Brocade Communications: There Is Blood on the Streets

Maker of data center networking equipment Brocade Communications Systems (BRCD) is enduring a very strong sell off on Tuesday. Following their first quarter earnings report, BRCD is trading down more than 20% on huge volume in early morning trading. The reason for the trouncing was a miss on the top line results in addition to a worse than expected guidance for the rest of the year. Excluding one-time events earnings came in at $.19 per share or four cents better than expectations, and compared favorably to a loss of 6 cents per share last year. However, revenue growth of 25% to $539.5 million was a disappointment from expectations of $548.4 million.

The more distressing factor was Brocade management’s cautious outlook for full year earnings $.54 to $.58 per share, which is less than previous guidance. They also anticipate sales to total $2.15-$2.19 billion, which pales in comparison to the previous outlook of $2.25-$2.45 billion. The softness is due to a slower than expected recovery in their Ethernet switching business. The company lost market share in enterprise and service provider Ethernet switching, which has caused a number of analysts to downgrade the company today, adding to pressure on shares. On the whole though, the analyst community remains quite positive on BRCD, as the majority have a positive outlook on shares and the median price target is $9 per share. With the stock trading at $5 and change today, the analysts are seeing a 67% increase in price as a reasonable expectation.

Coming into the week, at Ockham we have placed a Fairly Valued rating on BRCD, but this stock may be due for an upgrade in the coming weeks. There is no doubt that the weak execution in the Ethernet business is troubling, but today’s sell-off makes the valuation quite a bit more compelling. Even with the tamped down expectation for full year earnings, the stock is trading for a multiple of less than 10x. Furthermore, sales at the midpoint of their guidance would suggest growth of 11% in the year, and further double digit growth is expected in fiscal 2011. It is rare to find a stock with that sort of growth potential trading for such a depressed multiple.

The old adage tells investors “the time to buy is when there is blood on the streets”, and today’s 23% decline and at least three analyst downgrades certainly qualifies for such a situation. We are contrarian investors at heart and see the market’s response to this report as a little overkill. Any better execution for Brocade in upcoming quarters will likely be met with significant price appreciation. Based on the historically normal ranges of price-to-sales and price-to-cash earnings, we believe Brocade could easily achieve a price of $10 based on the current fundamentals.

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