Is the worst over for tech stocks?

Is storage a safe bet?

May 18, 2001: 3:00 p.m. ET

Analysts confident on storage companies despite lackluster earnings
By J.P. Vicente

SAN FRANCISCO (Red Herring) - The stocks of companies in the storage sector these days look a lot like wrapped presents around a Christmas tree on December 20. You know they hold lots of great things, but you need to wait a little longer to get your hands on the goodies.

That sentiment was confirmed this week after three industry stalwarts -- Network Appliance (NTAP: down $0.26 to $22.84, Research, Estimates), Brocade Communications Systems (BRCD: up $0.94 to $46.30, Research, Estimates), and QLogic (QLGC: up $2.55 to $54.00, Research, Estimates) -- reported subdued quarterly earnings and announced guidance that continues to point to flat-to-moderate near-term growth. Network Appliance earned $7.9 million, or 2 cents a share, on a pro forma basis in its fiscal fourth quarter. The result was in line with Wall Street expectations but is down from earnings of 11 cents a share in the fiscal third quarter, as well as the 7-cents-a-share profit of a year ago.

Meanwhile, Brocade said its net income was $12 million, or 5 cents a share, in its fiscal second quarter, compared to earnings of 13 cents a share in the previous quarter and 6 cents a share a year earlier. QLogic, a maker of host bus adapters, reported pro forma earnings of 28 cents a share in its latest quarter, flat from the previous quarter but up from 18 cents a share a year ago.

Despite the uninspiring news, these stocks all surged, bolstered by a vivid buying spree on Wednesday that lifted the entire technology sector. Network Appliance's stock rose 9.6 percent to $24.69, Brocade's shares jumped 11.1 percent to $47.41, and QLogic soared 12.5 percent to $47.81.

This sharp rally notwithstanding, we believe that storage firms are still suffering badly from an economic downturn that has forced corporations to reduce drastically -- and, in some instances, completely freeze -- capital spending on technology. As long as corporate spending remains depressed, so will these companies' bottom lines.

When is enough, well, enough?

The question going forward is, of course, when will corporations start spending again? As it stands today, the answer to that key question depends on whom you ask. After Brocade's conference call on Tuesday evening, chief executive officer Greg Reyes said he was feeling a lot more upbeat today about his business than he did a couple of months ago.

"We saw a period in the February-March time frame when we didn't have a lot of visibility, and IT spending was in a state of suspended animation," said Mr. Reyes. "But today, two weeks into our third fiscal quarter, we've got many data points where IT spending is, in fact, being released."

We posed the same question to Network Appliance CEO Daniel Warmenhoven on Tuesday. His assessment of the current and future situation, however, was a little more skeptical. "I just don't think anything will get materially better in a hurry," he said. "There's an old story in the financial community that says that there's no such thing as a one-quarter problem ... This is at least a two-quarter problem, and probably more like a three-quarter problem."

QLogic CEO H.K. Desai said in a statement that "the current economic environment remains challenging in the near term." Mr. Desai also said that revenue in the current quarter would fall on a sequential basis, and that earnings should come in at the low end of Wall Street forecasts, which are between 22 and 25 cents a share.

We are siding with Network Appliance and QLogic on this one. We think Mr. Reyes is correct when he says that the industry is indeed experiencing some incipient and scattered signs of recovery. But we don't believe that the faint improvement will be enough to have any significant positive impact on the companies' bottom lines in the current quarter.

Nothing would make the stocks in the sector a screaming buying opportunity just yet, especially since they still trade at extremely high valuations. After all, at Wednesday's closing prices, Brocade traded at 148 times fiscal 2001 earnings and 91.2 times fiscal 2002 earnings. Network Appliance's price-to-earnings ratio is currently at 77.2 for fiscal 2001 estimates and 103 for fiscal 2002. QLogic is the "cheapest" of the three, trading at 38.2 times fiscal 2002 earnings and 32 times fiscal 2003 earnings (QLogic's fiscal year ends in March).

Is the worse over?

But there's a silver lining. Industry executives do seem to agree that the worst of the downturn appears to be behind us. Although we might see one or maybe two more quarters of flat earnings growth in the sector, the pummeling has apparently ended.

Looking ahead, lower interest rates instituted by the Federal Reserve -- which cut borrowing costs by 50 basis points (a half-percentage point) for the fifth time this year on Tuesday -- are expected to encourage corporate spending. "I'm hopeful that the economy will start picking up as we enter the fall," said Mr. Warmenhoven.

Storage executives had better be optimistic about the future because many of them are betting the farm on the assumption that they can gain market share by continuing to spend aggressively during the downturn. Brocade and Network Appliance, for example, both posted year-over-year gains in revenue in the latest quarter -- 85.6 percent and 13 percent, respectively. But they both posted a decrease in earnings.

The reason for the decline in earnings is increased spending. On a year-over-year basis, total operating expenses grew 178 percent in the quarter for Brocade and 46 percent for Network Appliance. The fact that neither of those companies announced layoffs to cut costs explains only part of the story (Brocade actually hired 100 new employees last quarter). Both firms made a decision to increase research-and-development budgets -- up 194 percent at Brocade and 67 percent at Network Appliance on a year-over-year basis -- on the belief that they could come out of the downturn stronger if they continued to invest in developing new products.

"We decided to use these challenging economic conditions to position ourselves better going forward," said Mr. Reyes, adding that Brocade's next-generation product offering should ship in the fall. He did not provide further details.

Same scenario at Network Appliance, which is currently spending close to 80 percent of its R&D budget to develop next-generation software that will enable and facilitate management and virtualization of storage networks.

What Wall Street thinks
Several Wall Street analysts maintained their ratings on the companies after the results were announced, but cut earnings estimates for the next fiscal year. Tom Kraemer at Merrill Lynch, for example, kept his Buy recommendation for Brocade and his Accumulate rating for Network Appliance.

Mr. Kraemer maintained his Brocade earnings-per-share estimates of 30 cents for fiscal year 2001, which ends in October. However, he lowered his earnings expectations for fiscal year 2002 to 56 cents a share from 92 cents a share. As for Network Appliance, Mr. Kraemer reduced estimates for fiscal 2002 -- which ends in April -- to 23 cents a share from 29 cents.

Commenting on Network Appliance, Andrew Neff, an analyst at Bear Stearns, noted that while he remains confident about management's ability to execute, the near-term outlook remains weak and uncertain. He expects competition in the network attached storage (NAS) arena to become more aggressive as giant EMC (EMC: down $0.90 to $40.60, Research, Estimates) continues to make inroads in that market.

And, given the fact that Network Appliance's market capitalization dropped some 80 percent in the last six months to around $8 billion, Mr. Neff throws in a curious, and rather intriguing, comment at the end of his report: "The other issue for investors is whether Network Appliance could be acquired."

This is the first time we had heard rumors of a possible acquisition of Network Appliance. As it stands, it sounds a little far-fetched, mainly given the fact that the company is not necessarily a cheap buy. But if we had to make a guess, we think that IBM (IBM: up $2.09 to $117.16, Research, Estimates) would be a possible suitor. Why? With a market cap north of $200 billion, Big Blue has more than enough clout to acquire Network Appliance.

Also, IBM has a pretty comprehensive storage unit that, although fairly aggressive in the storage area network (SAN) space, is still developing a more broad-ranging NAS strategy. In that case, Network Appliance could fit like a glove.

Merger speculation aside, we continue to believe in the long-term upside potential for the storage sector. In the short term, however, we remain cautious. Despite the recent meltdown in stock prices, multiples remain very high. So until there are signs of significant improvement in earnings, it's hard to justify rushing back into the sector just yet.