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Another Tech Star Falls to Earth

Last summer, tech investors saw reason to hope that the shares of data-storage companies had bottomed. The stocks of leading suppliers such as EMC (EMC), Veritas Software (VRTS), and Brocade Communications (BRCD) seemed to stabilize in July and August after long descents. Sales in the sector were starting to grow again, albeit anemically. And thanks to rampant cost-cutting, analysts were projecting that many storage companies would return to profitability in the fourth quarter.

Then came September, and with it new signs that tech spending would remain dormant for the rest of this year -- and possibly longer. After bouncing between $7 and $9 for most of the summer, industry heavyweight EMC dropped to $5. That wiped an additional 30% off a stock that started 2002 at $15 -- and that two years ago traded above $100.

Much of EMC's decline -- as well as the fall of other storage companies -- came on Sept. 26, triggered by the ostensibly innocent decision of Brocade, a maker of switches for storage networks, not to issue earnings guidance at an industry conference.

DIDN'T WORK OUT. Investors read bad news into the silence, and assumed that sales for the quarter must be off-track. Brocade's stock plunged 20% that day and 6% more the next when Morgan Stanley cut its price target for the shares, citing a worsening technology-spending environment. Brocade is now at $7.60, down from $120 two years ago. Fellow component outfits QLogic (QLGC) and McData (MCDT) fell 10% on news of Brocade's zipped lips, as did other storage mainstays such as Veritas and Network Appliance (NTAP).

When corporate tech spending started to dry up in 2000, Wall Street continued to bet on storage companies, believing that the surge in data generated at corporations would keep them spending on storage equipment. The amount of data companies produce has continued to double every year, but intense competition and cutthroat pricing have meant that total sales volumes of storage software and equipment have declined. Even sales of the most sophisticated networked-storage systems, known by the acronyms SAN (storage area networks) and NAS (networked-attached storage), grew at a tepid 4% to 5% in this year's second quarter, according to research firm IDC.

Thus, one of the sectors that held up best when corporate-technology spending first stalled is now falling faster than most. For investors, this is a neon warning to avoid the group. Asked what public-storage companies he would invest in, Alex Mendez, a general partner at venture-capital firm Storm Ventures in Palo Alto, Calif., almost laughs. "None," he says. "Right now, the stocks are still finding a bottom. You want to buy stocks when they are going up, not down."

Robert Burgoyne a money manager in Ellicott City, Md., is also avoiding the sector. "Storage is a capital purchase item, and there's just no sentiment to invest at this point in capital equipment," he says.

LEADERS' ADVANTAGE. Hardly anyone is arguing that the storage leaders will go out of business. At some point, they'll almost certainly be worth investing in. But given such slow growth and few signs of a pickup in overall corporate-technology spending, analysts are increasingly wary of the group. While a few recommend select stocks based on valuation, others have simply given up on the idea of valuing tech stocks on a price-to-earnings basis. "The problem is that there's no such thing as normalized earnings" for these companies, says Burgoyne.

In fact, in a Sept. 16 report on the sector Merrill Lynch analyst John Roy trimmed his 2003 revenue and earnings targets for Brocade, McData, and Adaptec (ADPT). But based on their competitive positions and growth prospects, he recommends buying Brocade, Network Appliance, and Emulex. Overall, however, he thinks it will take higher profits for companies in the S&P 500-stock index, which would bring about a rebound in capital spending, for spending on storage to pick up.

On the bright side, given the slowdown in the development of new technologies, the current leaders are likely to become entrenched. In 2000, many analysts were starting to worry that stocks of outfits such as Brocade and EMC could be vulnerable because they had built their success on selling equipment that uses the fiber-channel protocol, which some thought would be replaced by the more versatile networking protocol, iSCSI. That may still happen, but the transition has been delayed. "In times like these, nothing changes real quick," says Roy. Of the storage pure plays, that leaves companies such as Veritas, Network Appliance, and Brocade among the favorites to bounce back first.

HEDGE STRATEGIES. EMC, meanwhile, has been dealing with a difficult transition. It has had to develop new strategies for the far more competitive landscape that developed when server companies such as Hewlett-Packard (HPQ), Sun Microsystems(SUNW), Hitachi (HIT), and IBM (IBM) got serious about selling storage equipment. The current trend in storage is toward so-called open systems -- built around standard technology -- that can be installed piecemeal, rather than as a result of one big sale based upon proprietary technology -- the strategy that made EMC a market power.

"It's very hard for a company that built its success on selling proprietary products to be aggressive and competent in an open approach," says Peter Smith, CEO of NearTek, which provides multiplatform backup and media-management software.

Analysts believe the best future bets in storage may be companies that base their strategy on selling open systems. "IBM is a bit of a dark horse," says Mendez. "It's a company that has reinvented itself many times. It's in a pretty strong position."

"DEATH MARCH." Cisco, which is making a big push into storage switches with its August purchase of Andiamo, is another way to play the sector while hedging your bets. "Cisco (CSCO) just threw a big brick into the pond with Andiamo," says Mendez. "If it goes any lower [than its current $11 or so], it's a great buy," he says. U.S. Bancorp Piper Jaffray analyst Ashok Kumar believes that Cisco will pose serious long-term competition for switch makers Brocade and McData. "In what we believe is a winner-take-all death march, we expect Brocade and McData will end up as the casualties," he wrote in a Sept. 30 research note.

In fact, Kumar believes that the storage-networking business may eventually be reabsorbed into the hardware and networking markets -- a possibility that would obviously pose a long-term risk for the pure plays. Most analysts, however, think companies with a focused storage strategy will prosper again as demand reignites and corporate customers opt for more sophisticated software -- and cheaper hardware -- for managing their mountains of data.

In the weeks ahead, investors may find select opportunities to pick up leading storage companies that have taken a hit. Generally speaking, though, it's a good idea to remain wary of a sector that continues to disappoint. By Amey Stone in New York

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