PC maker Dell Inc. (NASDAQ:DELL) could acquire Brocade Communications Systems, Inc. (NASDAQ:BRCD) in a bid to own assets in servers/storage/networking space.
California-based Brocade, which is one of the leading supplier of data center networking products, makes Fibre Channel switches and related software for connecting corporate storage systems and servers.
Brocade's products are used in storage area networks (SANs), which pool storage resources across enterprises for easier management and more efficient utilization of assets.
In addition, the company's SilkWorm switches automatically reroute data upon path failure and reconfigure the SAN when new devices are added. Brocade sells its products primarily through equipment manufacturers, including EMC (NYSE:EMC), Hewlett-Packard, and IBM, which together generate nearly half of the company's revenues.
Speculation of a potential Brocade acquisition has surfaced among institutional investors calling recently and in the financial media. Meanwhile,Brocade has been a target for other original equipment manufacturers (OEMs) for quite some time.
We believe Dell is looking to acquire a networking company given management's view that owning intellectual property across the data center stack (servers/storage/networking) is strategically important, Raymond James analyst Brian Alexander wrote in a note to clients.
Dell also needs alternative revenue streams as tablets are hurting sales of PC's, which is one of Dell's core revenue generator.
Meanwhile, Dell's motivation for buying Brocade would clearly be around the Ethernet switching intellectual property. Ethernet accounts for about 23 percent of Brocade's total revenue.
Brocade holds about more than 70 percent of the storage area network (SAN) switching market and is in about 80 percent of data centers worldwide. This vast installed base positions Dell in front of more data center accounts from which it can sell more servers, storage and also services.
That said, a significant portion of those accounts are with Brocade's OEM partners, who own those customers, which as stated above are at risk if Dell were to acquire Brocade.
Overall we still believe that there would be a net positive in terms of incremental customer accounts that Dell could sell additional hardware and services, Alexander said.
Another reason for Dell to buy Brocade would be significant cross selling opportunities within Brocade's large storage switching installed base.
How Much Dell Needs To Spend?
Dell would have to spend in excess of $4 billion to acquire Brocade whose current enterprise value is $3.7 billion.
However, Dell clearly has the dry powder to make the acquisition with $14.5 billion in cash and short term investments as of the end of its first quarter.
The company, which has $6.9 billion in net cash, has recently filed a shelf offering for $3.5 billion that gives the company with even more flexibility, but has partially fueled the recent speculation.
On the financial front, Brocade earned $28 million on revenue of $550 million for the quarter ended April 30, representing an increase of 27 percent and 10 percent, respectively, from the same period last year.
The company had more than $463 million in cash and cash equivalents and short-term investments as of April 30.
In 2010, Brocade earned $118.9 million and generated revenue of $2.09 billion. This was compared to a loss of $81.3 million and revenue of $1.95 billion in 2009.
Brocade Deal Not Without Risks
Alexander warned investors that there are a few issues with Brocade that could potentially inhibit an acquisition that investors may be underestimating, particularly the sustainability of Brocade's storage switching OEM business.
Brocade generates approximately 65 percent of total revenue from storage switching OEM relationships, of which IBM, EMC, and Hewlett-Packard represent 47 percent of total revenue.
If Dell were to acquire Brocade, we would expect the OEM revenue to decline materially as EMC would certainly end the relationship just as it did following Dell's Compellent acquisition, the analyst wrote.
It is unsure whether relationships with Hewlett-Packard (NYSE:HPQ) or IBM (NYSE:IBM) would change, but it is certainly a risk.
One alternative is Dell could acquire Brocade and subsequently sell the OEM business. However, the damage may have already occurred by then and therefore Dell may not realize the full value of the divestiture.
Given Brocade's already high market share and the risk that Brocade's OEM revenue could decline materially following the acquisition, Dell would likely rely on significant growth in Brocade's Ethernet business to generate an appropriate return.
An acquisition of Brocade is possible; however, the risk of fallout in the OEM business and required growth to generate an appropriate return must be carefully weighed, Alexander said.
Acquisition Against Strategy
While an acquisition of Brocade is certainly possible, it would go against Dell's recent strategy of seeking out high-growth companies with good technology, but limited reach.
In such cases, the analyst believes an acquisition of a company such as Arista Networks (private) or Force10 Network (private) are more likely.
Even then, it could impact Dell's current reseller agreements with Brocade and Juniper Networks (NASDAQ:JNPR).
Shares of Texas-based Dell closed Monday's regular trading session at $15.90 on Nasdaq.
Shares of Brocade closed Monday's regular trading session at $6.97 on Nasdaq. In the pre-market trading hours Tuesday, they were up 1.79 percent, or 12 cents, to $7.09.