G-S MORNING ENTERPRISE HARDWARE OVERVIEW:
Enterprise HW Co`s, Despite Cont`g Weak Environment, Shd Generally Make Qtr
SUMMARY:
We expect most of our key systems and storage companies to make their numbers this quarter. Price stabilization, seasonality, and currency benefits should allow the large systems and storage vendors to generally meet lowered June qtr expectations, while SAN component companies continue to see accelerating growth. Currency will help, but visibility remains weak for the heavily back end loaded September quarter although, at this point, any estimate revisions for Q3 should be relatively minor. Enterprise systems and storage valuations are now generally close to or within pre-bubble ranges.
GOLDMAN SACHS AND FIRST CALL JUNE/JULY QUARTER ESTIMATES
..........Conf Call..........Revenue ($M).............EPS
.......... Date........GS......First Call...GS...First Call
SYSTEMS
HPQ.......TBD......$16640.....$17024......$0.13....$0.15
IBM.......7/17.....$19660.....$19567......$0.81*...$0.84
SUNW......7/18.....$3250......$3292.......$0.00....$0.01
STORAGE
EMC.......TBD......$1394......$1373......($0.02)...($0.02)
BRCD......TBD......$150.......$147........$0.08.....$0.08
NTAP......TBD......$211.......$211........$0.05.....$0.04
ELX.......8/8......$71........$70.........$0.16.....$0.16
QLGC......TBD......$99........$97.........$0.23.....$0.23
STK.......7/23.....$500.......$508........$0.15.....$0.17
*Our IBM EPS excludes estimated add-back of $0.05 from HDD discontinuation in order to probably better comparability with FC estimates.
During the June quarter, the enterprise systems and storage sector continued to come under pressure with the Goldman Sachs Hardware Index (GHA) down 27% for the quarter, underperforming the S&P 500 by 14%. As of the end of June, the GHA was down 33% YTD, underperforming the S&P 500 by 16% and the Dow by 23%. Our key overview conclusions for the June quarter, followed by our stock-specific thoughts, are as follows:
1. WE EXPECT MOST OF OUR KEY COMPANIES TO 'MAKE THEIR QUARTERS.' This includes EMC, IBM, and SUNW.
2. JUNE QUARTER BUSINESS SEEMED TO BE SLIGHTLY EASIER TO CLOSE THAN IN THE MARCH QUARTER, WITH NORMAL SEASONALITY LIKELY MORE OF A CONTRIBUTOR THAN A DISCERNIBLE DEMAND IMPROVEMENT.
3. PRICING SEEMS TO HAVE GENERALLY STABILIZED AFTER A YEAR AND A HALF OF AGGRESSIVE, OVERSIZED DECLINES.
4. GEOGRAPHICALLY, THE U.S. SEEMS MORE STABLE - ALTHOUGH AT LOW LEVELS - THAN THE REST OF THE WORLD, WITH PARTS OF EUROPE STILL WEAKENING. AT THIS EARLY STAGE, IT IS STILL TOO EARLY TO CALL THE MAGNITUDE AND SUSTAINABILITY OF THE SMALL U.S.-BASED IMPROVEMENTS THAT WE HAVE SEEN.
5. CURRENCY IS BEGINNING TO HAVE A POSITIVE IMPACT, SWINGING FROM NEGATIVE TO POSITIVE IN THE JUNE QUARTER AND THEN CONTRIBUTING AT LEAST 200-300BP OF INCREMENTAL TOP LINE GROWTH IN Q3 AND Q4, ALONG WITH A SMALLER POSITIVE BOTTOM LINE IMPACT.
6. COMPANIES SEEM MORE ANXIOUS THAN NORMAL ABOUT Q3 GIVEN THE HEAVIER-THAN- NORMAL BACKEND LOADING ASSOCIATED WITH THE QUARTER AND CURRENT LIMITED VISIBILITY CONDITIONS.
