capitalized expense items have been kept in check over the past year, but could be considered a bit on the high side.
- Brocade has accrued a non-cash charge of about $1.7M associated with consulting services from its former CEO Greg Reyes. This reflects the company’s decision that his services were no longer valuable. The company is currently evaluating its options regarding this issue, which could potentially lead to a reversal going forward.
Recent Events
Date / Event / CommentsJune 10, 2005 / Brocade receives Nasdaq notification related to late filing of Form 10-Q for second quarter offiscal 2005 / As a result, Brocade will begin trading under the ticker symbol "BRCDE" w.e.f June 14, 2005. Brocade intends to request a hearing before a Nasdaq Listing Qualifications Panel for continued listing on the Nasdaq
June 10, 2005 / Brocade SilkWorm Multiprotocol Router named most valuable product at Storage World Conference 2005 / Built on the Brocade intelligent switch platform, it surpassed the competition, including networking equipment from Cisco, McData, QLogic, and Emulex Corporation to win the MVP award. The product enables resource sharing across isolated Storage Area Networks (SANs), making it easier for storage administrators to streamline data migration, consolidate backups, and enhance disaster recovery applications
Individual Analyst Opinions
POSITIVE RATINGS
AG Edwards (06/02/05)–The stock is rated Buy with a price target of $6.00. In spite of some competitive issues and concerns regarding the SEC or DOJ investigation that are expected to linger over the stock for the next several quarters, the analyst has a positive view on the shares given an attractive valuation. Although investor sentiment remains negative, the analyst believes upside to their current valuation should materialize in 2H05.
American Technology (06/02/05)– The stock is rated Buy with a price target of $6.00. The analyst finds the risk-reward position of the stock favorable with the pullback from the recent highs. BRCDE remains the largest player in the SAN space with over 5 M ports installed.
SIG (06/02/05)– The stock is rated Positive with no price target. Concerns over SEC investigation and competition from Cisco and MCDTA/CMNT continue to put pressure on the stock. However, based on BRCDE’s strong cash flow generation, large footprint in the SAN market and customer stickiness,the analyst believes there is substantial upside to the stock. BRCDE is believed to be leading the transition to 4 Gig products and market share gains are also expected.
Lehman (05/20/05) – The stock is rated Overweight with a price target of $6.00. April quarter were mixed and in line with pre-announcement. The analyst believes valuation and cash should provide support and product momentum could act as catalyst to the stock.
NEUTRAL RATINGS
Adams Harkness (05/26/05) – The stock is rated Market Perform with no price target. The new product ramp, which could have driven revenues and earnings higher, appears to be facing difficulties in materializing primarily due to excess customer inventory. Other concerns such as continued restatements of previous results, government investigations and shareholder lawsuits now appear to be greatly magnified. The analyst believes such issues should be resolved only in the next year.