Why I Believe Brocade Is a Likely Takeover Target

by: Marc Courtenay

I'm always on the trail of companies that are likely to be on the "radar screen" of bigger companies.

Buying shares of a company that would be a good acquisition for another company, with tons of cash in its coffers, is a lucrative way to invest. To be able to find that company before the acquisition occurs is not easy, but well worth the effort.

It's a win-win situation to find likely takeover targets. Even if they aren't acquired, you're likely to find a stock with very positive fundamentals and great upside potential. As the late comedian Henny Youngman might say, "Take Brocade Communications Systems (Nasdaq:BRCD) --please!" If there was ever a company that some "takers" might find attractive, it is this company.

What business is BRCD involved in? The company supplies end-to-end Internet protocol based Ethernet and storage area networking solutions for enterprises and service providers.

Its Data Storage segment offers infrastructure products and solutions, including directors, switches, routers, fabric-based software applications, distance / extension products, management applications, and utilities to centralize data management; and host bus adapters, converged network adapters, mezzanine cards, and storage area network switch modules for bladed servers.

While it competes with the likes of Cisco Systems (NASDAQ:CSCO), Juniper Networks (NYSE:JNPR) and EMC Corp. (EMC), it also has some unique products and protocols.

BRCD's Ethernet Products segment provides Open Systems Interconnection Reference Model (OSI) Layer 2-3 switches and routers. These enable the use of bandwidth-intensive network business applications and digital entertainment on local area networks and wide area networks.

Other OSI Layer switches that the company provides allow enterprises and service providers to build network infrastructures to direct the flow of traffic, and file area network products and associated management solutions. In the growing world of smart-phone and "tablet" traffic for the internet, these solutions are becoming more vital.

Brocade's Global Services segment includes break / fix maintenance, extended warranty, installation, consulting, network management, related software maintenance and support, and telecommunications services that assist customers in designing, implementing, deploying, and managing networking solutions, as well as post-contract customer support and customer support services.

It offers its products and services to end-user customers directly and through various distribution partners, including original equipment manufacturers, distributors, systems integrators, and value-added resellers in the United States, western Europe, Japan, and the greater Asia Pacific region.

As we can see by looking at the company's web site, it offers a full "menu" of what the internet "tsunami" is demanding, especially in the fastest growing technology regions of the world.

In a press release on March 28th of this year, Brocade made its aim and intentions crystal clear:

"[BRCD] today announced a number of investments, including a $100 million evaluation program designed to enable eligible customers in the Asia Pacific region to quickly deploy Ethernet fabrics as the foundation for highly virtualized data centers.

"Brocade believes that the IT trends driving transformation in this region make it prime to adopt this fundamental technology to migrate to private, public and hybrid cloud computing architectures.

"Ethernet fabric is a new category of networking technology that is purpose-built for virtualization and cloud-optimized data centers. Brocade's Ethernet fabric solution is powered by Brocade VCS™ technology and available through the Brocade® VDX 6720 Data Center Switch. In December, Brocade was the industry's first company to deliver Ethernet fabric products to market.

"The Asia Pacific region presents a vibrant market opportunity for virtualization and cloud-computing related technology investments as, according to industry research, expenditures for these technologies are expected to grow from $2.5 billion this year to more than $6.7 billion (USD) by 2016.

"Brocade intends to compete aggressively for the virtualization and cloud computing business in Asia Pacific because this region is so important to our company's long-term growth strategy," said Mike Klayko, CEO of Brocade. "We believe we have a highly differentiated offering in the Ethernet fabric space that is based on a 15-year heritage of technical innovation and experience in building the world's most mission-critical data center networks."

BRCD stock is currently priced at less than 11 times next year's earnings, and has a 5 year expected PEG (Price-to-Earnings-Growth) ratio of just 1.18, which speaks to the attractive valuation of the company's shares.

The book value of the company has been estimated at around $4.50 per share, giving it a book-to-price ratio (based on the most recent quarter and price-per-share) at a tantalizing 1.31.

Although its recent reported total debt is a tad high ($892 million), it is sitting on a nice pile of cash ($416 million) and the company has operating cash flow of $348 million (and rising), as well as levered free cash flow (trailing twelve months) of $86 million.

In 2009, the same group that just advised National Semiconductor (NSM) on its $6.5 billion sale to Texas Instruments (NYSE:TXN), Qatalyst Partners (Frank Quattrone's boutique investment bank), had advised Brocade Communications on a potential sale to Hewlitt-Packard (NYSE:HPQ). Those talks fell apart over price and HP bought 3Com instead, according to sources familiar with the matter.

BRCD looks more attractive today than it did in 2009 from many buyers' perspectives, and companies like CSCO and JNPR could integrate the strengths of BRCD into their business model in a New York (or Silicone Valley) minute.

Other possible suitors are the cash-rich companies that might like to branch out into other money-making, compatible areas, such as Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC).

Time will tell, but the recent barrage of technology company takeovers and the deep pockets of the big players makes me think that companies like BRCD are likely to meet their acquisition criteria at some point.

Disclosure: I am long CSCO, MSFT, INTC.

Additional disclosure: I may initiate a long position in BRCD over the next 72 hours