Brocade Breakdown Brings Opportunity

Fleeing investors could be missing the long-term picture.
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Investors dumped shares of storage networking gearmaker

Brocade

(BRCD)

Friday, but the short-term selloff may be set up a bigger year-end rally.

Shares were recently off 60 cents, or 6.5%, to $8.59, continuing the after-hours drop late Thursday following the company's

second-quarter earnings release, when the company forecast sales below most expectations and missed its own second-quarter target for gross profit margins.

Traders seem to be focusing on the most-prominent bad news to emerge from the postrelease earnings call. Brocade finance chief Richard Deranleau said he expects revenue for the June quarter to fall 2% to 4%, missing analysts' consensus estimate by $5 million, according to Thomson Financial.

Deranleau said seasonal weakness in third-quarter sales would be more pronounced this year because of a general slowdown in business spending in tech goods.

Deranleau's comments followed similar warnings from other storage companies that have recently reported earnings.

Qlogic

(QLGC)

expects sales to fall 1% to 5% in June quarter, while

Network Appliance

(NTAP) - Get Report

forecast a 6% to 7% slump.

Also, Brocade's gross margins, a measure of pricing power and profitability, hit the low end of the company's 53% to 55% projection. This might indicate that Brocade's products, which have higher margins, didn't sell as well as expected, increasing the proportion of McData products in the sales mix and diluting the overall gross margin figure.

Brocade didn't break out organic sales in its earnings release. But Caris analyst Shebly Seyrafi estimates that organic sales fell from the first quarter, though total revenue met analysts' consensus estimate.

Caris has no banking relationship with Brocade, and Seyrafi does not own Brocade shares.

The negatives overshadowed significant improvements in the company's operating structure as it met its target for cost savings from the McData acquisition two quarters ahead of schedule. The company also said that price pressures remain mild, especially now that the storage area market is effectively a duopoly with

Cisco Systems

(CSCO) - Get Report

.

Despite tepid IT spending, Brocade's sales could get a lift if businesses continue to consolidate their data centers to cut energy and operating costs. This could push more capital expenditures toward storage area network gear and so-called virtualized server and shared storage environments, markets in which Brocade makes products.

What's more, Chief Executive Michael Klayko said Brocade is developing products that will work in both McData environments and Brocade environments. That could stem defections by customers that worry about compatibility issues and switch to Cisco, Brocade's No. 1 rival.

Slimmer product lines that weed out lower margin gear could help the company hit its long-term gross margin target by the fourth quarter, estimates Seyrafi.

If Brocade has a seasonally strong third and fourth quarter and keeps costs under control, its stock could rise to roughly $11, in line with the industry's average ratio of price to earnings. According to Thomson Financial, analysts' median price target is $11.10, with several expecting it to reach $12 a share by year-end.