Publish date:

Cisco Looms Large in Brocade/McData Deal

The storage switch sector's two leading players cling together for survival.

Size matters.

Four years after networking giant

Cisco

(CSCO) - Get Cisco Systems, Inc. Report

began selling storage switches, the two leading players in that market have banded together for survival.

Brocade Communications

(BRCD)

will buy rival

McData

(MCDTA)

in a $713 million all-stock deal, the companies announced before Tuesday's opening bell.

The news sent shares of the two companies racing in opposite directions. In recent trading, shares of McData were up 37 cents, or nearly 12% to $3.48, while Brocade was off $1.19, or 19%, to $4.95. Volume was very heavy on both issues.

McData's weakness was underscored by the other part of Tuesday's announcement -- that it won't meet its fourth-quarter targets. McData now expects to post earnings ranging from a loss of 2 cents a share to break-even on sales of $150 million to $152 million. Wall Street was looking for a 5-cent a share profit on sales of $176 million.

Brocade, though, guided higher for its fiscal third quarter ended July 29. The company expects to make 8 cents or 9 cents a share on revenue of $188 million or $189 million. Analysts surveyed by Thomson Financial were looking for a 7-cent profit on sales of $180 million.

The merger announcement wasn't unexpected. Indeed, rumors that one company or the other would buy out its rival have persisted for years, sometimes with McData as the acquirer, sometimes Brocade, depending on which company was stronger at the time, said Goldman Sachs analyst Laura Conigliaro.

Combined, the two companies will represent roughly 70% of themarket.

Cisco and its partner

TheStreet Recommends

QLogic

(QLGC)

will also benefit, as some manufacturers shift business their way to have at least two suppliers for key products, said Baird analyst Daniel J. Renouard.

Goldman Sachs has an investment banking relationship with McData, but not Brocade. Baird does not have an investment banking relationship with either.

The dynamic is similar to that of the hard-drive market, where former customers of

Maxtor

, in the wake of that company's acquisition by

Seagate Technology

(STX) - Get Seagate Technology PLC Report

, have shifted to

Western Digital

(WDC) - Get Western Digital Corporation Report

. Ultimately, the switch market, which totals only about $1.8 billion, is too small to support four players, especially when one is Cisco, which has the strength to push prices down as its rivals scramble to hold on to business.

The deal, which is to be tax free to holders of the Broomfield, Colo.-based McData, will have McData holders getting 0.75 Brocade share for each McData share owned.

Investors have favored Brocade this year; its shares have appreciated by 51% (before Tuesday's announcement) while McData has lost nearly 20% of its value. But longer term, investors in both companies have done poorly. Since July of 2002, McData has tumbled by 68% and Brocade by 70%, while the

Nasdaq

has increased by 53%.

Brocade also has been hurt by its part in the growing scandal over the backdating of options. Last week, a federal judge set a $2 million bail for former Brocade CEO Gregory Reyes in the first criminal hearing arising from investigations into alleged stock-option manipulations. Former human resources Vice President Stephanie Jensen was freed on $500,000 bail.