Storage sell-off
By J.P. Vicente
Redherring.com, November 17, 2000
When storage company Network Appliance (Nasdaq: NTAP) reported after the bell on
Tuesday that it expects revenue growth to slow slightly in the coming quarters, the news
sent the company's stock into a tailspin on Wednesday, adding momentum to a sell-off
that was speeding up over the past month. Although Network Appliance competitor EMC
(NYSE: EMC) rallied slightly on Wednesday, it too is down sharply in the last month on
concerns that demand for storage is slowing.
All bets are off for network-storage stocks in the short term, but if you're in the market
for the long run, and you happen to own Network Appliance or EMC, here's a piece of
advice: forget about recent price drops and stick to your holdings.
And if you don't already own any network-storage stocks, here's some advice for you:
get them while they're cheaper!
Why? Storage is currently the fastest-growing segment in the technology world. The main
players in this market are solid companies with near-flawless balance sheets and steady
streams of earnings and revenues. And forecasts for the sector, no matter how you slice
the numbers, show that demand for storage products will continue to grow at a brisk
pace -- at least 20 percent a year -- over the next decade.
DON'T LEAP BEFORE YOU LOOK
So why, you may ask, have stocks such as EMC, Network Appliance, Veritas Software
(Nasdaq: VRTS), and Brocade Communications Systems (Nasdaq: BRCD) all tanked in
the past 30 days? Analysts attribute the price drop mostly to an adjustment in the
multiples of those stocks. Storage companies have been among the best-performing tech
stocks this year, and as a result, they've traded at very high valuations. So even though
Network Appliance reported that sales in its fiscal second quarter grew 109 percent on a
year-over-year basis while net earnings jumped 120 percent, the indication of slower
revenue growth ahead was all the justification momentum investors needed to head for
the exits.
"One can argue that the market might've gotten ahead of itself, and might have pushed
up prices of some of these companies a bit too high. But the recent drop is an
overreaction," says Mark Kelleher, an analyst at FAC/Equities, a division of First Albany
Corporation. "I see this as a buying opportunity. Prospects for the sector are still
extremely positive."
Indeed, they are. That's because the drivers of growth in the storage arena remain
mostly intact, despite the fact that some other segments of the technology sector --
such as PCs and consumer software -- appear to be slowing down. A recent survey of
information technology (IT) officials, conducted by the research firm Dataquest, showed
that spending on storage devices is expected to grow by 22.4 percent annually through
2004. That compares to 11.3 percent growth in overall IT spending, 6.2 percent growth
in server spending, and 5.9 percent growth in PC purchases. Meanwhile, the U.S. gross
domestic product (GDP) is seen expanding by an annual 3.6 percent in the period.
HONEY, WE NEED MORE BOOKSHELVES AGAIN
There's more. The number of Internet users -- currently around 170 million worldwide --
is expected to continue to double over the next few years. Although a slowdown of sorts
is expected, it's widely accepted that some 50 million new users will be added every year
over the next ten years. All those people will surf the Web, write emails, create Word
documents and Excel spreadsheets -- you name it. And all that data will have to be
stored somewhere.
As if those arguments weren't compelling enough, two more forces are driving the
sector's long-term growth. As broadband access to the Internet (DSL, cable modems)
becomes mainstream over the next few years, users will start creating and exchanging
larger files -- such as pixel-intensive digital pictures, even larger MP3 files, and all those
homemade digital videos. Needless to say, users will require bigger "boxes" to store
those files. And let's not forget about backup and redundancy systems at both
corporations and Internet service providers. The larger the live network, the larger the
space needed for backing everything up. "The key growth drivers are all in place," says
Tom Kraemer, an analyst at Merrill Lynch.
But that's not to say storage companies, as B.B. King would sing, "can't do no wrong."
Such growing markets tend to attract competition, which, in turn, creates price wars,
which send revenues dropping. Although the barriers to entry are high -- mostly because
of high research-and-development spending demands -- analysts say competition will
only get stiffer.
EVERYBODY WANTS TO STORE THE WORLD
Old dogs in the tech world, such as IBM (NYSE: IBM), Compaq (NYSE: CPQ),
Hewlett-Packard (NYSE: HWP), and Sun Microsystems (Nasdaq: SUNW), have all been
scrambling to beef up their storage units in order to compete against EMC and Network
Appliance. IBM, for instance, has already instructed its PR machine to start touting its new
storage software, Storage Tank, even though the actual product won't be delivered until
late next year.
Competition between the two storage leaders is fierce, as well. EMC is expected to launch
a new product in early December to compete more aggressively with Network Appliance
in the highly lucrative and fast-growing network attached storage (NAS) market, where
Network Appliance is currently the undisputed leader. Ashok Kumar, an analyst at U.S.
Bancorp Piper Jaffray, wrote recently that short-term upside for Network Appliance is
capped by jitters about the possible inroads EMC's new product might make into Network
Appliance's market share.
Also, analysts say, growth rates of more than 100 percent a year -- like Network
Appliance's, for instance -- are not sustainable in the long run. "While we are very
confident about the firm's underlying fundamentals ... Network Appliance's rich multiples
require continued strong upside surprises and estimate increases, both of which are
unlikely to happen near-term as the law of large numbers catches up with the company,"
says Andrew Neff, an analyst at Bear Stearns.
Mr. Neff was one of the few analysts who downgraded Network Appliance earlier this
week after the company announced its fiscal second-quarter results, and he does have a
point. Storage stocks are indeed expensive. Despite a 49 percent drop over the last 30
days, Network Appliance still trades at 172 times estimated fiscal 2002 earnings as of
Thursday's close. EMC trades at 84 times fiscal 2002 earnings, while Brocade trades at
208 times forecast profits for fiscal 2002.
Yet we believe that, at $73 a share, this is a good time to buy Network Appliance. At this
level, Network Appliance's trailing price-to-sales ratio is 32, only 19 percent higher than
EMC's price-to-sales ratio of 26, even though Network Appliance's revenues are growing
twice as fast. The truth is that long-term investors should remain unfazed by recent price
swings, as strong growth rates combined with expanding Internet usage will continue to
bolster the sector. Just think about it: what do you think is going to happen to the Net's
overall storage-capacity needs after your next mouse click?
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