Brocade's Doing Well, but Needs Better Catalysts

It's been several weeks since Brocade reported its fiscal first-quarter 2013 results. I felt the numbers were, on balance, pretty good. But the company received no standing ovation from the Street. In fact, the stock is now trading slightly lower than before the earnings announcement, which compels me to believe that the Street has a very short attention span.

Brocade needs a catalyst. There has not been a constant stream of positive news, and the stock has languished for quite some time. Granted, Brocade is not as flashy as Cisco, but the company has certainly outperformed Juniper and Riverbed. And with the possibility of a buyout always around the corner, patient investors can do well here.

Giving credit where credit is due
It has not been a great earnings season for enterprise IT companies. Except for Cisco, the entire sector has gotten punished for poor results, disappointing guidance, or both. Needless to say, heading into the Q1 report, Brocade's investors were chewing their nails to hear what management had to say. This is even though management had already guided for revenue of $565 million to $585 million.


To that end, Brocade did not disappoint. In fact, the company beat its own target by posting revenue of $588.7 million, representing an increase of 5% year over year, and 2% sequentially. For that matter, from a percentage standpoint, Brocade's year-over-year and sequential improvement were the exact growth levels of Cisco, which, by contrast, the Street applauded. Fairly or unfairly, this has been Brocade's reality.

In terms of profitability,  Brocade posted a GAAP loss per share of $0.05, down from a profit of $0.12 per share in Q1 2012. However, management said that the net loss was the result of non-cash tax charge, which reduced Brocade's deferred tax assets due to change in California's tax code. But when these charges are adjusted out, non-GAAP earnings arrived at $0.21 per share, $0.01 better than Q1 2012.

However, from an operational standpoint, it seems the Street is still overlooking how well managed this company is. That gross margin was able to advance 2% in this environment is not easy, especially when the likes of Juniper and Riverbed have been cutting costs to grow market share. This means that Brocade is able to withstand the pressure.

Management also attributed the improved margin to a more favorable revenue mix to SAN, or storage area network, products. Likewise, operating margin advanced more than 3% year over year, to 15.8%, helped by (among other things) better cost management. While bears continue to cite Brocade's strong competition as reason to avoid the stock, management has now proven for consecutive years that Brocade fears no one.

Can Brocade overcome doubt?
In the tech sector, a strong focus is always placed on top-line growth. However, I think it's a mistake to judge Brocade solely on this basis. This is a company that has produced solid free cash flow for eight consecutive years, while margins have always been strong. That the company continues to grow market share in its core SAN business indicates that the company's strong technology is still highly regarded. Here, too, the improved margins reflect this.

While I do like Brocade, and see some possible upside in the near-term, this is not by any means a flawless company. The improvements have been positive, but Brocade is still far behind Cisco and Juniper in enterprise data centers. Elsewhere, the debt-to-equity situation is not very attractive. The company has $683 million in cash, and $900 million in debt. The risk here is that Juniper or Cisco might turn up the heat at any point and squeeze the solid margins that Brocade enjoys today.

What of the stock?
I still see some upside potential here. The stock does not offer the safety of Cisco, but for investors with high frustration thresholds and appetites for risk, Brocade can be a solid play in the enterprise storage/network segment.

In the meantime, there will continue to be buyout rumors. However, as long as Brocade continues to grow long-term free cash flow and make modest market share gain in its core business, the stock should do well. But it's going to take some patience. What catalyst is better than solid execution?

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The article Brocade's Doing Well, but Needs Better Catalysts originally appeared on Fool.com.

Fool contributor Richard Saintvilus has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and Riverbed Technology. The Motley Fool owns shares of Riverbed Technology. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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