Value Play: Brocade Communications (Nasdaq: BRCD)

Whenever I find an extremely “cheap” stock based on snapshot valuation metrics, my first worry is that the company is a “value trap” — i.e., a company with declining business fundamentals. The holy grail of investing is finding that rare stock that is both extremely cheap and is exhibiting improving business fundamentals. I think I’ve found such a rare company: Brocade Communications, a manufacturer of computer networking equipment.

Technology Leader in Fibre Channel Switching

At a market capitalization of only $2.55 billion, Brocade is much smaller than industry leader Cisco Systems (NSDQ: CSCO), which sports a market cap of $110 billion, but Brocade’s storage area networking (SAN) product line (Fibre Channel) is technologically superior to Cisco’s in several areas, including architecture, internal usable bandwidth, connectivity and power efficiency. For example, in May 2011 Brocade was the first networking company to introduce a 16 gigabyte per second (G) Fiber Channel switch — it’s now February 2013 and Cisco is still stuck at 8Gs, although Cisco is scheduled to introduce a 16G product by June of this year.

According to a June 2012 report from market research firm Infonetics, SAN equipment will see “steady growth” over the next few years with Brocade’s product leading the way:

Fibre Channel continues to be the real star, with revenue from 16G Fiber Channel products growing at an astounding 52% compound annual growth rate from 2011 to 2016.

In the Fibre Channel  SAN switch space, Brocade continues to be the #1 player, with 70% revenue market share.

In a September 2012 report, Infonetics reported “skyrocketing shipments” of 16G Fibre Channel switches with “no end in sight.” Through 2016, the research firm forecasts $41.7 billion will be spent on SAN switches and adapters. With regard to Brocade, Infonetics said the following:

Brocade essentially owns the 16G Fibre Channel segment, with an astounding 99% of global revenue market share.

Making a Move into High-Growth Ethernet Switching With Strong Partners

While future growth in Fibre Channel SAN equipment is huge, Brocade’s growth potential goes far beyond storage. Cloud computing (the Internet-based connection of data servers and applications from several different locations) and its more-recent stepchild — Big Data — are tremendous growth opportunities for Brocade. According to IBM:

Big data is a collection of data sets that are so big that it is hard to collect, analyze, visualize, and process using regular software such are relational database management systems. Moreover, this data is typically unstructured.

A recent study indicates that unstructured data account for at least 80% of the world’s data. This means that many companies today are making mission critical decisions with only 20% of the data they have, the 20% of data that is structured and stored in relational databases.

In September 2012, Brocade introduced its VDX 8770 switch, which is based on the Ethernet fabric protocol. According to one independent techie:

Compared with Cisco Nexus and Juniper’s (NYSE: JNPR) QFabric, the Brocade VDX 8770 is a leader in latency, speed and density.

Ethernet fabric is the protocol of choice for cloud computing and analyzing Big Data. IBM (NYSE: IBM) has partnered with Brocade — combining Brocade’s VDX 8770 switch and an IBM mainframe computer — to handle the heaviest conceivable Big Data needs of corporations intent of collecting the most detailed business intelligence.

According to Consumer Goods Technology Magazine, IBM is one of the top-10 technology providers of business intelligence services – so Brocade is partnering with a winner. Furthermore, IBM’s decision to partner with Brocade is testament to Brocade’s state-of-the-art Ethernet switching technology. 

Software Virtualization is the Future of Hardware Switching

Brocade is more than just a hardware company; it is moving into software-based network virtualization. Virtualization saves clients money because the software optimizes the efficiency of networking hardware so that less hardware needs to be purchased.

In November 2012, Brocade acquired Vyatta, a leader in software-based networking that has been called “Cisco’s nemesis” because it offers open-source virtual routers at every performance level that are significantly cheaper than Cisco’s comparable hardware offerings. One independent analyst characterizes Vyatta’s technology as “great” and applauded Brocade’s acquisition as “low risk” and a “good move.”

