Brocade Sweats Out Q3 Profit

Fibre Channel switch maker Brocade Communications Systems Inc. (Nasdaq: BRCD) squeezed out a penny-per-share profit for its third quarter, as it struggled to ward off competitive pressure from McData Corp. (Nasdaq: MCDTA) and Cisco Systems Inc. (Nasdaq: CSCO) (see Brocade Posts Q3 Results).

"We were able to grow our business in a difficult environment," Greg Reyes, Brocade's chairman and CEO, said on a conference call yesterday. "We are very confident of our market position and of our ability to compete going forward."

In morning trading today, the San Jose, Calif., company saw its stock price skip up half a percent, to $5.54 per share.

Brocade posted third-quarter earnings of $2 million, or $0.01 per share, excluding deferred acquisition-related stock compensation. That was well below the company's profit for the same quarter last year of $18.3 million, or 8 cents per share. However, the results were a significant improvement over the company's second-quarter pro forma loss of $1 million; including acquisition-related charges, Brocade reported a loss of $146 million, or 57 cents a share, in its second quarter this year (see Brocade Hit With Q2 Loss).

The company posted third-quarter revenues of $133.5 million, up sequentially over the $130.9 million it reported in the previous period but substantially lower than its year-ago revenues of $151.2 million.Brocade's forecast for the fourth quarter also fell short of analyst expectations. The company says it expects to post earnings of 2 cents a share in its fourth fiscal quarter on revenues of between $134 million and $139 million. Wall Street has been forecasting earnings of 4 cents a share for the current quarter.

And while its earnings were in line with analysts' expectations, Brocade's revenues came in slightly under the $134.7 million that the Street had been expecting. More worrying, according to Kaushik Roy, an analyst with Susquehanna Financial Group, is that the company's results were at the low end of their guidance.

"Things were not as good as they were expecting," says Roy. "They know that they're losing share in the midrange to McData, and they know that Cisco is coming in."

Bear Stearns & Co. Inc. analyst Andrew Neff agrees. In a research note today he writes: "The larger issue for Brocade is that the competitive dynamics in the SAN market are likely to worsen, both between Brocade and McData and more importantly, with the presence of Cisco in the market." Neff says that McData is maintaining its strong position in the director segment -- an area Brocade viewed as a growth opportunity -- and that Brocade has significant "competitive challenges" in the low end of the SAN market from other vendors and new technologies such as iSCSI.

According to U.S. Bancorp Piper Jaffray analyst Ashok Kumar, the overall storage switch market has been flat over the last four quarters at about $250 million to $300 million. "Over the same time span, Brocade has lost 8 points of share (from 52% to 44%) to McData and more recently to Cisco," he writes in a note today. Kumar says he expects Cisco's launch of its midrange MDS 9100 switch to expand its estimated 5 percent share of the market ($15 million per quarter) to 10 percent by the end of the year. Cisco has not released any information about the 9100, but analysts expect it to be a fixed-port switch in the 20- to 40-port range.On a more upbeat note, Brocade reported that it increased its port shipments during the quarter by 10 percent, to a total of 2.8 million to date. The company also said it increased its cash holdings by $4.4 million during the quarter, to $909 million.

Another positive for Brocade during the quarter, according to Roy, was that it managed to keep its gross margins high, at 54.1 percent. But while the company says it expects its fourth-quarter gross margins to remain high, between 53 and 55 percent, Roy says they're bound to start slipping.

"When Cisco brings out their midrange product starting in October," he says, "that's when it's really going to hurt them. Their gross margins will definitely be under a lot more pressure."

Eugénie Larson, Senior Editor, Byte and Switch