Brocade 3rd Quarter 2008 results: Cisco long-term threat to Brocade's Fibre Channel switching franchise

Brocade Reports Third Quarter Fiscal Year 2008 Results
According to RBC Capital Markets, Cisco is a long-term threat to Brocade's Fibre Channel switching franchise. RBC Capital Markets Analyst - Tom Curlin commented to yours truly: "For fiscal 3Q08, Brocade reported upside revenue ($365.7 million) and non-GAAP EPS ($0.16) results versus the Street estimates ($351.7 million and $0.14)." "Upside revenue in the quarter was driven by switch, embedded, and service revenue contributions, as the director business performance was rather muted even though Brocade is currently in a major director product refresh cycle." "Despite solid enterprise-level visibility into the ongoing director product cycle, macroeconomic imposed conservatism led to Brocade providing a below normal seasonal sequential increase for revenue for the October 2008 quarter (+3-5% versus +6-8%); however, the revenue outlook was still above the Street consensus estimate (non-GAAP EPS outlook was in line)." "Total revenue grew 3% sequentially and 12% year-over-year (+9% year-over-year excluding the SBS acquisition that closed in the April 2008 quarter)." "Core SAN revenue increased 4% year-over-year and 1% sequentially, as switch revenue growth (+5%, +12% year-over-year) offset muted trends in the director business (down sequentially, +3% year-over-year)." "Embedded switch revenue continued to report very strong results (+12% sequentially, +39% year-over-year)." "Meanwhile, service revenue continued its healthy performance, with 8% sequential and 43% year-over-year growth." "The OEM revenue mix was flat sequentially at 86%, reflecting 3% sequential and 14% year-over-year growth. EMC, HP, and IBM, each greater than 10% of revenue, totaled 62% of revenue, reflecting growth trends (-2% sequentially, +8% year-over-year) below the corporate figures." "Geographically, Brocade noted that North American demand was stronger-than expected (40% mix), China and India continued their healthy growth rates, and Japan experienced a slowdown." "Driven by an improved product gross margin, total gross margin improved 80 basis points sequentially to 61.9%, which was above the company's outlook of 59-60%. The sequential average selling price decline continued to be in the low-single digits, and Brocade expects this trend to continue for the October 2008 quarter. Operating margin was at 22.6%, down 30 basis points sequentially but still above the company's outlook for the quarter (19-20%) and its long-term range of 18-22%." "Net cash totaled $421 million at quarter's end, which included $169 million of convertible debt that matures in February 2010 and a $160 million current liability associated with the recent share litigation settlement. For the first time over the past five quarters, inventory increased on a sequential basis, which we believe likely reflects Brocade's completion of reducing its legacy product inventory while the new 8Gb product inventory ramps. Reflecting a relatively linear quarter, days' sales outstanding were flat sequentially and down two days year-over-year to 43 and were well within the company's targeted range of 40-50 days." "On a trailing 12-month basis, Brocade posted $294 million in cash flow from operations, $140 million in capital expenditures, and free cash flow to the firm (FCFf) of $154 million. On a diluted share basis, TTM July 2008 FCFf declined to $0.39 versus $0.51 for TTM April 2008 due to the large increase in capital expenditures which was mostly attributable to the new headquarter campus construction. In the quarter, Brocade repurchased $38 million of its shares (or ~1.3% of basic shares outstanding) and had $414 million remaining under the buyback authorization, which was suspended during the quarter due to the proposed Foundry acquisition and the associated large upcoming debt raise." "Brocade reiterated its expectation that the economic environment will not improve until early CY09. For the October 2008 quarter, Brocade provided a revenue outlook ($375-$385 million) above but a non-GAAP EPS outlook ($0.15-$0.16) in line with the current Street consensus estimates ($373.6 million and $0.16). Gross margin is expected at 61-61.5% due to a higher director contribution benefiting profitability. Operating margin is expected at 20-22%, with Brocade continuing to impose expense discipline until an improvement in the macroeconomic environment. Also, the company noted that a typical seasonal sequential revenue growth trend for an October quarter is up 6-8%, which implies revenue of $391.3 million, leaving potential for upside revenue execution if the macroeconomic environment proves