Will Brocade Shares Continue to Grow?

Over the past year, Brocade's  (NASDAQ: BRCD  ) share price has grown steadily and has increased by almost 70%. During this time, quarterly year-over-year revenue has been decreasing at an accelerating rate. The latest guidance by Brocade's management calls for more negative growth. What could explain the positive share-price trend, and can Brocade continue on this path in the future?

Rumors about a sale
In August 2012, Brocade's then-CEO Michael Klayko announced his resignation after seven years on the job. Brocade put on a search for a replacement, and in January 2013, industry veteran Lloyd Carney was chosen to fill Brocade's top post.

With this change, speculation intensified that Brocade might be sold. According to Bloomberg, Klayko's resignation was a move by the board to expedite the sale of the company. Carney seems to be the perfect candidate to help with that; he previously served as CEO at two companies, Xsigo and Micromuse, at the time that they were acquired by Oracle and IBM, respectively.

However, it's not clear that Brocade will be sold any time soon. First of all, Brocade has been unsuccessfully trying to find a buyer for years. Second, in an interview following his appointment, Carney said that there are no plans to sell the company. He added that he served as CEO at Xsigo for five years and at Micromuse for three prior to the sales, and that he is not a "quick-turn guy."

Clearly, a sale sooner or later is still possible, and this probably affected the share price over the last year. It might even continue to do so down the line. However, Carney and Brocade seem determined to prepare for the long term as a stand-alone company. How are they doing on this front?

Efficiency and focus
A big change over the last year has been an increase in efficiency. Brocade set a goal to reduce annualized spending by $100 million and accomplished it by the fourth quarter of 2013. Combined with expanding gross margins, this led to a record EPS of $0.24 in the fourth quarter for a 41% increase year-over-year. This efficiency is directly benefiting shareholders, with 60% of free cash flow in 2013 being returned to investors.

Brocade also pared down its business and decided to focus on a few key areas, particularly on data centers and on public sector networking. It is closing or selling off several product lines that were not competitive, such as network adapters and wireless. According to management, this will lead to an annualized revenue drop of $80-100 million, which partly explains the year-over-year decreases in quarterly revenue.

The efficiency gains and the resulting EPS surge are impressive, but they were probably one-time events (the consensus analyst estimate for EPS is $0.19.) Brocade's changing business focus is more interesting, but will it lead to future growth?

The SDN opportunity 
Software-defined networking (SDN), a collection of technologies that aim to make networks more easily manageable and changeable, is beginning to transform from a buzzword into a real opportunity. Industry analyst IDC estimates that SDN, which had "almost negligible penetration in 2012," will grow to become a market worth $3.7 billion by 2016.

Brocade is fighting hard to dominate this new market. It acquired Vyatta , a provider of virtual networking software, in November 2012 in order to strengthen its position in the SDN world. It also insists that its open and standards-based approach will be more attractive to customers than the closed and proprietary approach of Cisco  (NASDAQ: CSCO  ) , Brocade's traditional competitor and a presence in the SDN market with its Application Centric Infrastructure.

Cisco was recently downgraded, with analysts expressing "cautious views around uptake in new products and secular headwinds." In spite of its stated confidence in its superior solution, Brocade is exposed to many of the same trends. With cost cutting in the federal IT budget as well as increased competition in the SDN market, it remains to be seen in 2014 whether Brocade can carry out its plan for successful expansion.

In conclusion
Brocade's stock price has risen steadily over the past year, but this might reflect several one-time events such as efficiency gains and a corresponding growth in EPS. While speculation about the sale of the company will likely continue, Brocade will need to prove itself in the emerging SDN market over the coming year to convince investors that it is a good buy.

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