Brocade cheap but dramatic rally unlikely

NEW YORK (Reuters) - Hedge funds have piled out of Brocade Communications Systems Inc (BRCD.O) this year on weak sales and fading hopes for a buyout, making the stock look like a bargain.

But analysts caution against expecting too much of a rebound until the company shows stronger business results.

Andreas Halvorsen's Viking Global Investors, Lee Ainslie's Maverick Capital and Chris Shumway's Shumway Capital Partners were among major equity-oriented hedge funds that sold Brocade shares in the first quarter, according to recent regulatory filings.

That made Brocade one of the top stocks dumped from the portfolios of 30 of the largest equity-oriented hedge funds in the quarter, Thomson Reuters data showed.

Brocade shares enjoyed a strong run-up through most of 2009 as investors bet the company would be acquired and a recovering global economy would lift sales of its communications switches and other networking infrastructure equipment.

But investors counting on a buyout were disappointed as potential bidders skipped over Brocade even as they shopped for niche technology firms. Hewlett-Packard Co (HPQ.N) last November chose to acquire 3Com instead.

Brocade's last two quarterly reports have also let down investors, and few analysts see the shares rising above their 52-week range of $5 to $10 over the next several months.

Even with the shares trading at around 9 times estimated earnings for the year, compared with a multiple of 15 for bigger rival Cisco Systems Inc (CSCO.O), they say it's hard to be too bullish before seeing better results.

"In our view, Brocade continues to possess tremendous strategic value but also continues to be a 'show-me' story over the next several quarters," said Broadpoint AmTech analyst Brian Marshall, who nonetheless rates the stock a "buy."

Brocade's latest, fiscal second quarter results showed it was struggling to integrate Foundry Networks, which it bought for $2.6 billion in 2008. Analysts say it faces tough competition from its main rival Cisco as well as smaller players like QLogic (QLGC.O).

And while most analysts recommend either a "hold" or "buy" on the shares, Thomson Reuters I/B/E/S data shows the median share price taret is $7.25, compared with Wednesday's close of $5.29 -- still 46 percent below their 2009 peak of $9.84.

STRATEGIC VALUE

"It's clear they've mis-executed on the Foundry transaction, and they're currently working their way through that. But I think the risk-reward is extremely attractive here," Broadpoint's Marshall said.

He said that aside from industry leader Cisco, Brocade was still the only company with both fiber channel and ethernet switching technologies. That means Brocade is still an attractive M&A target, although the shares don't carry a premium for such a possibility, he said.

Paul Mansky, analyst at Canaccord Genuity, upgraded Brocade to "buy" from "hold" last Friday, but his share price target is only $7 and he does not expect a sharp rebound in the business right away.

"To be clear, by no means do we anticipate a V-shaped fundamental recovery, and July remains a material question mark for us," Mansky said, citing competition and the risk of a slowdown in Europe.

Analysts say the good news is that Brocade management, led by Chief Executive Michael Klayko, is aware of problems and is trying to address them.

Klayko, who rose from running the sales side of the company, has a resume that includes stints at major competitors including HP, EMC (EMC.N) and International Business Machines (IBM.N).

(Reporting by Ritsuko Ando; additional reporting by Aaron Pressman; editing by John Wallace)