Brocade (NASDAQ:BRCD), which sells high-end storage solutions, gave its investors "shock treatment" when it announced it was shelling out $713 million for its ailing competitor, McData (NASDAQ:MCDT). Brocade's stock plunged 18% for a simple reason: the deal is the wrong solution for the company's problems.
It is true there are synergies between the two firms; that is, they develop technologies that allow companies to manage huge amounts of data. Products include things like storage area networks (SANs), which involve complex hardware and software configurations.
It's also true that Brocade announced upbeat preliminary results for the second quarter. Revenues are expected to range from $188 million to $189 million, up from their May guidance of $174 million to $183 million. Earnings are expected to be between $0.08 to $0.09 per share, which compares to prior guidance of $0.07 per share.
Unfortunately, McData's preliminary results were awful. Revenues are expected to range from $150 million to $152 million, down from their May guidance of $170 million to $180 million. Earnings are forecasted to switch from a gain of $0.04 to $0.06 to a loss of $0.02 to break-even.
Given the deterioration, it is no surprise that McData wants to sell out. Of course, this certainly puzzles Brocade shareholders. Why pay a premium? Why not wait as McData gets desperate?
On the conference call, Brocade provided mostly cliches about its rationale for the deal: provide customers a comprehensive offering, cost savings, "converged products," "synergies," and so on. It's a tired story that rarely comes true with big tech deals.
However, Brocade management is masking a core problem: its business model. The company relies primarily on OEM partners to sell its products. Companies like EMC (NYSE:EMC), Hewlett-Packard (NYSE:HPQ), and IBM (NYSE:IBM) sell Brocade technologies using their own private label (these three companies represented about 70% of sales).
Relying too much on OEM partners often means losing control, as the technology provider is separated from the ultimate customers who actually use the products and may not get enough feedback.
This provides opportunities for competitors, which has been the case with Cisco (NASDAQ:CSCO). Over the past few years, the company has built a SANs business that exceeds $500 million in revenues. Frank Slootman, the CEO of Data Domain -- which develops next-generation storage products -- drives home the point. "Cisco controls its own distribution at all levels," he told me. "Both McData and Brocade are severely limited on strategic options as their distribution is completely dominated by the large storage OEMs. They can't upset those relationships by venturing into areas that the OEM partners frown upon."
The bottom line is that the Brocade-McData combination does not address the strategic issues. If anything, it means management will be distracted with the melding of different corporate cultures, integration of product lines, and consolidation of customer relationships. There is also the ongoing distraction from the option-backdating scandal, which has involved several former Brocade executives.
Simply put, the expected $100 million in cost savings is not enough to justify such a deal and Wall Street completely agrees.
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Fool contributor Tom Taulli does not own shares mentioned in this article.
