Why This Networking Company Is No Longer Attractive

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Brocade Communications Systems (NASDAQ: BRCD) has done an excellent job of growing its business, with revenue quadrupling in a decade. However, over the past couple of years, the growth seems to have stagnated, and the company is actually expected to report slightly lower revenue for the current year. Earnings are expected to be flat for the next few years, and the competition keeps getting stiffer.

Curiously, shares have spiked lately, up about 16% in a day after a better-than-expected earnings announcement, that too after already shooting up by about 25% in the previous six weeks or so. After a move like this, it is only natural to wonder if you should sell and take profits, so let’s take a closer look and see what the best course of action is.

What they do
Brocade is a manufacturer of data and storage networking products, such as network-attached storage, data center switches, software-defined networking, enterprise routers, and much more. The company is a leader in storage area network (SAN) switches, which was helped by the company’s acquisition of Foundry Networks a few years ago.

As mentioned earlier, Brocade has grown tremendously over the past decade or so, both as a result of eight major acquisitions over that time period as well as by organically growing its customer base, which is actually rather narrow right now. In fact, about half of the company’s total revenue comes as a result of its three largest partnerships: EMC, Hewlett-Packard, and IBM.

The future is slow (for now)
Going forward, the company plans to grow its direct sales, which should strengthen the sales of its Ethernet products, which currently make up just about one-fourth of Brocade’s total sales. My main concern has to do with the company’s dependence on government and corporate spending, not to mention Europe, all of which have been less than stellar over the past several years, hence the inconsistent revenue since 2010.  

These types of customers are still much too uncertain about the economy to justify investing money in high-performance networking equipment. Any further economic weakness is a potential disaster for Brocade, and a quick comparison of the slope of the above chart before and after 2009 shows what weak spending can do. 

The numbers and the share price tell different stories
As a result, revenue (and earnings) are not really expected to grow much in the next few years. The company is expected to report earnings of $0.65 per share for this fiscal year, meaning that shares trade for about 12.3 times this year’s earnings, which at first might sound pretty cheap.

The consensus calls for earnings of $0.67 per share in both 2014 and 2015, which actually makes the P/E seem a bit high. The extremely volatile nature of the data storage industry (which accounts for about 57% of Brocade’s business) warrants a substantial discount to the current valuation. For example, Seagate Technology (NASDAQ: STX), a data storage leader, trades for just 7.6 times this year’s earnings, and is expected to grow over the next few years. With that in mind, let’s take a look at some other investment options for comparison purposes.

Alternatives: Cisco Systems and Seagate
The most obvious alternative to Brocade is Cisco Systems (NASDAQ: CSCO), the world’s largest supplier of computer networking systems. Cisco does not have quite as much growth potential as Brocade, but it makes up for this with its strength, stability, and value. There is also a pretty good buying opportunity in Cisco as shares have dropped considerably as a result of the company’s comments during its recent earnings release. The numbers actually came in above estimates in terms of both earnings and revenue, but the CEO referred to the economy as “challenging and inconsistent” before announcing the company was cutting 4,000 jobs, or 5% of its workforce.

While Cisco’s current-year P/E of 11.9 sounds pretty good already, note that the company also has over $32 billion in net cash, which reduces the multiple to 8.9 when taken out of the equation. The company also pays a pretty solid yield of 2.6% and has an excellent record of share repurchases. It is also worth considering that Cisco’s enormous size and cash stockpile gives it somewhat of a competitive edge when developing new technologies. While reducing workforce is unfortunate, Cisco seems to be more proactive than Brocade in dealing with the inconsistency of the economic recovery, which is a positive factor.

A not-so-obvious alternative is Seagate. While Brocade’s storage solutions are network-based, Seagate produces hard drives for virtually every application. Shares appear to be at an excellent entry point right now, especially with the recent 15% dip due to a mediocre quarterly report issued a few weeks ago. Seagate currently yields over 3.7% annually, among the best in the sector, and trades for just 7.6 times expected earnings for this year. There is, however, substantial risk involving the gradually declining sales of traditional hard disk drives, which is probably the reason for the discounted valuation. However, Seagate has been an industry pioneer for new storage technologies in the past, and as such, investors shouldn't discount the company straightaway.

Buy, sell, or hold?
Investors should consider booking their gains in Brocade and look elsewhere, especially with some much more compelling alternatives to invest in. There are many bargains in the networking and data storage businesses, but Brocade is certainly not one of them.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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