Brocade: NOT FOR SALE

On October 6, the Wall Street Journal reported an oxymoron: "Brocade Communications Systems Inc. has quietly put itself up for sale."  Since then news from one of the most widely read publications in the world has taken on a life of it's own as the industry leveraged the full capabilities of social networking to speculate on the endless possibilities.

I'm told at the Brocade sales meeting last week in Las Vegas, CEO Mike Klayko put up a slide that read "NOT FOR SALE." I for one am joining the Brocade sales team in taking it at face value and moving on. It's not going to happen, at least not now.

The reason that it's not going to happen is best illustrated in the October 7 Canaccord|Adams Daily Newsletter titled "FOR SALES GOOD AS SOLD?" where Paul Mansky and Katie Benson agree that Brocade boasts strong strategic positioning and that fundamentals warrant a $9-$10 share price, but take issue with the prevailing argument the company is a near-term acquisition target.

"The independent OEM-centric business model is central to the company's ability to maintain its storage footprint during the pending protocol transitions, while the "anybody but Cisco" story in Ethernet switching has not even begun to ramp. Ownership by a single OEM would hasten the demise of Fibre Channel (60 percent of revs) while limiting the Ethernet switch TAM expansion story. In our view, a sale today is like punting on a second down."

Mr. Mansky and Ms. Benson acknowledge that nothing is completely off the table, but they identified three primary issues with the logic behind the transaction. The following is excerpted from the Daily Newsletter:

1. Why own when you can rent? Although the slope of the curve is subject to some debate, Fibre Channel will ultimately (2-3 years) yield to alternatives including FCoE, iSCSI, CEE/DCE and 10/40/100GbE. The degree to which Brocade will be successful in this transition is yet to be fully knowable but the TAM expansion opportunity is clearly present (8-10x). The question becomes one of trade-off between TAM expansion and transitioning from a duopoly to a potentially much more crowded market. Given it is Brocade's OEM customers themselves that will to a large degree dictate which direction this debate will take, acquisition by any one becomes an exercise in mutual exclusivity. Moreover, it would most likely hurry the transition away from Fibre Channel. This, in our view, warrants a rental (OEM) versus an ownership approach.

2. What would a suitor be willing to pay? Relative to our C2010 estimates which are largely in-line with consensus, this would imply a take-out price of $9.50-$10.00 (~$5 billion), or 6-11% above current levels post the 19% move on Monday (October 6).

3. Less expensive alternatives elsewhere. Whether the objective is fleshing out an Ethernet switch line or gaining access to Fibre Channel switching technology, we believe there are a number of more economically attractive candidates elsewhere. In Ethernet switching, we point to less expensive alternatives at 3Com ($2B cap), Extreme ($220M cap) and Force 10 (private). In Fibre Channel switching, QLogic is keen to divest itself of its switch business (~8% market share) - which we value at $300-350 million.

By the way, the people I talked to said the morale of the Brocade sales force was sky-high. I'm looking to Brocade to announce solid numbers on November 24. Thanks to Canaccord|Adams for allowing me to excerpt their Daily Newsletter.  The entire report is downloadable.