A recent Forbes Magazine article discusses the competitive threat of software virtualization to hardware network vendors like Cisco, Juniper, and Brocade, but I think Brocade is in the best position of the three to co-opt the virtualization threat.

New Brocade CEO Carney is “The Man”

Not only did Brocade acquire Vyatta, but it also has a new CEO who has a strong background in network virtualization.  On January 14, Lloyd Carney took over as Brocade CEO. Carney is a well-respected networking executive with almost 30 years experience in the high-tech industry. Furthermore, Carney’s specialty is software virtualization, having been CEO of Xsigo Systems — a software virtualization company that was acquired by Oracle (Nasdaq: ORCL) in July 2012 and is described as having “a dagger aimed at Cisco’s business.”

In his first conference call as Brocade CEO, Carney said that 90 percent of Xsigo customers used Brocade products. Carney is very familiar with Brocade’s capabilities. If anyone knows how Brocade can successfully compete against Cisco, it is Lloyd Carney and he has already declared that Brocade will pursue a “software-based strategy” to challenge its competitors. Interestingly, in February 2013 market research firm Gartner ranks Brocade as more visionary than both Cisco and Juniper, and better able to execute on its vision than Juniper.  

Brocade is a Takeover Target

Under prior CEO Mike Klayko, Brocade had attempted to sell itself almost continuously for more than three years — first in October 2009 and then again in October 2011. The second time, serious bids came in from private equity firms, but no deal was consummated. Speculation is that Klayko demanded both a very high sales price and a future executive role for himself in the merged company — conditions no potential acquirer was willing to accede to.

When bidders withdrew all offers, Brocade’s board of directors decided it was time for Klayko to go and in August 2012 Klayko announced his plans to retire. Speculation ran in both directions as to whether Klayko’s resignation made a sale of Brocade more or less likely.

With the appointment of Lloyd Carney, I think the answer is less likely — at least in the short term. Although Carney sold both of the previous companies he headed — Micromuse to IBM and Xsigo to Oracle — the sales did not occur until three years and five years into his tenure, respectively. When asked the question, Carney said the following:

“This is not a short-term proposition. If someone shows up with stupid money, I have to listen to it. But my history is I’m not a quick-turn guy. I’ve never done that.”

Brocade’s previous attempts to sell itself were during periods when the company was heavily in debt — thanks to its 2008 acquisition of Ethernet-networker Foundry Networks for $2.6 billion — and future growth of its flagship Fibre-Channel SAN products was in doubt.

Times have dramatically changed for the better. As noted above, shipments of 16G Fibre Channel products are skyrocketing and expected to remain strong through at least 2016. In addition, Brocade’s balance sheet in both the fiscal fourth quarter of 2012 (page 56) and fiscal first quarter of 2013 (page 7) exhibited more cash than debt for the first times since the 2008 Foundry Networks acquisition. I agree with the analyst who argues that Brocade would be crazy to sell itself now just when its business is starting to improve:

“I would find it hard to imagine the board would sell the company on the precipice of cloud, SDN, fabric, etc., taking off. These are natural accelerators for Brocade, assuming good execution, meaning it wouldn’t make sense to sell the company now regardless of who the CEO is. 

Also, Brocade is in great financial shape and is a cash-generating machine. The company generates over $100 million per quarter in cash so it doesn’t need to sell for an infusion of money.  Again, if someone like Dell were to significantly overpay for Brocade, then of course they would sell.  Barring that, I see Brocade remaining an independent company.”

Improving Fundamentals Refute Charge That Brocade is a Value Trap

Financial evidence of Brocade’s business improvement is clear. In its Q1 2013 financial report, Brocade announced record revenues and higher gross and operating profit margins – the exact opposite of the declining business fundamentals indicative of a value trap. A Piotroski F-Score of 7 (highest possible is 9) further underscores the company’s recent business success.

