Insight--S&P:"Overgrown Prices for Fledgling Data Storage Stocks?"
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>>>Thursday July 13, 2000 (09:14 am ET)
The industry is already so hot that investors who haven't bought in yet may be arriving a little late to the party. So pick carefully
By Amey Stone, Business Week Online Street Wise
NEW YORK, Jul. 13 (Business Week Online) - Not many hearts start racing when the topic of data storage comes up. But you can bet that of the folks who do get giddy, a good many are investors. Too much time in chat rooms? Hardly. Just look at the skyrocketing returns of storage stocks over the past year: Leading equipment maker EMC Corp. (EMC) is up 150%, up-and-comer Network Appliance (NTAP) is ahead 425%, and networking hot shot Brocade Communications (BRCD) is up 650%.
StorageNetworks Inc (STOR), which lets companies outsource their storage needs, brought the entire market for initial public offerings back to life when it launched at the end of June. Originally expected to go for $17 to $19 a share, the stock was upped to $23 to $25, and eventually priced at $27. It ended its first day of trading on June 30 at $90 1/4. Still going strong, it closed on July 12 at $115 1/2.
After Internet infrastructure, data storage is probably today's fastest-growing tech sector, analysts say. Thanks to the Net's growth, companies are buying expensive new computer systems and software that not only give them more room to store stuff but also help them retrieve and use all that data at high speeds.
Second phase
But even though the industry is just cranking up, investors who haven't bought in yet may be arriving a little late to the party. Merrill Lynch analyst John Roy believes the storage sector is now into the second phase of the typical growth stock cycle. In the first phase, no one believes in an industry's growth prospects. In the second, people see some evidence, and everyone buys in. "Most people are still just catching on to the story now," says Roy, who is bullish on storage. But he admits that the big financial institutions have already caught on to the story and pushed up the stock prices.
However, the perilous third stage -- when the bubble bursts -- may not be far away. That period is marked by industry consolidation, the demise of second-tier players, and the survival of the leaders. Storage stocks are plenty expensive now, which leaves them lots of room to fall if the sector loses favor with investors. While these companies deserve credit for having earnings, the market may be giving them too much credit right now: Network Appliance has a price-earnings ratio of more than 400, and EMC nearly 150. Brocade's p-e is 880.
For EMC and Netapp, both makers of storage devices, the market for their new devices is so torrid that the third stage is probably still a ways off. But challenges loom that could hurt their stocks anyway. For example, some corporate customers think EMC, which has 37% of the high-end storage market, has grown arrogant, and its products too expensive. As the price of raw storage comes down, EMC may have to fight to maintain its price points by offering the best software and service with its systems. It could also get hurt if the industry moves to open standards. Now, if a customer chooses an EMC system, it must go back to EMC to add to it.
"Sweet spot"
Another risk for EMC: Nearly all the big server suppliers, who used to neglect storage -- companies such as Sun Microsystems, IBM, and Hewlett-Packard -- have launched new products in recent weeks. Ashok Kumar, an analyst with US Bancorp Piper Jaffray, thinks the coming competition will be fierce and wouldn't recommend EMC. Further down the road, the company could suffer if the "network attached storage" (NAS) solution sold by Network Appliance becomes more popular with corporate users than the "storage area networks" (SAN) approach EMC emphasizes.
Merrill's Roy thinks EMC will be able to handle such challenges and hold onto its top spot at least for the next few years. He lists EMC, as well as NetApp and Veritas, as companies in the storage "sweet spot."
Network Appliance, which Kumar favors over EMC, faces hurdles as well. Its share price dropped in half this spring when e-commerce stocks plummeted. Investors were concerned that its core customer base of dot-coms might not need so much storage after all, and that even if they did, they might not opt for NetApp's pricey systems. The Gilder Technology Report, in fact, recently picked a maker of lower-cost NAS appliances, Procom (PRCM), to add to its list of key technology companies. "They are coming up from down-market and likely to achieve very high unit volumes," says Richard Vigilante, the newsletter's publisher.
Wrong issue?
Still, it's hard not to like Network Appliance, which makes devices that plug easily into large networks and don't require as much maintenance as other, more complex storage systems. It reported revenue and profit growth of more than 100% for its 2000 fiscal year, ended Apr. 28. Some analysts believe NAS will be more popular than SAN and expect NetApp to grow into the "next EMC." But industry analysts say NAS vs. SAN is the wrong issue and that the two will probably co-exist and eventually both be part of a hybrid solution.
While the equipment makers are still going strong, a shakeout has already struck the software and networking segments of the storage market. Software maker VERITAS Software (VRTS) is gaining share over its chief competitor, Legato Systems (LGTO), which has run into accounting trouble. Legato is trading at just $13, down from a high of $82.Veritas fell sharply from its high of $174 during the technology correction, but it has bounced back to $129.
Another victim of stiff competition, Gadzoox Networks (ZOOX), which competes with Brocade in the market for networking equipment, fell nearly 50% in one week after it warned on June 19 that revenue for its first quarter ending June 30 could be as much as one-third less than the previous quarter. It has remained flat at around $13 a share, down from a high of $110, since the warning. As an alternative to pricey Brocade, Piper Jaffray's Kumar recommends buying networking equipment maker QLogic Corp (QLGC) instead. It's merging with Ancor Communications, a competitor with Brocade, and is much cheaper. It's p-e of 110 looks tame next to Brocade's 880.
"Be careful"
Some analysts believe that StorageNetworks' IPO afterglow may be short-lived. Many are skeptical that corporate customers will want to outsource storage. "How comfortable will companies be in outsourcing their mission-critical data to a third-party provider?" asks Kumar. "The business model needs to prove itself out before we'll see widespread adoption." Tom Taulli, an IPO expert at internet.com, suggests that investors wait a while to get a better price. "After an IPO you have to be careful," he says.
In the fourth stage of a growth stock, the leaders that remain reap the benefits of declining competition, says Merrill's Roy. If you're sure you've got the storage leaders pegged and are buying for the long term, go ahead and jump in now. As competition heats up, the business changes, and technology evolves, today's winners have the best chance at holding onto their top spots.
But that's far from a sure thing. "We're definitely past the stage where you can use a dartboard approach," says Taulli. "In fact you could lose a lot of money if you pick wrong." Amen.<<< |
