Did Brocade Blow an Opportunity?

Whats Brocade Communications Systems Inc.'s (Nasdaq: BRCD) excuse for its year-over-year decline in earnings?

Investor expectations were high for Brocade, in part because its two major competitors stumbled: McData Corp. (Nasdaq: MCDTA) got squeezed by its major OEMs; and Cisco Systems Inc. (Nasdaq: CSCO) had experienced production problems. Brocade, however, failed to meet those expectations when it annnounced fourth-quarter earnings Thursday (see Brocade Q4 Revenue Slips, EMC Playing Hardball With McData?, and Cisco Still a Kid in Storage).

Brocade’s fourth-quarter net income of $14.8 million was down 6 percent from the same period last year, and its $137.8 million in revenue was down 10 percent. Not surprisingly, its stock price dipped sharply today -- down 17 percent, to $5.92, in midafternoon trading.

“Brocade suffered from a misalignment of expectations,” says analyst Steve Berg of Punk Ziegel & Co. “People looked at Cisco and they didn’t even report [switch] numbers. People looked at McData and their problems with their major supplier [EMC]. Everybody thought Brocade would pick up the slack.”

Brocade did ship more SilkWorm 12000 director switches than the previous year, and CEO Greg Reyes said the company picked up market share in that high end and in the low end, while holding share in the midrange. And CFO Tony Canova said he’s confident Brocade will extend its lead in a fiercely competitive market.“We expect the SAN market will remain competitive,” Canova said, on a conference call with investors. “But we’re committed to maintaining our leadership position, capitalizing on our installed base, and gaining market share.”

Brocade said it shipped more switches than in the previous quarter, including 80 12000s. However, its 11 percent increase in number of ports shipped from the third quarter only translated to a 3 percent increase in revenue, which implies Brocade was hurt by falling prices.

“The overriding issue for Brocade is pricing pressure,” wrote Lazard analyst Cliff Su, who downgraded Brocade’s stock from to Sell from Hold. “Competition in the switch market will only become fiercer as the system vendors lean on the switch players to reduce pricing, and upstarts like QLogic enter the market.”

But Brocade’s Reyes said he doesn’t expect pricing pressure to affect his company as much as it has McData. Brocade’s OEM business is more diversified, with Hewlett-Packard Co. (NYSE: HPQ), EMC, and IBM Corp. (NYSE: IBM) making up 67 percent of its business. Most of McData’s business comes from EMC.

“We have traditionally provided our OEMS with quarter-over-quarter price declines,” Reyes told analysts on the conference call. “My sense is what you saw with one of the competitors may have been more indicative of relationship issues than a specific economic action. But I’m just speculating.”In the second quarter of 2004, Brocade plans a new product based on the Fabric Application platform it acquired by buying Rhapsody; and it's expected to complete a deal with Dell Computer Corp. (Nasdaq: DELL) for low-end switches. Reyes said he expects revenue from the high-end fabric application switch in the third quarter (see Brocade Reupholsters Rhapsody).

“We plan on taking share in the director space, and we plan to grow in the low end,” Reyes said.

Will that leave McData to gain in the middle? Analysts say Brocade had to reduce its midrange pricing to compete with McData’s Sphereon 4500 this year. McData already announced it would miss expectations for the current quarter because of pricing pressures, but McData CEO John Kelley claimed the company would make up that revenue in future quarters.

“Now that you can see the Brocade quarter, you have to be confident McData will regain the revenue lost in [this] quarter,” Berg says.

Meanwhile, in an 8-K filing yesterday, Brocade disclosed that it purchased the San Jose, Calif., building that it currently leases for its engineers. The company anticipates taking a $75 million to $85 million charge next quarter in costs related to the purchase.— Dave Raffo, Senior Editor, Byte and Switch