Brocade acquires Ethernet equipment maker Foundry Networks for $3 billion

The acquisition of Foundry matches Brocade's product lines to Cisco's, but observers are concerned about the $3 billion price tag, which dwarfs the $713 million buyout of McData.

Brocade Communications Systems said Monday night that it has entered into a definitive agreement to acquire Ethernet networking equipment maker and service provider Foundry Networks for $18.50 per share of common stock, for a total of $3 billion. The acquisition is still subject to shareholder and regulatory approval and is not expected to close until January 2009.

Foundry Networks offers enterprise Ethernet networking equipment, as well as application switching, security, network management and services products. "The time for this strategic combination is now," said Brocade CEO Michael Klayko on a conference call yesterday. "This gives us the opportunity to provide industry-leading networks on either side of the server, from LAN to WAN, from the Internet to the heart of the data center."

In other words, the acquisition will make Brocade more like its much larger rival Cisco Systems Inc. The acquisition makes Brocade and Cisco the only "end-to-end" networking players in the market, and expands Brocade's total addressable market from $2 billion to $20 billion.

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Klayko said Brocade is hoping that the continued diversification of the company's product lines will catch users in the midst of a widespread technology refresh in the data center.

According to users, that refresh has a lot to do with Ethernet, whether iSCSI storage or the developing Fibre Channel over Ethernet (FCoE) standard. "We're in the midst of making a decision as to how to go about designing our new fabric," said Michael Biedermann, systems analyst at the University of New Mexico Hospital. The hospital is a legacy McData shop that's stuck with Brocade since the McData acquisition, but Biedermann said he's also been in talks with IP networking vendor Cisco about updates to storage networks.

"We haven't made a decision yet, and we definitely have to learn more, especially in light of this news," Biedermann said. "But we're rethinking how much Fibre Channel is needed in our environment, and whether iSCSI is robust enough, especially with 10 gigabit Ethernet coming."

Brocade data center infrastructure group senior director Marty Lans said Ethernet is the meat of the product strategy behind the acquisition. "We're looking to sell from the heart of the data center out," he said. FCoE and 10 GbE are already areas where Brocade has some products, including FCoE equipment that Lans said will ship when the FCoE is ratified, probably later this year. "Those are within the four walls of the data center--this is an extension to our product line meant to go beyond the data center."

Though Brocade may say otherwise, analysts are keying on FCoE and data center Ethernet as strong factors in the deal. According to Arun Taneja, founder and consulting analyst with the Taneja Group, "[FCoE's] got to be at the heart of this," he said. "I would say 10 gigabit Ethernet is probably the primary reason for this—Brocade probably felt the need to have control over the underlying Ethernet layer. Otherwise, Cisco would have a field day."

Cost of deal a concern on Wall Street

However, some Wall Street observers are concerned about how much it took to get there. In a note to investors, Wachovia analyst Aaron Rakers noted that the acquisition was financed with $1.4 billion in cash and $1.5 billion in debt, "resulting in a net-debt position."

"Either Brocade makes a move or potentially [becomes an] acquisition candidate itself," Rakers wrote. "[But] investors will primarily focus on the hefty premium paid." Brocade will use a $120 million line of credit for operational purposes. The company expects to carry significant debt through fiscal 2009.

Klayko didn't address this issue directly, but emphasized the financial strength of Foundry on the call. "This is a financially strong company with healthy margins and a pristine balance sheet," he said. Lans pointed out the potential upside of expansion from a $2-5 billion total addressable market (TAM) to a $20 billion TAM for Ethernet and Internet networking equipment. "This is a way to do a better job penetrating that Cisco base."

Since acquiring McData, Brocade has repeatedly said that it plans to diversify its business, but as recently as last fall's Analyst Day, the company will still emphasizing reliance on its existing install base. "Incumbency matters in this market," said Tom Buiocchi, vice president of worldwide marketing, at the event.

Since then, Brocade has also gotten into the HBA business based on its acquisition of Silverback Systems and a partnership with LSI Corp.

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