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Cashing In on Storage

By Richard Stice, CFA In recent years, the volume of stored electronic data has expanded significantly, due largely to the growth of data-intensive technologies such as online transaction processing, data mining, data warehousing, multimedia, and Internet applications. As a result, the capacity and numbers of storage devices used by large companies have increased.

In the late 1990s, in response to the increasing need for storage scalability, manageability, and reliability, large outfits began to deploy storage area networks, or SANs. These configurations transform dedicated servers and storage devices into network resources, thereby greatly improving the performance and scalability of enterprise storage.

In the last few years, network attached storage (NAS) appliances have gained acceptance in the storage marketplace as well. In the NAS architecture, data is converted from block form to files before it's delivered to servers or personal computers.

We at S&P believe the benefits of the SAN and NAS systems, which make up the broader network-storage category, have enabled them to supplant the traditional direct-attached storage systems. In the first quarter, network storage for the first time represented more than half of the total external disk storage-systems market, according to International Data Corp. Network storage made up 53% of total storage systems revenue, up from 48% in the first quarter of 2002, according to IDC.

FIBRE CONNECTED. We believe this trend bodes well for Emulex (ELX

, which S&P ranks 5 STARS, or buy; recent price, $26.50), a supplier of key components involved in network-storage arrangements. Emulex is poised to take advantage of the increasing demand for storage products, in our opinion. The Costa Mesa (Calif.) company is the world's leading "fibre channel" supplier of host bus adapters (HBAs), achieving a revenue market share of 47% in 2002 (up from 40% in 2001 and 35% in 2000), based on IDC data.

Fibre channel technology was introduced in 1994 as a way to interconnect multiple host servers and storage devices, and became the first storage-networking technology to be widely adopted by the leading server and storage manufacturers. HBAs are data-communication products that enable servers to connect to storage networks by offloading communication-processing tasks as information is delivered and sent to the SAN.

Based on 2002 revenue, Emulex garnered more than 50% above its nearest competitor, QLogic (QLGC

, 2 STARS, or avoid; $48.07). IDC projects that the total fibre channel HBA market will grow at a compound annual rate of 8.5% between 2003 and 2007, reaching approximately $880 million.

PATENT PRODUCER. We believe Emulex will maintain its leading market position. We think its dominant share will help offset pricing pressures. Moreover, we believe the industry has high barriers to entry, given the technological sophistication and intellectual property needed to be competitive. As of June, Emulex had a number of issued patents and pending patent applications in the U.S. and abroad. It also actively pursues patent protection for its inventions when products are being developed and introduced.

Emulex has increased its research and development spending notably in the last three years. In fiscal year 2003 (ended June), it spent $58.8 million on R&D, up from $45.5 million in fiscal year 2002 and $26.2 million in fiscal year 2001.

Emulex' execution has been solid, in our opinion. The company's gross margins have expanded for nine consecutive quarters, reaching 64% in the June quarter. In addition, operating margins have expanded in six of the last seven quarters and stand at 35%. The balance sheet had cash and investments totaling $385.6 million as of June, or roughly $4 per share.

DEBT IS DOWN. Emulex reduced its long-term debt, which consists of 1.75% convertible subordinated notes, by almost 40% in fiscal year 2003. Moreover, on Sept. 24, it announced an additional repurchase of the notes at a discount to face value, as well as an expanded share buyback program. The company has also generated a steady amount of free cash flow, producing $45.3 million in fiscal year 2001, $81.5 million in fiscal year 2002, and about $90 million in fiscal year 2003.

We project that fiscal year 2004 revenues will increase 21%, to around $374 million, reflecting our view of further market-share gains, the benefits of new product introductions, and international expansion. Also, we believe a pickup in information-technology spending is likely, particularly for data-storage related products, as companies have made this a high priority. We see gross margins widening, resulting from higher volumes, abating pricing pressures, and a favorable product mix. We forecast operating EPS of $1.02 for fiscal year 2004, vs. 84 cents in fiscal year 2003.

Our valuation of Emulex shares encompasses two metrics: price-earnings-to-growth and discounted cash flow. Based on our fiscal year 2004 EPS estimate of $1.02 and an expected five-year earnings growth rate of 20%, the shares trade at a p-e-to-growth ratio of 1.3, vs. 1.9 for the S&P Computer Storage & Peripherals Index. Using this group's ratio would give Emulex a share price of $39.

IT'S A BUY. We think the company will continue to boost free cash flow given its leading industry position, favorable long-term IT spending trends in data storage, and our view of a strong balance sheet. Our discounted cash-flow model assumes a weighted average cost of capital of 11.7%, an accelerating growth rate through year five, followed by a steady deceleration thereafter, and an expected terminal growth rate of 3%. These inputs equate to an intrinsic value of $28.

Combining the two valuation measures, we derive an expected 12-month target price of $34. Given our view of Emulex' favorable industry position and attractive valuation, we recommend that investors buy it shares. Analyst Stice follows computer storage and peripherals stocks for Standard & Poor's

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