Cisco And Brocade: An M&A Match Made In Heaven

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 |  Includes: BRCD, CSCO, DELL, HPQ, JNPR
by: Richard Saintvilus

With the news that Blackstone Group, which is said to be the world's largest private-equity firm, ended its bid to acquire network company Brocade (NASDAQ:BRCD) because the price had become too high, I immediately began to line up other possible suitors. It is no secret that Brocade, which last year was on the verge of being acquired by Dell (NASDAQ:DELL), has been shopping itself to potential targets since 2009. The fact of the matter is Brocade will be sold eventually. The only question that remains is to whom? The number one company at the top of my list continues to be king of networks, Cisco (NASDAQ:CSCO). The only question for Cisco is, does it need this deal?

The case for a Cisco acquisition

First, Cisco has the financial means to make this deal happen yesterday if it wanted to - this is even though Brocade, by the rebounding of its stock, is growing more expensive each week. This is due to its fourth quarter earnings report that not only beat analysts' estimates and helped by record revenue in its Ethernet business, but the company also raised guidance. Not to mention that it also beat consensus estimates on both year-over-year declines and its end of range. As respectable as the numbers were, it seems that there were many who remain unimpressed by its results. I think this has a lot to do with the fact that Brocade operates in a space dominated by the aforementioned Cisco as well as better known names such as Hewlett Packard (NYSE:HPQ) and Juniper (NYSE:JNPR).

I will concede that as Cisco indeed continues its turnaround story, there is a good chance that Brocade may suffer slightly from Cisco's resurgence. But that is not to take away from the many accomplishments that it has logged this year, especially considering the market's early reaction to its once perceived inability to compete when it missed estimates last year. But the reality is the company has more than doubled its free cash flow in the past five years. So it must be doing something right - and this is why a deal for Cisco makes sense.

In 2008, Brocade took a page out of Cisco's book and acquired one of its competitors, Foundry Networks. That was an acquisition that seems to now be paying off. In its acquisition, management sought to broaden the company a little bit more and place less dependency on its storage business. The other advantage was it wanted to be able to sell networking gear to its existing customer base to provide the services of a one stop shop, a strategy that is now proven to have worked or at the very least, currently working.

There is no denying that Cisco is clearly the market leader, and it's not going away. But Brocade is proving that it can do just fine with a small piece of the pie. This has also proven to be the case for other Cisco competitors such as Aruba (NASDAQ:ARUN). But the sad reality for them is that (as we started discussing earlier) growth continues to be a challenge. While it appears that Brocade does not have a problem demonstrating growth, however, growth happens to be an area where Cisco is trying to recapture and prove to the market that it can produce. On the flipside, the market is wondering how long Brocade can continue to grow absent an acquisition. It's a match made in heaven - at least from my vantage point.

Although this deal with Blackstone may have arrived as a disappointment to Brocade shareholders, I have reason to think that the disappointment will be short lived as a deal with Cisco makes too much sense to be ignored. In the meantime, the stock may continue to experience some upside movement on the assumption that, at some point, an acquisition will indeed take place. As I've said, the more likely scenario is for Cisco to enter the discussion and eventually close the deal. The benefits for both sides are obvious. However, as Brocade is due to report earnings in a couple of weeks, I think acquisition or not, the company deserves a long look on the basis of its continued improving fundamentals as well as the return of technology spending.

Summary

As enamored as I have been with Cisco, Brocade has become a turnaround story in its own right. I have to say that the stock is worth a long look at current levels - particularly as it is widely assumed that the worst is behind it. There are a lot of questions that need to be answered, but from a risk-reward point of view, it's one that is worth taking a chance on.

Disclosure: I am long CSCO.