let's get ready to rumbullll!!!
but who says you can't bet on both?
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Posted 1/12/99
Jubak's Journal
2 high-tech heavyweights and the tale of the tape
The data-storage battle features champ EMC in one corner, with upstart Network Appliance in the other. I'll check my scorecard to come up with a winner.
By Jim Jubak
Which is the better stock to buy: the established industry leader or the feisty upstart just about three years removed from its initial public offering?
That question comes up all the time, especially in technology investing. Right now, the market, infatuated with all things Internet, is voting strongly for the upstarts. Unencumbered by traditional thinking -- and certainly free from the burden of defending an established market share -- companies like Amazon.com (AMZN), Yahoo! (YHOO), eBay (EBAY) and DoubleClick (DCLK) are going to revolutionize retailing, advertising and communication. That, at least, is what investors indicate by the market capitalization being awarded to these stocks.
But, of course, for every company that does storm the barricades to topple a Digital Equipment, an AT&T (T) or a Sears, Roebuck (S), dozens of companies die in the trenches. Owning Dell Computer (DELL) has been extremely profitable. Buying shares of AST, Commodore or Kaypro (remember any of those names?) hasn't been nearly as pleasant.
So how do you decide? One way is to put the champ and the challenger head to head in the same way that a sports analyst would tally the strengths and weaknesses of two competing teams. Does the playing field favor one team or the other? Can one side neutralize the other's best weapons? Which side has more experience handling pressure?
Pitting two of 1998's top performers
I'm going to apply this approach to the classic battle now shaping up in the computer data-storage industry between EMC Corp. (EMC) and Network Appliance (NTAP), two of the best performers of 1998 (up 210% and 153%, respectively). Let's handicap the two sides on positioning, offense, defense, management and valuation, and see who comes out the likely winner. But first, a refresher on the two companies.
Ten years ago, EMC was the upstart, taking on Storage Technology (STK) and IBM (IBM), the two top companies in data storage for computers. EMC had an unproven technology called RAID (Redundant Array of Independent Disks) that used a collection of smaller disk drives to match, at a fraction of the price, the data-storage capacity of the huge tape and disk drives sold by Storage Technology and IBM. As the two leaders fought to protect their established market, EMC ate their lunch, and today EMC is the top maker of computer memory hardware and software for mainframes. A $10,000 investment in EMC in 1988 has appreciated 21,329%. The gains on IBM and Storage Technology over that period slightly trail the 352% turned in by the Standard & Poor's 500.
Now Network Appliance is the newcomer. Founded in 1992, the company is part of the trend toward appliances -- relatively cheap, specialized computers or storage devices that are designed to perform just a few functions. Like routers, the specialized computers that direct traffic over the Internet and that have been the key to Cisco Systems' (CSCO) phenomenal growth, Network Appliance's dedicated "filer" performs just a single job: managing access to stored data on a network. Each appliance uses commodity PC hardware and simple software written with just 30 or so system commands. (The standard approach uses a general application file server that can do a range of tasks from managing and accessing files to managing a database.) As the company has grown, it has added other specialized appliances, such as a cache server that stores frequently requested Internet pages closer to the end customer, thus reducing wait time and traffic volume on networks.
In November, it was announced that Dell would incorporate Network Appliance filer technology into a new line of Windows-based PC servers for corporate networking that Dell will begin marketing in early 1999. (Network Appliance will focus on selling its own server hardware to companies using Unix or a combination of operating systems.) Once Dell and Network Appliance have trained the Dell sales force, the agreement should give a big boost to Network Appliance sales, which totaled $217 million in the four quarters ended Oct. 31, 1998. (Not that Network Appliance is hurting for growth -- sales increased 71% in the last quarter over the same period in 1997.)
Handicapping the upcoming battle
The Dell deal, though, does put Network Appliance and EMC on a collision course, with impact likely sometime in 2000. By that time, both companies will be selling software for managing storage to companies using Microsoft's Windows 2000 (also known as NT 5.0) operating system. (Microsoft owns and publishes MoneyCentral.) The stakes are pretty high, too. According to International Data, the Windows NT external storage market grew by 157% in 1997.
Neither company yet has a lock on that market; EMC may have owned an 8% share by the end of 1998. So, here's how I handicap the coming battle.
Positioning: a toss-up. EMC owns the big company, big-storage market. About 72% of the Fortune 500 are now EMC customers. As NT works its way into these companies, they'll turn to EMC. On the other hand, the trend is with Network Appliance. As the Internet grows, it creates new customers who often don't have the extensive in-house information technology expertise of a Fortune 500 company. These new customers -- think of who buys from Dell -- want easy-to-install, inexpensive-to-maintain and relatively cheap-to-buy tools. And they won't have any special allegiance to EMC. In selling to this emerging class of customer, the sales channel offered by Dell is a crucial advantage.