Since 2006, Brocade’s free cash flow has more than tripled, and the company’s future growth prospects remain bright far into the foreseeable future, which leads me to believe that the stock is severely undervalued at its current price and very attractive as a new purchase.

Brocade is Undervalued By 30 Percent

The stock is currently trading at $5.55, which is lower than the $5.88 it was trading for in August 2012 when a Bloomberg article made the following observations about Brocade:

• Brocade’s price-to-free-cash-flow ratio of 5.3 is lowest in three years, less than the 9.6 median of its peers, and cheaper than 90 percent of similar-sized computer-storage firms.
  • With a free-cash-flow yield of 19 percent, Brocade produces almost twice as much cash from its operations relative to its stock price than the median of computer-storage companies with more than $500 million in market value.
  • Brocade owns its headquarters building in the Silicon Valley and “it’s a really nice building.”

The positive first-quarter report led many analysts to increase their price targets on the stock:

• BMO Capital Markets and Needham & Co. both raised to $7.00
• Buckingham Research raised to $7.25
• Wunderlich Securities raised to $7.50.

Those are stand-alone valuations; according to ThinkEquity, a takeover would probably be done at an even higher price of at least $8.00 per share. With the stock price currently $5.55, an $8.00 takeover would equal price appreciation of 44 percent. Brocade is not one of those growth stocks that could end up being a 10-bagger, but its undervaluation is significant and offers superior appreciation potential.

Brocade Communications is a buy up to $6.25; I’m also adding the stock to my Value Portfolio.

Momentum Play: HomeAway (Nasdaq: AWAY)

I don’t like buying initial public offerings (IPOs) when they first come out because the selling company has the advantage. Company management waits until financial performance has peaked (at least short term) and only then decides to sell shares to the public when the sales price will be highest.

As George Soros protégé and Investment Biker author Jim Rogers said last year in explaining why he would not be buying the Facebook (Nasdaq: FB) IPO:

It’s been demonstrated many, many times before that sellers are usually smarter than the buyers, and they usually know when the best time to sell is.

The best time to start buying IPOs is around six months after they come public because insider lockup expirations typically occur at the 180-day mark and insider selling (as well as anticipation of their selling) usually depresses the stock price up until that time frame.  

In the case of HomeAway (Nasdaq: AWAY), the world’s leading online marketplace of vacation rentals, six months after its June 29, 2011 IPO priced at $27 per share, the stock bottomed on cue at $20 per share on December 27, 2011. HomeAway CEO Brian Sharples admitted in an October 2011 interview that the timing of its IPO was not random:  “We were able to pick our spot. It’s not just on luck, we picked a time in the market we thought was good.”

Strong Price Momentum

After bottoming in December 2011, HomeAway stock shot back up to a high of $28 in January 2012 and $27.47 in October 2012 before falling back down to $20 in December 2012.  Just recently, it broke to a new 15-month high above the $28 resistance level on fourth-quarter earnings and forward guidance that beat analyst estimates.

Strong Earnings Momentum

With strong price and earnings momentum, I don’t see any reason why HomeAway cannot easily challenge its all-time high of $45.75 reached in September 2011. Profit growth has accelerated over the past two quarters. Consider the following earnings growth for Q4 2012 and growth estimates for 2013:

Source: Zacks Investment Research

Super Earnings Quality

Equally impressive is the company’s earnings “quality,” which I measure by comparing reported net income to free cash flow:

Anything above 1-to-1 is considered quality earnings, so HomeAway’s ratios demonstrate super-quality earnings that will continue to grow for many years to come as the huge excess of free cash flow from prior years eventually makes its way to the earnings bottom line. The main reason HomeAway has higher cash flow than earnings is because it generates revenues from annual subscriptions to its listing service.

Under GAAP accounting, the portion of annual subscription revenue applicable to future months must be deferred until those future months occur, whereas the sales and marketing costs needed to acquire the clients who pay for the subscriptions are typically expensed immediately (AOL capitalized such marketing costs in the 1990s but got in trouble with the SEC and started expensing them). The combination of deferred revenue and expensed costs minimizes current earnings compared to the actual cash that is being generated.

