Brocade-McData Draws Extra Scrutiny

Wall Street analysts say the government is keeping a close eye on Brocade's planned acquisition of switch rival McData, and the Federal Trade Commission is considering taking action to stop it. (See Brocade Bags McData For $713M.)

Sources say they expect the deal to go through but there is enough resistance within the FTC to make investors nervous. The FTC is the U.S. government agency charged with preventing anti-competitive business practices.

Under questioning at the Needham & Co. investor conference in New York today, Brocade executives insisted they expect the proposed $713 million deal would win government approval. Brocade and McData shareholders will vote on the acquisition Jan. 25.

"We believe it will go through, as early as the end of this month," Brocade marketing VP Tom Buiocchi says. "We believe [the FTC] will determine the transaction is good for both customers and shareholders."

Brocade revealed in November that the FTC issued a second request for information about the deal because of concerns over diminished competition in the Fibre Channel switch market. Despite Brocade's public confidence, the word on Wall Street is the deal is no slam dunk."We believe the FTC is closely scrutinizing Brocade's intended acquisition of McData," analyst Tom Curlin of RBC Capital Markets wrote in a research note today. "Apparently the revenue and port share of the combined entity and the resulting pricing power are two sources of concern for some of those involved in the evaluation of the proposed combination."

Curlin points out that the combined Brocada-McData company would have between 60 percent and 70 percent of the director switch and between 75 percent and 80 percent of the fabric switch market. Cisco makes up most of the rest of the share, with QLogic looking to become the third supplier after McData's demise.

Curlin maintains EMC is likely to OEM QLogic's new SANBox 9000 director switch to fill part of the void left by McData, but QLogic's market share remains negligible in switches. (See QLogic Grabs Director's Chair.)

Two other financial analysts who asked not to be named confirm Curlin's note, saying there is support inside the FTC for bringing a lawsuit against Brocade to stop the deal. However, both say they consider such an action a longshot.

"We know there are some parties at the FTC recommending a suit," says one of the analysts. "We expect to hear conclusively before the vote. We think it's unlikely the government would go to litigation, and if it goes to litigation, we think the government will lose. We haven't been able to find many customers complaining at this point. Nobody is too perturbed about this deal happening."Conspiracy theorists see Brocade using subtle hints to try to pursue the FTC that the deal will not hurt the competitive landscape. The 10K annual report Brocade filed with the SEC Tuesday hinted that increased competition around 4-Gbit/s switches would bring down prices in 2007. Of course, one FTC objection to the deal would be a rise in prices because of less competition without McData.

Another industry insider speculates that Brocade's acquisition of iSCSI chip vendor SilverBack Systems Monday for less than $10 million was done at least in part to establish itself as a greater competitor to Cisco. (See Brocade Grabs Silverback.) Silverback gives Brocade a greater stake in Ethernet technology, Cisco's sweet spot.

"If I'm trying to convince the government I'm a competitor to Cisco across the board, this is a real cheap way of doing it," he says.

If the FTC stops the acquisition, Brocade would have to pay a $60 million termination fee to McData. The consequences could be more dire for McData, however, considering its market share had been steadily declining even before the deal was announced. (See 4-Gig Boomerangs on Brocade, Brocade's Costly Victory, and Cisco's First in Directors, Dell'Oro Says.)

One analyst says he would expect somebody else to step in and buy McData if Brocade can't. "You think QLogic wouldn't be interested?" he asks. "They've made it clear they want to move into the switch business and McData has a lot of customers and products out there."Dave Raffo, News Editor, Byte and Switch