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), 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) 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), 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) 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.
With these structural issues now largely in the past, the company can focus on growing its business and defending its strong competitive position against competitors such as Cisco and EMC. In early March, the company made several strategic initiatives that are designed to support above market-average top-line growth for the foreseeable future. First, the company acquired software company NuView, which will add to its storage capabilities, in a deal valued at $60 million. Analysts expect the deal to be accretive to Brocade's earnings in 2007. Brocade also unveiled iSCSI Gateway, a new application that works with existing corporate platforms to lower the cost of data storage. Also, Brocade said it is building on its highly successful SilkWorm brand of storage products, which are used by companies to store data on corporate networks, with new versions that will hit the market later this year. These initiatives, if successful, will help Brocade achieve analyst sales and growth targets for fiscal 2006 and fiscal 2007. As it stands now, the Street expects Brocade to earn 26 cents a share in the current fiscal year, which ends in October, and 31 cents a share in fiscal 2007. Brocade's top line is expected to reach $665 million in fiscal 2006 and grow to $728 million in 2007. We believe these estimates are attainable, given the strong backdrop for storage demand. The sector is also ripe for consolidation, and Brocade's strong competitive position as a market-share leader in network switches, combined with its attractive valuation, would make it an obvious target for a larger acquirer. Just last August, Sun Microsystems ( SUNW) acquired another storage company, Storage Technology, in a $4.125 billion deal. Cisco is the most frequently mentioned potential Brocade suitor. Brocade's shares are currently trading at depressed levels. The stock was recently trading at $5.73, down 29% from its December 2004 high. We will continue to watch Brocade closely and will update subscribers as we get closer to the company's earnings report.