The continuous creation of data will be a driving force for growth in storage systems worldwide. The enormous amount of data creation is leading to the demand for storage devices and the networks that connect them. Brocade (BRCD) is a company in the business of storage solutions and Ethernet networking. The storage industry is valued at $23 billion in this year and is expected to continue the upward momentum in the coming years. Though the storage and networking industry provides an inherent opportunity, the competitors in this industry are also large and aggressive.
Here we have analyzed how Brocade is taking on the competition in its business domains.
A race for glory
For the third quarter Brocade reported revenue of $369.2 million from the Storage Area Network, or SAN, business, which is a 2% decline year over year. A SAN is an aggregation of computer storage devices and consists of switches, directors and fiber channel products. This slowdown in demand for these storage devices happened due to decreased spending by IT companies. However, we believe the demand for the SAN devices is poised for growth due to advancement in data center technology and increasing adoption of cloud computing. According to Cisco, the global data center traffic is to grow four folds from 2011, reaching 6.6 zettabytes annually by 2016, and the cloud traffic is expected to grow from 683 exabytes in 2011 to 4.3 zettabytes in 2016. This phenomenon is causing an increased demand for high volume of data along with high frequency to access the data. This is leading to the adoption of high speed 16 Gigabit per second, or Gbps, Gen 5 Fiber Channel products by Brocade, which is at present the highest available speed in computer network technology. The adoption of the 16 Gbps FC is driven by the twice faster data transfer capabilities and lower power consumption compared to its predecessor 8 Gbps FC.
Saying that is only half of the story. The company's Gen 5 Fiber Channel is under pressure from Cisco Systems' (CSCO) competing technology of Fiber Channel over Ethernet, or FCoE. FCoE technology has the capability to integrate networks like Local Area Network, or LAN, and SAN into a single user interface, simplifying the management of multiple networks. This combination of networks is called convergence of networks. The increase in the convergence of networks is fueling the growth of FCoE technology because it provides the facility of storage networks and LAN under the same infrastructure.
Cisco not only competes with products, it also backs them up with services. Brocade receives competition from Cisco's Unified Computing System, or UCS. The UCS provides a complete data center solution with servers, storage systems, and equipment to tie these together. For Cisco, the system generates revenue at a run rate of over $2 billion. The emergence of a converged solution like UCS is gaining traction because of its ability to simplify the IT infrastructure of a company and thereby increasing efficiency of accessing and using data. The number of customers for the UCS grew from around 1700 in 2010, to above 20,000 in 2013, and it maintained the revenue run rate throughout this period. This shows an increasing threat to Brocade's product lines. We believe that Brocade is in a disadvantageous position because it still hasn't developed a data center solution service comparable to that of Cisco's UCS.
We believe that Cisco will continue to threaten Brocade's market share in the storage networks business through continuous promotion of its FCoE technology and UCS service. Here we can observe an increasing trend in adoption of Cisco's products and services.
The fabric wars
Brocade's Ethernet business registered revenue of $167.3 million in the third quarter ending in June 2013, which is a 2% increase quarter over quarter. Ethernet fabric products like VDX switches drive the growth in the Ethernet business. VDX switches are devices that connect servers over the Internet. VDX switches are based on Brocade's fabric technology. The fabric switching products contribute around 12% of the total Ethernet revenue. The company currently has a customer base of around 1,100 for these products, which have an annualized run rate of $80 million. The growth of Brocade's Ethernet products comes from the existing customer base that is adopting these technologies with the rise in data transactions.
The Ethernet switching market is poised for growth because of the rising number of data centers and the need for faster speeds. Though Brocade has first mover advantage in the Ethernet fabric space, it is facing competition from the likes of Cisco and Juniper (JNPR). The networking infrastructure market is valued at $50 billion this year.
Now let's talk about the competition from Cisco. It has a major share of the Ethernet market of around 70%, much higher than Brocade's market share of less than 10%. Cisco has developed FabricPath Ethernet technology that also helps connect data centers. This technology helps enhance the transaction of data across data centers. Also, the company is expecting growth in its Ethernet business because of the increase in network connectivity. The company also has a heavy presence in the Ethernet switch and router market. This primarily consists of 10 Gigabits Ethernet, or GBE, products, which are the most recent product lines for the company.
Also, Juniper will give Brocade tough competition in the Ethernet business segment. It has its own line of products named QFabric data center switching lines, which compete with Brocade's Ethernet fabric products. The QFabric products are gaining customer mindshare. This can be understood from the increasing number of customers over a time frame. Juniper had 200 switch customers last year, and the company now has the ability to reach around 20,000 customers worldwide with its switching products in the QFabric line.
What's in store for the future?
In the year to come, Brocade will be under a significant amount of competitive pressure from Cisco and Juniper. This competition might strain the future growth potential of Brocade. A brief comparison among the P/E ratios can give a glimpse into this context.
The competition of the SAN business between Brocade and Cisco is heating up as the two companies are designing competing technologies. It's a race to see which company will establish its technology, FC or FCoE, as the market leader. So, to take a bigger share of the market, Brocade needs to come up with more advanced technology than the existing ones, which will help it gain the required lead.
As we can see, the current P/E and forward P/E multiples of Juniper show a huge difference. Juniper's lower forward P/E multiple shows its higher growth potential compared with that of Brocade. Juniper has a turnover almost twice that of Brocade, but it is still registering better growth prospects, which is reflected in lower forward P/E ratio. We also fear that the growth of Brocade's Ethernet business might face tough competition from Cisco. This company is by far the largest player in terms of market share, and it is aggressively protecting this market share by launching competing products. Therefore, any growth for Brocade is tough in the current market.
Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Rohit Gupta, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.