Taking Stock: Change Casts Clouds Over SAN Stocks

Brocade and McData's stock prices stall after Cisco enters market
Change for an investor can be cause for cheer or a cause for Pepto-Bismol. However painful or delightful, the stock market adjusts quickly to new circumstances. What the market digests less gracefully is the type of uncertainty that comes with shifting markets, where altering dynamics often cause stocks to go nowhere or decline. The market for storage area networks is undergoing that sort of change right now.

The SAN market arose from the need to handle increasing volumes of business data. Speed, reliability, and the need to back up data were factors leading to the development of separate networks for storage. EMC, Hewlett-Packard, IBM, and others supply storage units, while Brocade Communications Systems and McData make switches and other infrastructure for SANs. The SAN market is expected to grow significantly, from roughly $1.2 billion in 2002 to $4.3 billion in 2006, according to market research firm Gartner. This would be a nice market if Brocade and McData were the only players. But in August 2002, Cisco Systems said it would enter the fray by acquiring Andiamo Systems. This entry came at a time when the entire economy was mired in a recession and demand for SAN switches had eased. Cisco's presence has altered the industry dynamics.

Brocade and McData rely on others to resell their switches and software either through relationships with original equipment manufacturers or via value-added resellers. EMC and IBM resell McData's switches and accounted for 47% and 29%, respectively, of revenue in the fourth quarter of last year. Brocade's relationships include EMC and IBM, as well as HP, each accounting for more than 10% of revenue during the last fiscal year.

Cisco also has forged agreements with EMC, HP, and IBM, but, in addition, it has a powerful direct-sales organization. Plus, Cisco can potentially leverage relationships with a large number of companies that have selected its routers and switches.

The latest quarterly results from Brocade and McData show that growth has returned to the SAN industry. McData reported that revenue increased 20% quarter over quarter to $114.0 million, and pro forma earnings per share rose to 3 cents from 2 cents in the previous quarter. Sales for Brocade rose 8% quarter over quarter to $145.0 million, while pro forma EPS was 3 cents, up from 2 cents.

Both companies expect revenue to grow for the remainder of this year and next, but their stocks have underperformed the Nasdaq substantially. Neither stock is particularly cheap, with McData trading at 26 times next year's First Call consensus estimate and Brocade trading at 30 times next year's estimate. It appears to me that the combination of the stocks being somewhat expensive and the shifting industry dynamics will likely keep a lid on stock prices. I think this situation may last until the competitive picture clears or investors decide there's enough room for Cisco in the market, too.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected]. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.

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