Data Storage: The Pain Goes On

EMC and Emulex are the stars of the bunch -- but that's not saying much, given that Corporate America is keeping IT spending on hold

By Richard Stice

With their profits under pressure, companies are keeping a lid on information-technology (IT) spending -- and the data-storage sector continues to feel the squeeze. As new IT spending initiatives continue to be delayed or cancelled altogether, an improvement in demand for storage products has not materialized. According to International Data Corp., the market for disk-storage systems is expected to decrease by close to 20% in 2002, following a 21% decline in 2001.

This slowdown comes even as storage has become a higher priority for many companies -- particularly data recovery and replication, due in large part to the September 11 terrorist attacks. Although near-term visibility is limited, we do not expect spending in the technology arena to show any meaningful improvement until sometime in the second half of 2003.


  With such an uninspiring outlook, many data-storage outfits have taken matters into their own hands, moving to realign their cost structures and create future growth opportunities. One example is through product diversification, in which companies have begun selling software products to go along with their hardware offerings. And no wonder: The benefit to earnings can be substantial. Typically, software margins are significantly higher than those for hardware, because of a less labor-intensive production process. Companies such as Brocade (BRCD ), EMC (EMC ) and Network Appliance (NTAP ) now derive well over 15% of their revenue base from software-related products.

In addition to beefed-up product lines, these companies are focusing on opening up new sales channels. One way they're pursuing this objective is through partnerships and/or marketing alliances. A recent example of this strategy is an arrangement between EMC and Dell Computer (DELL ). Under this agreement, Dell is selling EMC's CLARiiON storage system to its clients. For Dell, this fills an important gap in its product line. For EMC, it provides access to a new set of potential clients while lowering overall selling, general, and administrative costs.

Finally, other cost reduction efforts, such as employee layoffs, greater manufacturing efficiencies, and the outsourcing of production are also helping to shore up earnings results, despite the unappealing macroeconomic environment.


  Against this backdrop, let's review how some of the leading companies in the storage industry performed during their most recent earnings period.

EMC. The tough times continue for the industry leader, which reported a loss per share of 2 cents (as adjusted) for the third quarter of 2002, in line with analysts' estimates. Revenues fell 9% from the prior quarter and gross margins narrowed because of lower volumes and pricing pressures. In addition, EMC forecast fourth quarter 2002 revenues to be flat with the third quarter. Through cost-cutting measures, the company has lowered its quarterly, break-even revenue level to $1.4 billion -- from $1.8 billion in the second quarter of 2001. But the continued weakness in IT spending has prompted EMC to make further head count reductions that, once implemented, will result in a 30% decline over the first half of 2001 total.

For 2003, we see EMC's revenues growing about 7%. We expect the company to post a loss per share of 5 cents for the full year. Although the shares trade at a discount to their industry peers on a price-to-sales basis, we remain cautious in light of the poor near-term visibility for business conditions and the lack of a pickup in demand. As a result, we view EMC (ranked 3 STARS, or hold) as no better than a market performer over the next 6 months to 12 months.

Emulex. The company posted strong results in its September quarter. Earnings per share totaled 19 cents, before amortization and one-time items, which was 2 cents above our expectations. Revenues rose 34% year-over-year, aided by market-share gains. Gross margins eclipsed the 60% barrier due to higher volumes and manufacturing efficiencies. Emulex' (ELX ) numbers were impressive, and helped to further solidify its position as the leading player in the market for host bus adapters -- the devices that provide connectivity solutions for storage area networks, among other things.

And the good times should continue in fiscal 2003 (ending June). We anticipate revenues to climb about 21%, and earnings per share 84 cents. The stock was recently trading at 31 times our fiscal 2003 EPS estimate, about double the price-earnings (p-e) multiple for the broader market, and more than twice the level of its peer group on a price-to-sales basis. Even with its solid execution and market position, the excessive valuation leads us to believe that Emulex shares (ranked 3 STARS) will only perform in line with the market in the coming 6 months to 12 months.

Brocade: October quarter results for the maker of switching products for storage area networks were mostly consistent with analyst expectations. Revenues rose about 1% from the previous quarter and 31% over the year-ago period. Gross margin narrowed in a more challenging pricing environment. EPS of 7 cents was in line with the Street consensus. But Brocade's outlook for the January quarter was downbeat. Its guidance for revenues and EPS ($120-$125 million and breakeven, respectively) was well below our previous expectations of about $150 million in revenues and EPS of 7 cents. In addition to the difficult IT spending climate, we believe Cisco's expected entrance into the storage area network switch market is resulting in the near-term shortfall.

For fiscal 2003 (ending October), we expect revenue growth to be roughly flat with the prior year and earnings of 11 cents per share. Brocade's earnings quality is a also concern. Under accounting rule SFAS 123, the inclusion of options expense would have transformed fiscal 2001 net income of $2.8 million into a loss of $592 million. Based on our fiscal 2003 estimate, the shares trade at a premium to the broader market on both a p-e and p-e-to-growth basis. As a result, we rank Brocade 2 STARS, or avoid, and would advise investors to place their funds elsewhere.

Analyst Stice follows computer storage stocks for Standard & Poor's

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