better than what Brocade currently expects." "The Foundry Formula. This proposed combination addresses the Cisco threat in terms of product and go-to-market." "Cisco's increasing focus on Ethernet as a unified fabric for the data center presents a long-term threat to Brocade's Fibre Channel switching franchise. With a broader portfolio that includes deep Ethernet capabilities, Brocade can neutralize this threat." "Foundry also brings a more direct go-to-market model that can be leveraged to reduce Brocade's dependency on OEM channels and more effectively fight Cisco's larger presence. Originally provided at the mid-September 2007 analyst day presentation, Brocade's long-term operating profile includes gross margin of 57-60% and operating margin of 18-22%. Notably, current Street consensus estimates for Brocade on a standalone basis assume margins above this target operating range, yet Brocade has referenced Street consensus in providing accretion guidance for the deal. In our view this suggests that Brocade's internal plan for standalone FY09 operating margin is closer to Street than to guide, or that management believes the operating synergy potential in the combination with Foundry is greater than publicly indicated (i.e. the actual accretion potential is greater than indicated)." "Director Level. Brocade is currently in the midst of its first major product cycle refresh since the McDATA acquisition. We believe the majority of Brocade's key OEMs are now selling both the DCX and 48k 8Gb Fibre Channel directors. The company reported total director revenue was seasonally down on a sequential basis and up only 3% year-over-year in the July 2008 quarter, which was a marked slowdown from the April 2008 quarter's results (+5% sequentially, +19% year-over-year). Brocade attributed this to normal seasonality. As for the coming quarters, we believe Brocade's ability to execute on this director cycle is a primary catalyst for near-to-intermediate upside revenue and gross margin potential." "Competitively, Brocade does not expect Cisco in the market with an 8Gb MDS solution until the end of calendar 2008. Additionally, the recently introduced Nexus converged director platform, with its Ethernet centric approach, is not expected to gain material traction until the calendar 2009 time frame, coinciding with more substantial progress on the Data Center Ethernet (DCE) and Fibre-Channel-over-Ethernet (FCoE) standards." "HBA Intentions. While Brocade initially leveraged an LSI-sourced product as an on-ramp into the 4Gb market, the company announced in June 2008 the availability of the internally-developed 8Gb Fibre Channel platform. Brocade expects initial HBA revenue in the second half of 2008 and more material revenue contribution in FY09. Both HDS and Fujitsu Siemens have committed to qualify and sell the 8Gb offering, and Brocade expects additional OEM qualifications in the October 2008 quarter. To be monitored is the extent to which Brocade can penetrate the existing stronghold on the adapter market currently shared by QLogic and Emulex." "ILM Deliverance. Brocade continues to invest significant resources in expanding its emerging portfolio of information lifecycle management (ILM) software and service offerings. While FAN revenue continued to be an immaterial piece of business in the July 2008 quarter (down sequentially and year-over-year), service revenue strength helped recent execution (17% of revenue, +19% sequentially, +32% year-over-year). Excluding the impact of the recent acquisition of Strategic Business Systems (SBS), organic service revenue still grew well on a year-over-year basis at roughly 20%. Finally, go-to-market partnerships with HDS, IBM, and NetApp are expected to drive continued performance in the coming quarters." "Based on our valuation and historical metric analysis, we estimate potential forward 12-month P/Es of 15x/8x on upside/downside execution. Brocade guided for upside revenue but in line non-GAAP EPS relative to the Street consensus estimates for the October 2008 quarter. Given the in line non-GAAP EPS outlook, we assume neutral execution sentiment over the near term, which implies a near-term trading range of $7-$8. However, the shares may get some support over the coming weeks as faster money trades the upcoming analyst day (September 17th)." "On a 12-month basis, we maintained our $9 price target, Sector Perform rating, and Above Average risk assessment." "Brocade is entering a period of easy comparables with a time to market advantage in 8 Gbps Fibre Channel switching versus Cisco." "However, the proposed Foundry acquisition presents new execution risks and constrains financial flexibility."
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