Brocade Communications Systems Inc. today announced that it will acquire McData Corp. in an all stock transaction valued at approximately $713 million. The acquisition has been in the cards since Cisco Systems Inc. entered the storage market in 2001 and immediately began taking market share from both Brocade and McData.
"Brocade and McData together offer a legitimate competitor to Cisco, which has been quietly flexing its muscle in the background and gaining share all over the place," said Steve Duplessie, founder and analyst of the Enterprise Strategy Group. "The combination will give a legitimate second choice to a world that doesn't like having only one option, especially when it is as powerful as Cisco." Cisco was unavailable for comment as this story went to press.
That said, Brocade and McData users face a bumpy road ahead as the two companies converge headcount and product lines. Company executives would not comment on potential layoffs or product overlap, except to say that there would be a "converged platform long term."
Sorting out which products stay and which get killed "is usually the hardest part of such a merger, where the product lines are so overwhelmingly overlapping," noted Arun Taneja, founder and consulting analyst with the Taneja Group. "I am impressed with Brocade's recent aggressiveness, as it has reached out of its comfort space and acquired a bunch of companies in the file space. But those acquisitions are nothing compared to this one, in terms of rationalizing the product lines."
Analysts agree that the combination of the two companies was inevitable but are perplexed at why Brocade decided to acquire McData now, at such a hefty premium. The price represents a 48% premium over Monday's closing price of McData's shares sending Brocade's stock tumbling 14.4% to $6.14 on news of the deal.
"One company is doing well, Brocade, and one company is stumbling, McData. Why not wait a couple of quarters while the company is still losing share?" said Mark Kelleher, analyst with Canaccord Adams on a conference call Tuesday morning.
Adding fuel to the fire, Brocade just reported that it expects third quarter net revenues of $188 million to $189 million, up from previous revenue guidance of between $174 million and $183 million. While McData just announced that it expects second quarter revenue of $150 million to $152 million. That's below the company's previous guidance of $170 million to $180 million in revenue.
"McData has been down on one knee for a while -- why now?" another analyst asked.
Michael Klayko, Brocade's CEO, said that there had been no bidding war for the company, as some analysts speculated. "This is about the long term, not the short term," he said, adding that both companies' customers were "frustrated by the lack of interoperability among vendors" and want "simpler more scalable solutions."
Steve DuplessieFounder and analystEnterprise Strategy Group
Touching on a sensitive subject, Tom Curlin, analyst with RBC Capital Markets, suggested the deal might be taking place now as Brocade's new growth initiatives bring it into conflict with its original equipment manufacturer (OEM) partners. "You are going more direct to the customer with respect to the Tapestry initiatives," he said. Brocade acquired NuView Inc. in March picking up file-level virtualization products that compete with EMC. Meanwhile Brocade collects up to 30% of its revenue from this OEM partner.
Klayko dismissed this theory. The deal is "very beneficial to our OEMs," he said. "It eliminates [duplication] and testing costs."
ESG's Duplessie added that the deal will also help because these two have always competed with each other inside the OEM community -- and the OEM's have been able to leverage them against each other to force better pricing but lower margins for both. "With only two games in town, the new Brocade/McData combo will all of a sudden be the best looking girl in the room with the OEMs, since Cisco is viewed as a black widow spider by most of them," he said.
Following the closing, Brocade's executive management team will continue to serve in their current roles. John Kelley, McData's CEO, will serve as an advisor to Brocade. Brocade will retain its name and corporate headquarters in San Jose, Calif., and McData will become a wholly owned subsidiary of Brocade. Two McData directors are expected to join the Brocade board of directors upon closing.
Under the terms of the agreement, McData stockholders will receive 0.75 shares of Brocade common stock for each share of McData class A common stock and each share of McData class B common stock they hold. Upon completion of the transaction, McData stockholders will own approximately 30% of Brocade. The transaction is expected to be tax free to McData stockholders.
The company said it is expected to be accretive to Brocade, on a non-GAAP EPS (generally accepted accounting principles/earnings per share) basis by the fourth quarter of combined operations. And, it will generate annual synergies of approximately $100 million, coming from both headcount and nonheadcount related expenses by the fourth quarter of combined operations.