NTAP--Storage titans push for piece of pie
By J.P. Vicente
Redherring.com, December 14, 2000
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Quote & Chart for: EMLX QLGC JNIC
There's never a dull moment in the burgeoning storage business. A recent slew of acquisitions and product launches from heavyweights like IBM (NYSE: IBM), Sun Microsystems (Nasdaq: SUNW), and Dell Computer (Nasdaq: DELL) has sharply intensified competition in the industry, and analysts believe that alliances made during this round of consolidation may be crucial to define winners and losers in the storage game in the long run.
Earlier this month, Sun announced the acquisition of HighGround Systems, a privately held maker of storage management software that works with several platforms, instead of only with Sun's Solaris boxes. In turn, IBM recently said it was working on a new product code-named Storage Tank, also a multi-platform storage software package, to be launched in the second half of 2001. And Dell has formed a storage systems business unit, independent of the enterprise systems group, to explore opportunities in this market. Its first products should hit the market in January.
Meanwhile, the battle between two current leaders -- EMC (NYSE: EMC) and Network Appliance (Nasdaq: NTAP) -- has become even bloodier after EMC earlier this month launched a new, cheaper product to compete directly with Network Appliance in the highly lucrative network attached storage (NAS) market. EMC also acquired storage software maker CrosStor last month.
And this frenzied state of activity has even filtered its way down to the makers of components for storage networks. Last week, Emulex (Nasdaq: EMLX), a prominent maker of Fibre Channel host bus adapters (HBA), gobbled up Giganet, a private firm that is working on implementing the Virtual Interface (VI) protocol to move large chunks of data over Ethernet networks.
STICK WITH THE BIG DOGS
What does this all mean to storage investors? Our assessment is that while competition will get stiffer, the number of players will continue to shrink as further consolidation ensues. One of the main reasons behind that trend is that the stock meltdown of the last few months has closed the IPO door to many small storage companies, leaving those firms -- most of which have interesting products but still unproven technologies and earnings streams -- as perfect acquisition targets.
The trend, analysts say, clearly benefits industry leaders with large market capitalizations who can afford to buy these companies. That's why we think the winners in the storage business tomorrow will likely be the ones forging the best alliances today.
"These companies have been in this business for a long time, and, as the market stands today, they continue to have an edge over the competition," says Clint Vaughan, an analyst at Salomon Smith Barney.
We believe this to be true not only for the big heavyweights like EMC and Network Appliance, but also for the lower-profile storage companies who focus on the components side of the storage equation. As it turns out, several players, including QLogic (Nasdaq: QLGC) and JNI (Nasdaq: JNIC), are working hard to expand their business. QLogic, for example, acquired Ancor Communications, a maker of Fibre Channel switches, earlier this year.
But we believe that Emulex, at least for now, seems to have the clearest vision of what the future will look like. As a result the stock does trade at a hefty 80 times earnings estimates for its next fiscal year. That's a premium to both QLogic and JNI, which trade at 70 and 35 times next year's earnings estimates, respectively.
EMULEX IS A SMART SHOPPER
There's no question that Giganet came with a somewhat high price tag to Emulex -- roughly $640 million (4 million shares), or 11 percent of Emulex's total market value of $5.8 billion. But we believe the deal is positive because it will expand Emulex's addressable market substantially beyond its current Fibre Channel base. How?
Emulex's HBAs, in simple terms, work as converters connecting the back ends of servers to storage area networks (SANs). On the other hand, the front ends of servers connect to a local area network (LAN), usually through a network interface card (NIC), also known as an Ethernet card. The problem with Ethernet cards is that they run the IP and rely on the computers' CPU for most of their processing, making them poor handlers of large data transactions.
A number of companies, including Network Appliance with its direct access file systems (DAFS) initiative, have been trying to address the issue by developing faster protocols that can run on Ethernet. One of the most promising is VI. Giganet, as it turns out, has developed a host bus adapter that can replace NICs and handle VI. Granted, there's no guarantee that Giganet's technology will become the standard, but we believe that now, together with Emulex, they have a better shot at gaining wider acceptance.
Back in 1996, for example, Emulex was very successful in porting its products to work with the then-young Fibre Channel architecture. Today, Emulex is the No. 1 provider of Fibre Channel host adapters to EMC, IBM, and Compaq (NYSE: CPQ).
"Giganet broadens our product base. With them, we can offer solutions in an IP world, in a Fibre Channel world, and in a VI world," says Emulex's CFO, Michael Rockenbach. "We're truly agnostic about those religious arguments on technology. We just see ourselves as a provider of that connection in a networked storage world. That's where the market is going to."
AVOIDING THE HOLY WAR
We like Mr. Rockenbach's approach because we believe that the more you get tangled in technological discussions -- SAN vs. NAS? who cares? -- the more you restrict your business opportunities. The bottom line is that the demand for storage networks in general is growing rapidly. So the long-term leaders in this market will be companies offering technology-agnostic solutions for all those potential clients trying to integrate mixed networks.
Mr. Rockenbach adds that the Giganet deal brings Emulex closer to Network Appliance, which has been a large client of Giganet's but not of Emulex's itself. Network Appliance is currently a major QLogic client. "Today, roughly 15 companies own 80 percent of the storage market. So the opportunity to get another high-quality original equipment manufacturer like NetApp is a nice opportunity for us," he adds.
No kidding! Key strategic clients are to the storage business what baseballs are to a pitcher. You can't be in the game without them. Despite the impact of the acquisition and the fact that Giganet is not expected to be a short-term revenue generator, Wall Street analysts, according to First Call, expect Emulex to earn $1.48 a share in fiscal 2001 -- a 96 percent increase from this year -- and $1.98 a share in 2002, which would be a 35 percent gain. These numbers do not take into account a pending 2-for-1 stock split for Emulex that will take effect on December 15.
We believe Emulex's acquisition of Giganet makes overall sense and gives us a good example of the kinds of deals we might see in the near future. Analysts say several private firms in that space -- including Troika Networks, one of the few remaining independent sources of VI expertise; storage software maker Datacore Software; and Pirus Networks, a manufacturer of storage and IP infrastructure equipment -- are all potential acquisition targets.
As one industry executive at a major storage company, who requested anonymity, puts it: "What has surfaced so far is just the tip of the iceberg. There's a lot more to come." We can't wait to see it, especially because those doing the acquiring will just get stronger and be better investments as a result. |