Offense: plus to Network Appliance. Dell showed what happens when you sell systems built around off-the-shelf components while your competitors are still using proprietary parts and conducting their own R&D. Facing impossibly higher costs, the competitors either go out of business (Digital Equipment) or eventually and reluctantly begin to use off-the-shelf parts themselves (Hewlett-Packard). And even the established competitors that follow suit face tough times. The lower prices of the new off-the-shelf machines eat into sales of higher-margin products.
Of course, that's exactly what EMC did to IBM and Storage Technology in its own rise to the top. Now, Network Appliance is attempting the same trick. From the outset, the company has built its systems around industry-standard components. By signing with Dell, the company has just guaranteed that it will have the lower price on off-the-shelf hardware and a trusted name to boot.
Defense: plus to EMC. EMC almost never loses a customer; attrition is less than 1% annually. That's especially impressive since EMC's prices are about 7% to 30% higher per megabyte of storage than its competitors'. Superior service, rigorous quality control and the complexity of changing to a new system, I think, explain why EMC's customers are so tightly locked in. Credit Suisse First Boston recently estimated that EMC's advantage over its competition would last for 10 to 20 years.
Management: plus to EMC. No disrespect to the folks running Network Appliance, who certainly have good pedigrees (the CEO came out of Hewlett-Packard and IBM; the CFO worked at Bay Networks; the vice president of engineering was VP for system software at Sun Microsystems), but the team at EMC has proved that it can execute. Pushing IBM out of the No. 1 slot -- when its hardware dominated the industry -- took planning and focus. Keeping market share against IBM, a company known for its service and the reliability of its products, requires constant attention to detail. What's most impressive, though, is that EMC doesn't seem to be out of ideas. The company has been investing in research and development at an increasing pace, with the tab over the next three years expected to hit $1 billion.
Valuation: plus to EMC. On the surface, there doesn't seem to be much to set these stocks apart. They both trade at very lofty price-to-earnings ratios. EMC sells for 70 times trailing 12-month earnings and 49 times estimated 1999 earnings. Network Appliance goes for 122 times trailing 12-month earnings and 72 times projected earnings for the fiscal year that ends in April 2000. With EMC and Network Appliance projected to grow 53% and 30%, respectively, in fiscal 1999, the two stocks show remarkably similar P/E-to-growth rate ratios (PEG ratios) of 2.32 and 2.29 respectively.
When a stock trades at this high a P/E ratio, investors are betting that the company will be able to sustain the high current growth rate for a long time into the future. And that's why I think EMC has the valuation edge.
Enough growth potential for both players
The explosive expansion of the Internet and its storage demands potentially supplies enough growth potential for both companies. But EMC's growth is more certain than that of Network Appliance. First, EMC's tried-and-tested management makes it more likely that the company will execute to plan. And second, that huge locked-in customer base almost guarantees the success of EMC's current strategy to increase profit margins.
The big profits in this industry are in software, not hardware. Gross margins for EMC's software business approach 90%. The company only recently has started to sell its software into that installed base of Fortune 500 companies. Credit Suisse First Boston estimates that software sales could climb from $400 million in 1998, or about 10% of the company's total sales, to $1 billion in 2001. And since software is a business where costs per unit decline rapidly as a company sells more units, that increase in sales should keep EMC's net margins climbing upward. EMC's net profit margin was 5.6% in 1990 and 18.8% in 1997.
I certainly wouldn't call EMC cheap at its current price, but given the trends in its business and the likely longevity of those trends, I don't think investors can count on this stock getting a lot cheaper short of a retreat in the market as a whole. And even then, I'd find comfort in the predictability of this stock's story.
After a head-to-head comparison like this, there's certainly no reason that you can't buy both stocks or neither. To decide that question, you need to turn all these pluses and minuses into some target prices and see what the potential returns might be on each stock. I figure that EMC's rising margins and its record of consistent earnings surprises translates into 1999 earnings of $1.98 a share -- that's about 6 cents a share above the current consensus forecast. After factoring in a likely earnings surprise in the current quarter, I calculate EMC's earnings growth rate at about 31% next year. Assuming a P/E ratio of 63 -- about a 10% discount to the current multiple -- I get a target price of $125 for next January. That's a potential gain of 32% -- enough to pass my hurdle rate for this market.
The same calculations for Network Appliance -- a projected 52 cents in earnings per share for the four quarters that end in January 2000 multiplied by a P/E ratio of 112, a 10% discount to the current P/E ratio -- yields a 12-month target price of $60.50 and a potential return of 21%. That isn't enough to pay me for the risk in this stock or the market.
So I'm passing on Network Appliance at this time -- it's a great stock that's simply too expensive -- and I'm adding EMC to Jubak's Picks with a December 1999 price target of $125.
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