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If tech has a sure bet, data storage is it
Demand for storage is a certainty, but the protocol to provide it isn't. Here are 8 stocks with the flexibility to take advantage of changing technology.
By Michael Brush
No one knows when the Federal Reserve’s aggressive interest rate cutting will turn the economy. But you can be fairly certain of one thing: Once it picks up and companies start spending on technology again, data storage will be at the top of the list.
The reason is simple.
“Storage is mission critical,” says John LaForge, a portfolio manager with Florida-based Phoenix Investment Partners. “Storage is an absolute must.” So if you are thinking of putting money back into tech now that the markets appear safer, storage stocks should be at the top of your list, too.
Companies need storage systems to handle everything from e-mail, voice and video files, to all that data generated by customer-care and supply-chain software. Since these apps are constantly generating data, corporations can really only delay new storage deployment as pressure mounts to add more. “Demand in the storage sector should show good growth trends over the long haul because there will be more of a reliance on storing and retrieving all sorts of data on a faster basis,” says Thomas Anderson, chief financial officer of QLogic (QLGC, news, msgs).
If you have any doubts about the huge need for storage, consider this projection from a recent University of California study: More digital content will be created over the next three years than in all of history. No wonder analysts believe storage should continue to be one of the fastest-growing spaces in technology over the next three to five years.
Catch the trend
What’s the best way to invest in this trend?
First, remember that it is tough to pick winners in rapidly evolving areas of technology. Products become extinct quickly. And there’s no guarantee that yesterday’s winner will be tomorrow’s leader as well. “So don’t bet on one individual stock. Have a basket of them,” says LaForge, who holds storage stocks in the Phoenix Hollister Small Cap Value Fund (PDSAX).
Which companies should you put into that basket? There are lots of factors to consider. But above all, it pays to focus on companies that are relatively agnostic when it comes to storage system “protocols,” the technology used to allow components in a storage system to talk with each other.
“If a company marries itself to one protocol, it is toast,” says LaForge.
Before we get to which companies have reasonable exposure to the various protocols, here are the highlights of the major options.
Fibre channel: This is the dominant protocol today. Introduced a few years ago, fibre channel is rapidly replacing the protocol that used to rule -- Small Computer System Interface, or SCSI. Fibre channel is better because it moves larger packets of data more quickly and more reliably. It also permits “many-to-many” connections among sources of data and storage units, in what are called storage area networks, or SANs. Fibre channel’s efficiency helps take the load off of local area networks that employees use to get their day-to-day jobs done. While fibre channel is good, there is no guarantee it will be dominant in two years. It might be replaced by either of these two protocols in development.
Infiniband: An advanced form of fibre channel, Infiniband promises even faster speeds and backup capabilities. Infiniband will boost performance in part by allowing larger clusters of servers to work in parallel. This protocol still needs to be refined, and costs have to come down. But it could be deployed as early as next year.
Storage over Internet Protocol (IP) : Instead of requiring a new infrastructure, this protocol essentially manages storage through Ethernet -- which is already in place. This is a big plus. “By using the current infrastructure, the only changes that need to occur are on the end points -- the servers and storage devices,” says Mark Edwards, senior vice president of product marketing at QLogic. “You don’t need to put in a new infrastructure.”
That sounds good, but there are a few potential disadvantages. For one, Ethernet is not as reliable as fibre channel. Congested IP routers frequently drop packets. “Ethernet is good at recovering lost packets. Fibre is good at not losing them in the first place,” says Jay Kidd, vice president of product marketing for Brocade Communications (BRCD, news, msgs). Next, storage activity requires large data transmissions. When moved through IP networks, they can tie up servers, slowing other apps. With Storage over IP, you also lose the SAN advantages that fibre channel brings.
Storage over IP -- which is being developed by Cisco (CSCO, news, msgs), among others -- goes by several names, including Internet SCSI (iSCSI) or Gigabyte Ethernet. “I am not sold on this yet,” says LaForge. “But I would not bet against Cisco. They have deep pockets.”
