Betting on Brocade

This alert was originally sent to subscribers of TheStreet.com Stocks Under $10 on March 15 at 2:45 p.m. EST. For more information on this newsletter, click here.

One strategy we use in the Stocks Under $10 service is identifying trends and the companies that should benefit from them. One of the biggest booms in the past few years has been the enormous demand for networks to store data and applications that are used on the Internet.

One company that could benefit from the storage demand is Brocade Communications Systems(BRCD Quote), which manufactures products just for this purpose.

We aren't taking any action in this alert, as we want to see Brocade's fiscal second-quarter earnings report in May. Instead, we are adding the stock to our watch list in anticipation of a strong earnings report. While we are bullish on Brocade, we believe it is prudent to wait on the earnings results for confirmation of our thesis.

Brocade has been gaining investor attention of late due to strong earnings results from the storage industry and its inexpensive valuation relative to its peer group. Competitor McData(MCDTA Quote) announced solid fourth-quarter earnings results March 9 that were 2 cents ahead of analyst expectations of 6 cents a share. In February, Network Appliance(NTAP Quote), a network storage company, delivered 30% year-over-year revenue growth for its fiscal third quarter, which topped analyst expectations and sent shares higher.

On valuation, Brocade is among the least expensive stocks in the storage space. According to data compiled by Capital IQ, a service from Standard & Poor's, Brocade shares change hands at just 21 times 2006 analyst earnings-per-share (EPS) estimates and two times analyst 2006 sales estimates. Its peer group trades at an average of three times sales and 25 times earnings.

Brocade's shares are cheap for a reason, however. The company was forced to restate three years of financial results under former CEO Greg Reyes in March 2005. Reyes was replaced by former EMC (EMC Quote) executive Michael Klayko in late 2005. The restatement was the result of an internal audit that found the company was not accounting for stock options properly and resulted in an investigation by the Securities and Exchange Commission.