Buy, Sell, or Hold: Brocade Communications

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Last year was a struggle to get back to even for Brocade Communications' (Nasdaq: BRCD  ) shareholders. An earnings warning in August sacked investors' hope and the stock ended the year down 2% after having been down 40% at its worst in 2011.

Despite the relatively flat year, traders on both sides of the coin have reason to be excited about Brocade in 2012. Let's take a look at some of the things that could make you want to buy, sell, or possibly hold Brocade this year. At the end, I'll weigh in with my take.

The two primary lures to buying into Brocade are the possibility of a buyout and as a value play relative to its peers.

Brocade unsuccessfully has put itself up for sale before, but many feel it could be different this time around. According to reports from The New York Times, Brocade is in the early stages of talks with private-equity firms with nothing yet being set in stone. Brocade is profitable and has supply partnerships currently in place with IBM (NYSE: IBM  ) , Hewlett-Packard (NYSE: HPQ  ) , and Dell, to name a few. With Hewlett-Packard having moved out of the hardware segment, IBM could make a perfect suitor for Brocade.

Brocade also makes for an intriguing value play. Having purchased 9% of its outstanding shares in its latest quarter, Brocade is trading at just 10 times forward earnings and a reasonable 1.3 times book value. It's considerably larger storage peer, EMC (NYSE: EMC  ) , is valued at 13 times forward earnings and a price-to-book value of 2.5. EMC's valuation isn't outrageous, but Brocade's average growth rate of 23% over the past five years trumps EMC's 12% easily.

There are two equally compelling reasons to be on the short-side of this trade: innovation and, ironically, value.

After paying a hefty $3.4 billion for Foundry Networks in 2008, Brocade locked in its dominance in the Fibre Channel switch market. Unforunately, when Cisco Systems (Nasdaq: CSCO  ) announced an investment of $1 billion into developing a competing Fibre Channel over Ethernet switch, it essentially rendered Brocade's switch obsolete. With little in the way of innovation, investors realize the ceiling is only so high for Brocade's current product portfolio.

Valuation is also in the eyes of the beholder. I came to Brocade's defense in November after the company's impressive fourth-quarter results, but the rally in the stock since then has chased many would-be buyout offers away. In fact, some have speculated that with Brocade having nearly doubled from its 52-week lows, a full valuation may already be baked into the stock.

The primary reason to hold Brocade is if you feel the business will continue to generate solid cash flow, management will continue to aid profits by repurchasing shares, or if you think the company has a genuine chance to boost share value by being purchased.

Now, here's my take on Brocade...

The verdict
In August and November I came to Brocade's defense, and the stock has responded with some incredible gains since then. However, I also can't help but be unimpressed with Brocade's lack of innovation for the future. Share repurchases are only going to grow earnings so much before investors realize that Brocade's growth is slowing. I am mildly optimistic that 2012 is the year that Brocade does find a buyer, but I wouldn't be looking for a huge premium over its current valuation. Temper your expectations and I think shareholders will have a much better year in 2012 than they did last year. Given this, I will be maintaining my CAPScall of outperform already in place on CAPS.

What are your thoughts on Brocade? Share them in the comments section below and consider adding Brocade to your free and personalized watchlist so you can keep track of the latest news with the company.

Also, if you're tired of companies failing to innovate, then I invite you to download a copy of our latest special report: "The Next Trillion-Dollar Revolution." It details a company highlighted by our own senior technology analyst, Eric Bleeker, that's set to revolutionize the mobile market. Best of all, this report is completely free for a limited time, so don't miss out!

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong. The Motley Fool owns shares of IBM, EMC, and Cisco Systems, and has created a bull call spread position in Cisco Systems. Motley Fool newsletter services have recommended buying shares of Cisco Systems and Dell. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that's always rated a buy.

Read/Post Comments (2) | Recommend This Article (7)

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  • Report this Comment On January 19, 2012, at 1:06 PM, DiggerandSydney wrote:

    It would help if you got a couple of things correct before posting an article of "advice".

    Brocade did not pay $3.4bn for Foundry - it was more like $2.9bn. Either way, still too much. This acquisition had NOTHING to do with FC SAN. As a Brocade customer, they have achieved market leadership by producing better, faster, more innovative and easier to use products than their only competitor in FC SAN - Cisco. The acquisition of Foundry enabled Brocade to get into the IP/Ethernet space and they are now one of the contenders in the Data Centre and Campus switching space alongside Cisco, HP, Juniper and some other smaller players.

    As far as innovation is concerned, they have been primary movers in the convergence of Data Centre Networking which is a very interesting area. Not massive yet, but a potential key to the scalability and flexibility of massive virtualised infrastructures and Data Centres.

    Finally, Cisco have not really countered anything that any of their competitors have done by being innovative or producing anything best of breed. Their products are all fit for purpose, but never market leaders in terms of features, benefits or capability. Cisco owe their very significant success to M&A - not technology innovation.

  • Report this Comment On February 09, 2012, at 2:28 PM, surfdawg1969 wrote:

    I think from a technical and user perspective Digger and Sydney are correct but from an investment point of view there are some very large issues with Brocade.

    1. Their manufacturing counterparts (Asia competitors) have realized that they can produce similar technology at a fraction of the cost.

    2. Can assembly teams out in the field and secure delivery and engagement for a fraction of the cost.

    3. And will take the time and incur the long term investment to drive down the price of this technology for a greater share of the marketplace.

    This spells a big misfortune for Brocade being the maller player in the field and a deinflationary environment for the other players.

    I think coupled with the Foundry fiasco, that many would think twice before ever paying too much or anything for Brocade.

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