And the winners are …
Here are some of the companies likely to win no matter which protocol dominates.
EMC: There are four big storage sub-system vendors: IBM (IBM, news, msgs), Compaq (CPQ, news, msgs), Hitachi (HIT, news, msgs) and EMC Corp. (EMC, news, msgs). But EMC dominates, and it is the only real pure play you can make.
Falling prices for the storage hardware that EMC sells are pressuring margins. But the revenue mix is shifting toward software, where EMC is strong. “Their software is now 20% of their revenue. It is high margin, and growing, and a very good business for them,” says Don Easley, an enterprise software analyst with T. Rowe Price. Analysts expect several new software products to be announced in coming months. “In essence they are protocol neutral,” says LaForge. “As the times change, they will change.”
Veritas Software: This company’s software serves as the critical “glue” linking devices together in the storage environment, says Craig Smith, a senior portfolio manager at Aim Funds, which holds shares in the company. No matter which storage protocol winds up getting used, Veritas Software (VRTS, news, msgs) products should fit in.
The switch makers: The leader here is Brocade. Like EMC, Brocade sells hardware, but it’s better to think of it as a software company. That’s because so much of the functionality of its switches comes from the software that runs them. “I think Brocade will be one of the end-all winners,” says LaForge.
One problem for Brocade is that it is heavily dependent on the fibre channel protocol, at least for now. But analysts and marketers at the company believe Brocade will be ready when other protocols take over. “Yes, we will become agnostic,” says Kidd. “We intend to incorporate IP over Ethernet and Infiniband into our products. We will be ready either way. The critical thing to remember is that fibre channel is the only one that can be deployed today. The others won’t emerge for two or three years.”
Brocade’s chief competitor is Mcdata (MCDT, news, msgs), which was recently spun out of EMC. Analysts at Merrill Lynch say that while Mcdata is the leader in the high-port count switch space, a key challenge will be to invest enough in software development going forward to stay competitive. Back when it was with EMC, other divisions took care of this.
The component makers: The three main producers of components are Emulex (EMLX, news, msgs), Qlogic, and JNI (JNIC, news, msgs). They make products like host bus adapters and application-specific integrated circuits. These components permit communication among the storage devices made by firms like Brocade, Mcdata and EMC. Another strong component maker is Finisar (FNSR, news, msgs). It gets about 75% of its revenue from transceivers sold to storage device makers. The rest comes from sales into the fiber optics market.
These component makers are all focused on the fibre channel market for now. But that is changing, as many of them develop skills in the other two protocols, either internally or through acquisitions. “The companies which have made a good leap forward in being agnostic are Brocade and QLogic,” says LaForge. “Emulex is getting there, too. Finisar is not tied to any protocol, so it is very agnostic.”
While JNI is a strong player in the fibre channel host bus adapter market, a potential shortcoming is that its products are mainly used in Sun Microsystems' (SUNW, news, msgs) Solaris servers. “JNI could be a winner,” says LaForge. “But today I would be cautious because over 90% of sales come from high-end business on the server side with Sun.”
When do you buy these stocks?
It may pay to wait, given that all of them rebounded nicely last week. The stocks came back in part because EMC noted corporate storage budgets appear to be firming up, when it announced earnings April 19. Anything better than “no visibility” was good news for investors. So they piled in, driving many storage stocks up near their 12-month price targets.
That was too fast, say many tech analysts. They note that it may take a while for spending on storage -- and tech in general -- to really come back. “We think the bottom of this 'U' could last six to 12 months,” says Steven Milunovich, technology sector strategist at Merrill Lynch.
In the meantime, tech stocks face the summer doldrums, as well as another quarter or two of bad earnings numbers, says LaForge. “Everyone will get scared again.” He doesn’t think this will make storage stocks retreat to their early April lows. But he thinks they could pull back another 20% to 30% from where they traded this week.
At the time of publication, Michael Brush owned or controlled share in the following equities mentioned in this column: EMC, Emulex, Mcdata and JNI. |
