Buy Brocade: The Stock Does Not Reflect The Opportunities Ahead

| About: Brocade Communications (BRCD)

When we look for stocks to invest in, we seek either companies that are rapidly growing or are mispriced relative to their true values. Our searches have led us to companies like Chipotle (NYSE:CMG), a rapidly growing company that is able to resist economic malaise, and Clearwire (CLWR), a company whose share price in no way reflects the assets it holds. Today, a focus on mispriced companies has led us to Brocade (NASDAQ:BRCD)

Brocade is a $2.6 billion networking company that competes with some of the giants in the industry, most notably Cisco (NASDAQ:CSCO). And while a look at Brocade's performance over the past year reveals nothing outstanding, we think that a down the line, the chart will look a whole lot different.

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Before we lay out our case for investing in Brocade, we must first address the takeover rumors that have once again surfaced regarding this company. On Monday, January 9, Brocade's stock soared over 6% on rumors of a takeover. It is important to note that Brocade has tried to sell itself before, only to have a deal fall through due to disagreements over its price. But, Brocade's stock has fallen since then, and while that may be disappointing to existing shareholders, it presents a good opportunity for prospective shareholders, and prospective buyers of the company.

If you are a short-term investor, this is where you must ask yourself if you believe in a takeover, and invest accordingly. While the options market may think that a deal is imminent, there is no way to know for sure what will happen. Brocade has been in the spotlight several times before, and no deal has occurred. If you believe that the company will be taken over, then by all means buy the stock. But if you are wary of the prospects of a takeover, then you should avoid the stock, IF you are a short-term investor. There is the possibility that Brocade may fall if no deal is announced in the near to medium-term future, and as such, investors that are not in it for the long-term should plan accordingly. But if you ARE someone who is thinking of Brocade as a long-term investment, we think that a drop resulting from a lack of a sale is an opportunity to pick up more shares of the company.

Brocade has had many missteps in the past, but we think that the company is turning around its operations. It is true that Brocade posted a loss of 1 cent per share in the fourth quarter. However, those results were due to a huge surge in income tax provisions. Brocade had income tax provisions of $45.446 million last quarter, compared with just $5.431 million in the previous year. Why the jump in income tax provisions? Brocade repatriated $200 million in cash to buy back stock, and as such it had to pay taxes on it. Before investors begin to fret about the effect this has on Brocade's finances, the tax charge in the last quarter was all noncash. As Daniel Fairfax, Brocade's CFO stated on the conference call, "All that [income tax provisions] was noncash as we used significant NOLs, so we have here in the U.S. to offset that. Once we repatriated cash in the form of -- it was done as a company dividend. And we've been into the market in a 10b5-1 trading plan and purchase of shared [sic] all within Q4." Adjusted earnings at the company were 16 cents per share, easily beating the consensus analyst estimate of 10 cents/share, and Brocade's own forecast of 9 to 11 cents. Revenue of $550.5 million also beat expectations of $527 million.

So where does Brocade go from here? Earnings in 2011 were depressed by aggressive investments the company made in its business. And those investments are beginning to pay off. The company's ethernet business will be the main growth driver going forward, and we like what we see. In Q4, ethernet revenue grew by 14% sequentially, and the size of the deals signed by the company grew by over 20%. Furthermore, Brocade is increasingly able to cross-sell its ethernet products to its SAN customers. At the end of the fourth quarter, more than 60% of the top 100 SAN customers were using Brocade's ethernet products. Furthermore, Brocade is confident that it can continue to gain market share in the business and hold its own against competitors like Cisco. The ethernet business is the future of Brocade, and the future seems bright.

A look at Brocade's financials reveals that the company is working aggressively to improve its balance sheet. And we are impressed with what the company has been doing. In the fourth quarter, Brocade generated a record $206 million in cash flow from operations. It paid down 46% of its term loans in fiscal 2011. And in the fourth quarter alone, Brocade repurchased 46.5 million shares of stock, representing 9% of the entire company. Furthermore, days sales outstanding fell from 54 days in the third quarter to 41 days last quarter. It is true that Brocade has over $367 million in net debt on the balance sheet. But this is a marked improvement over the past few years, and the company is steadily working to deleverage the balance sheet, which we profile below.

Brocade Balance Sheet
2011 2010 2009 2008 2007
Cash & Cash Equivalents $414.976 Million $335.982 Million $338.871 Million $820.125 Million $793.33 Million
Lease Losses $2.496 Million $3.984 Million $10.150 Million $15.007 Million $25.742 Million
Senior Secured Notes $595.803 Million $595.373 Million N/A N/A
Convertible Subordinated Debt N/A N/A $169.332 Million $159.147 Million $149.814 Million
Term Loans $186.858 Million $325.897 Million $898.936 Million $1.055005 Billion N/A

We should note that the $1 billion of term loans added to Brocade's balance sheet in 2008 was related to the acquisition of Foundry, which was paid for with a mix of cash and stock, totaling $3 billion.

Investors should not make the mistake of assuming that Brocade's future will be the same as its past. The future of the company, its ethernet business, is growing rapidly, gaining customers, revenue, and profit for the company. The balance sheet is steadily improving. And earnings will rebound from depressed levels. Brocade does trade at a P/E ratio of almost 53. But its forward P/E ratio is just over 10. Brocade invested aggressively into its business in 2011, depressing its earnings. Yet, the company is projected to post earnings per share of 53 cents in 2012, an increase of over 419% from 2011, when Brocade earned 10 cents per share.

We think the market is being too pessimistic about Brocade's future. The Reuters average analyst price target for Brocade is $5.73, 4 cents below where Brocade is currently at. We think this price target will rise as analysts see the potential this company has. Should a takeover of Brocade occur, investors will be rewarded with a nice premium. And should there be no takeover, we think investors will be glad to own a company that is growing, improving the balance sheet, and whose earnings potential is yet to be unleashed. Brocade's best days are ahead of it, yet that is not currently being reflected in the stock price. We recommend investors buy the stock at these levels. It is an investment that should give investors a great return.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BRCD over the next 72 hours.