Tuesday, July 22, 2008

More pressure for Cisco or last survival effort?

Brocade Communications Systems Inc., dominant in an obscure corner of the data storage market, wants a piece of a bigger pie: Cisco Systems Inc.'s cash cow business of networking equipment that transports Internet traffic. San Jose-based Brocade said Monday it has agreed to pay $3 billion to acquire one of Cisco's smaller competitors, Foundry Networks Inc. The deal is the latest sign of forces that are driving together companies which serve separate niches in networking, allowing them to offer customers a broader line of products that work together.

The merger agreement calls for Brocade to pay a combination of $18.50 of cash plus 0.0907 share of Brocade common stock for each share of Foundry's common stock, representing a total value of $19.25 a share or 41 percent premium to Foundry’s closing stock price Monday before the deal was announced. Brocade would raise $1.5 billion in debt to finance the acquisition. No comments were made on whether Brocade anticipates any layoffs; however Brocade's and Foundry Networks' product lines don't overlap, so there would be few obvious areas to cut. Deal is supposed to be "additive" to Brocade.

The deal moves both companies beyond being niche players in the marketplace. The price premium Brocade paid for Foundry was a little high but that’s what you need to acquire a technology leader. As a result, Brocade will be able to jump quicker into the market than some of their competitors. The acquisition would combine two companies with deep presence in the data center space and cause a direct challenge to Cisco. Surging Internet traffic, especially in bandwidth-hogging video, has driven intense demand for the routers and switches that direct Internet traffic, Cisco's home territory. That has also lifted the fortunes of Cisco's smaller rivals, including Santa Clara-based Foundry Networks, which specializes in high-end networking gear, making them attractive takeover targets.

Brocade wants Foundry Networks because its primary business, dominant in a type of switch that connects servers to data storage machines -- is under pressure. Data centers are changing, and networking companies are focusing on acquisitions or expensive R&D efforts to come up with technologies that make the servers, storage and related equipment more robust and easier to manage. The acquisition promises to make Brocade a better-rounded competitor to Cisco, but isn't likely to significantly jeopardize Cisco's dominance as Foundry Networks, with $607 million in sales last year, is still considered a niche player. As servers become more powerful, and information technology managers demand more control over increasingly complicated machinery, Cisco has been advocating that the Fiber Channel and Ethernet technologies themselves should be merged somewhat in a direct assault to the core business of Brocade and Foundry Networks. Enterprises and Service Providers alike really need to reduce the complexity, especially at the high end of the data centers.

Sooner or later, this type of acquisition was likely to happen. It was a matter of who and when. How much impact will cause on Cisco? It remains to be seen. However, Cisco’s dominance on end-to-end solutions will continue to be a significant competitive advantage and one acquisition in just one of the several niches markets that Cisco has presence on should not create big market disruptions. Granted, it may lose some temporary market share on data centers. Let’s wait and see Cisco’s next move and don’t be surprised if we face yet another round of acquisitions on this space.


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