Arsensio September 6, 2002 (condensed)
We have been conducting research on a segment of the data storage market called Storage Area Networks (“SAN”). In particular we were interested in learning the manufacturing and sales costs, and the competitor behavior, among Host Bus Adaptor (“HBA”) and Fibre Channel Switch (“FCS”) suppliers. HBAs and FCSs are two components that many SAN original equipment manufacturers purchase from outside suppliers. Two HBA and two FCS companies (both of which are public) accounted for approximately 74% and 83% of their respective market’s sales in 2001. We became interested in performing this research due to the combination of declining margins and these companies’ very large market valuations relative to their revenues and profits.
The HBA companies referred to above are Emulex Corporation (NYSE:ELX, $16.16) and QLogic Corporation (NASDAQ:QLGC, $32.41). Emulex has 82 million shares outstanding and $287 million in cash net of debt. QLogic has 93 million shares outstanding and $547 million in cash net of debt.
The FCS companies referred to above are Brocade Communications Systems, Inc. (NASDAQ:BRCD, $13.69) and McDATA Corporation (NASDAQ:MCDT, $8.81). Brocade has 233 million shares outstanding and $332 million in cash net of debt. McDATA has 113 million shares outstanding and $290 million in cash net of debt.
These companies trade at very high multiples of sales, and trailing and projected earnings. We believe there are serious questions concerning the sales and earnings potential of HBAs and FCSs. Therefore we are currently considering the appropriateness of short selling some or all of these companies.
We currently view Brocade as the most questionably valued company in this group of SAN component companies. We believe that there are serious issues concerning Brocade’s accounting that may obscure its rapidly deteriorating financial condition. We are not alone in questioning the value of Brocade’s shares. As of August 15, 2002 there were a reported 15.5 million shares of Brocade stock that were sold short. Brocade has a $3.2 billion equity market capitalization and has traded an average of 15.6 million shares a day over the last 90 trading days.
On August 14, 2002, after the close of trading, Brocade announced its financial results for its fiscal third quarter ended July 27, 2002. Brocade announced sales and earnings per share of $151.2 million and $0.08, respectively, exceeding its $150 million revenue guidance and meeting analysts’ consensus earnings per share estimate. Brocade said it would give 2003 guidance customarily at the end of its fiscal fourth quarter. By August 22nd Brocade’s stock had risen 11.4% to close at a high of $16.76 per share. During the same period the QQQ rose 8.8%, the S&P 500 Index (“SPX”) rose 4.7% and the DJIA rose 3.6%.
On August 15, 2002 Lazard Freres issued a Brocade equity research report with a lowered price target of $10. On August 16, 2002 Merrill Lynch issued a network storage “Flash Note” stating that the introduction of Cisco Systems, Inc.’s (NASDAQ: CSCO, $12.77) Fibre Channel switching products “could weigh on Brocade’s” stock. TheStreet.com has written three stories titled, “Cisco Deal Shakes Up Storage-Area Business,” “Despite Switch Skeptics, Brocade Advances” and “Brocade's Profit Rises and Its Guidance Is Good, If Skimpy” since Brocade’s earnings announcement. These three stories reiterate concerns about Brocade including deteriorating margins in its core business and increased competition from new market entrants. Cisco with an equity market capitalization of $95.5 billion (including net cash of $21.5 billion) announced in its form 8-K filed on August 20, 2002 that it expects its complete family of switches to be available in the fourth quarter of calendar year 2002.
We write this to show that a public debate already exists concerning the value of Brocade’s stock. We are monitoring product and competitive developments, company and analyst comments, and stock price developments in Brocade’s market, its peers and broader industry participants. We are also monitoring the developments in the patent infringement lawsuit against Brocade by McDATA. We are monitoring these developments to determine when, and if, we will initiate research coverage of Brocade or any of its peers.
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