Just about every aspect of Cisco's (CSCO) business is envied throughout the network equipment industry. Its balance sheet, its market share, and its distribution network have scared away dozens of potential competitors. Yet somehow the executives at Tasman Drive have become dissatisfied with owning 70% of the routing and switching market, and would now rather compete for 5% of the server market.
While there is little reason for Cisco to expand out of networking, there is also little reason to expect that the rumored IBM OEM deal can help Brocade (BRCD) take much share from Cisco in the nearly $20 billion a year Ethernet switch market, particularly when the Foundry products it acquired last year have done best in segments where customers buy directly from manufacturers. Additionally, Brocade itself is straying from its dominant position in storage networking in order to pick up a sliver of the LAN switch market.
Big Customers Still Buy Direct, and Prefer Alternative Suppliers
Much like its 2007 purchase of Silverback Systems, Brocade's acquisition of Foundry was driven largely by the concern that Fibre Channel's six year success holding off Ethernet and iSCSI was about to come to an end, particularly with the advent of Fibre Channel over Ethernet. This made sense strategically, but issuing $1.1 billion of debt was a rough move financially, particularly with the deal closing before the great stock market collapse during the fall of 2008. Additionally, in an industry where it is very rare to carry more long-term debt than cash, financial liabilities can become a much greater disadvantage strategically than a technology shift, especially when Cisco is still sitting on $22 billion of net cash it can use to finance equipment, buy new companies, or for incentives with its distributors.
One of the ways Extreme (EXTR), Foundry, and Force10 have gotten around Cisco's distribution network is to find customers who buy direct from the manufacturer. For Foundry, this once meant targeting hosting centers and ISPs, and from 2002 and on, the Federal Government, which accounted for 22% of its revenue. Its Reston, Virginia sales office, initially opened to serve DC area technology companies like AOL and Cable & Wireless, was effectively transformed into a Federal sales office after 9/11, but in both cases account teams were trained to meet with customers, not resellers.
Brocade’s vision to be a “second viable player” providing “end-to-end solutions” is exactly the wrong direction any Cisco competitor to be taking, because the companies showing any signs of success against Cisco are not broadening their product lines, but rather focusing narrowly on niches the large vendor has ignored. In addition to Cisco, Brocade/Foundry must now contend with a new crop of competitors like Arista Networks, Blade Network Technologies, and Woven Systems which focus on inexpensive, entry-level switches. In addition to pricing 10GBASE-CR and -CX ports at $500, these lean startups are going after a high volume market not dominated by Cisco, a fact which has already encouraged Juniper (JNPR) to compete in this sector.
The Foundry acquisition is reminiscent of the Nortel-Bay and Lucent-Ascend deals in the 1990s, where it was argued that a bigger company teaming with an existing Cisco competitor would produce stronger resistance against the large networking supplier. But in practice, the opposite happened, a new company at the time, Juniper, successfully took on Cisco by focusing on just the high-end router market, while Bay and Ascend did little for their new parent companies other than empty their checking accounts.
Dominating Storage Makes More Sense than Trying to Dominate Corporate Networks
Rather than make it stronger against Cisco, the Foundry deal only puts Brocade at greater risk of losing share to balance sheet strong competitors like QLogic (QLGC) and Emulex (ELX). The company would have been better off buying one of its HBA (Host Bus Adapter) competitors and consolidating its lead in storage, much like it did in 2007 when it acquired McData. Allowing Broadcom (BRCM) to walk away with Emulex for less than Brocade paid for Foundry will be a major blow strategically.
IBM has sold Brocade's Fibre Channel switches for over a decade, and the company is likely to remain strong in the Storage Area Networking market, whether its transports Fibre Channel or Ethernet frames. However, IBM is still no match for the thousands of Cisco resellers distributing over $10 billion of equipment annually in the broader LAN and WAN markets.
Legendary investor Peter Lynch once said that "competition in business is never as healthy as total domination". Now Brocade must figure out how to pay its debt back with a share of the Ethernet market that is far from dominant.
Disclosure: No positions