As the list of subscription-based clients grows, a larger percentage of revenues will come from renewal subscriptions which require almost zero marketing expense — compared to new subscriptions. Marketing expenses should decline in the future whereas cash flows should continue to increase, leading to an earnings explosion down the road. As one analyst puts it:

“What has intrigued me about the company is its subscription-based business model and the residual income that it creates. Companies that have to sell something new every day to make money are always faced with a lot of variables and marketing expenses. But for enterprises like AWAY whereby customers renew the sale for years to come via an e-commerce charge to a credit card, new selling costs are eliminated, income can grow geometrically and profit margins continue to increase.”

HomeAway’s recent decision to forego costly television advertising, and focus on more cost-effective cost-per-click and display advertising only, is a good sign for higher profit margins and future earnings growth.

Being No. 1 Player Gives HomeAway Positive Network Effects

HomeAway’s leading network of vacation rental lessors reminds me of eBay’s leading auction seller network and OpenTable’s leading restaurant reservation network.  In each case, the largest network wins because of strong network effects that create a never-ending positive feedback loop. The larger a network becomes, the more valuable it becomes for both sellers and buyers, which in turn attracts more people to join the network. To use an astrological analogy, it’s like a black hole where the gravitational pull gets stronger the more mass is sucked into the hole, which results in more mass getting sucked in, which creates a greater gravitational pull, etc. 

HomeAway is the world’s leading online marketplace of vacation rentals, with websites representing approximately 712,000 paid vacation rental home listings throughout 171 countries. For purposes of comparison, HomeAway’s closest competitor is TripAdvisor’s Flipkey, which only has a network of 170,000 listings.

Vacation Rental Market Opportunity is Huge

While HomeAway’s market-leading 712,000 listings are impressive, they are minuscule compared to the potential $85 billion-per-year market opportunity of 19.6 million vacation rental properties in the U.S. and Europe. Furthermore, only 1 in 10 Americans has ever rented a vacation home. In other words, HomeAway has a very long runway of future growth. Renewal rates of the annual listing subscriptions currently run about 75 percent, which CEO Brian Sharples has called “the highest renewal rates in history.” Business is booming because in a difficult economy property owners want to bring in additional income and vacation travelers want to lower their cost of lodging – everybody wins.  One travel agent explained the value proposition for travelers this way:

If you need five hotel rooms in Italy at $500 per night per room, and can get a three- or four-bedroom villa for $5,000 for a week for four couples, it’s cheaper.

Not only is the basic lodging cost lower, but a rental also doesn’t try to price gouge you with a bunch of exorbitant additional fees for incidentals like parking, Internet access, telephone calls, and a mini-bar refrigerator. Furthermore, rentals offer amenities that many hotels simply don’t offer, such as a kitchen, hot tub, and laundry facilities.

Of course, people are more prone to travel if the economy is improving, so HomeAway would be hurt if the economy fell back into recession. Fortunately, vacation travel is on the upswing and estimates of future vacationing activity are positive. According to a November 2012 HomeAway survey, the percentage of Americans planning to travel over the 2012 Thanksgiving and Christmas holidays increased by 53% and 82%, respectively, compared to the 2011 holiday season. HomeAway CEO Brian Sharples characterized the market as perfect for HomeAway’s business:

It seems people feel optimistic about the economy and are starting to travel more, but our research shows they’re still cost conscious.

Valuation is High But Deserved

Sporting a P/E ratio on trailing earnings of 161 and 37 on forward earnings, nobody could confuse HomeAway with a value stock. Nevertheless, the stock is exhibiting very strong price and earnings momentum, has a great cash-flow to earnings ratio, and is the leading player in a market with huge growth potential. 

HomeAway is a buy up to $32; I’m also adding the stock to my Momentum Portfolio.