Brocade (BRCD), the network equipment maker, is for sale, or at least that is what the financial media claims. Word of a possible merger or acquisition transaction raced around the market and Brocade’s shares jumped 17% to $8.99. Barron’s quickly identified Hewlett-Packard (HPQ) and Oracle (ORCL) as potential buyers. Then Oppenheimer & Co said a buyout was unlikely. Put simply, no one actually knows what is going on, at least outside of Brocade.
On Wall Street, one merger sometimes causes others in the same industry. Consolidation can be used for cost cutting, to create broader product lines for sales staff, and to build competitive advantages by combining related products. Once Dell (DELL) bought EDS and Cisco (CSCO) bought Tandberg, the speculation flood gates about tech M&A opened.
Brocade is, in many ways, an unlikely buyout candidate. Takeover speculation has pushed the shares to a 52-week high, and the stock now trades for well over four times its 52-week low. Brocade is a niche company in a competitive market. Its stock has risen 175% since the beginning of 2009, while the shares of Cisco are up 40% and Oracle 20%. Brocade must have hidden treasures.
Brocade’s main business is not unlike Cisco’s, which is not really good for the smaller company. The IP router and switch market is large worldwide, but Cisco has tremendous market share and the balance sheet to maintain competitive pricing and weather a downturn. In the June quarter, Brocade’s revenue was only $402 million and its operating income $21 million. Cisco’s revenue in its last quarter was $8.5 billion. Brocade lives in Cisco’s very large shadow.
The best chance that Brocade has of finding a buyer is for one of the very large tech companies, like Oracle, to decide that being in competition with Cisco is critical to its future. Dell is buying Perot (PER) because it will allow it to compete in the IT consulting business, which is very profitable for rivals IBM (IBM) and HP. Buying Perot is a strategic move, which may be why it was bought at a premium of 60%.
Brocade’s biggest single enemy may be its own share price. It will be hard for a buyer to pay much of a premium above a stock that has already risen sharply on rumors. Brocade’s forward PE is 14. Cisco’s is 15. The smaller company should trade a big discount because the risk of its business being hurt by the loss of a key customer or an ongoing business downturn is greater.
Brocade may end up being bought, but someone will have to think it is a real prize or risk being seen as having overpaid.
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