7. STORAGE NETWORKING COMPANIES CONTINUE TO ACCELERATE, DRIVEN BY A HIGHER STANDING ON THE IT SPENDING PRIORITY LIST, CONSOLIDATION, AND MARKET SHARE GAINS.
8. ENTERPRISE SYSTEMS AND STORAGE BALANCE SHEETS REMAIN HEALTHY.
.........Net Cash/...% of...Book Value/....Price/...FreeCash
..........Share...Mkt Cap...Share.....Book Value..FlowStatus
SYSTEMS
HPQ........1.63.....11.......8.53......1.6..........Positive
IBM........1.98.....3........13.15.....5.5..........Positive
SUNW.......1.23.....28.......3.13......1.7..........Positive
STORAGE
BRCD.......$1.21....8%.......$2.57.....6.8x.........Positive
EMC........2.36.....35.......3.38......2.2..........Positive
ELX........2.20.....11.......9.32......2.4..........Positive
NTAP.......1.27.....12.......2.43......5.2..........Positive
QLGC.......5.16.....15.......6.48......6.1..........Positive
STK........4.42.....30.......9.71......1.6..........Positive
......P/E....Pre-bubble P/E.......P/S.......Pre-bubble P/S
.....CY03....HI.....LO.....AVG....CY03....HI....LO....AVG
SYSTEMS
HPQ...11.6...21.8...12.3...15.8....0.6...2.1...0.7....1.1
IBM...15.5...47.2...7.8....16.3....1.5...1.4...0.4....0.8
SUNW..18.0...20.6...9.3....14.2....1.1...1.8...0.3....0.9
STORAGE
BRCD..26.9x..44.9x..14.8x..26.7x...4.8x..9.7x..4.1x...6.3x
EMC...38.0...35.6...10.3...19.4....2.4...5.0...0.7....2.3
ELX...28.5...33.7...11.4...22.2....4.7...3.0...0.3....1.3
NTAP..31.5...87.2...28.9...47.7....3.8...9.3...2.9....4.8
QLGC..31.9...26.9...7.8....18.1....7.4...3.8...0.4....1.4
STK...13.9...62.0...9.1....17.0....0.8...2.1...0.5....1.2
COMPANY COMMENTS:
1. BROCADE (RL, BRCD, $17.47)
INVESTMENT THESIS: Brocade remains a standout in the tech sector, with continued strong demand driven by a new product cycle in the Silkworm 12K and a sound strategy for transitioning into the intelligent platform for storage networking. With a current PEG of slightly below 1, BRCD's valuation seems compelling.
*DEMAND IS SOLID AT THE OEM LEVEL. The near-term demand picture for Brocade remains sound with growth driven by Brocade's 2Gb line, especially the Silkworm 12000 core switch. While EMC has not fully certified the 12K, it is taking orders and shipping product, and should be certified by quarter- end. We are comfortable with our SilkWorm 12K revenue estimate of $22M for the July quarter, up from last quarter's $12M. Brocade's entry-level product, the 3200, is gaining rapid market acceptance as evidenced by recent deals with Legend and Bell Microproducts. While McData should begin to see some success with its 2Gb ramp, pricing remains stable, with Brocade having its entry level product and software as key incremental weapons.
*THE HP COMPAQ MERGER HAS NOT CAUSED ANY BUSINESS DISRUPTION FOR BROCADE. Checks indicate that Brocade's business with both HP and Compaq has been consistently strong all quarter and climbing. We remain comfortable with our July and October estimates of $150M in revenues and $0.08 in EPS, and $167M and $0.11, respectively, including potential for some upside this quarter.
2. EMC (RL, EMC, $7.59)
INVESTMENT THESIS: EMC is well along in its efforts to re-align itself strategically and operationally, with operating leverage improving and market share stabilizing. We expect operating leverage to expand, absorbing some of EMC's multiple, which at 38x our CY03 EPS estimate, is at the higher end of our sector.
*EMC IS LIKELY TO HIT Q2 CONSENSUS ESTIMATES. Our checks indicate that business has been slightly easier to close this quarter and that pricing appears to have firmed somewhat, partly due to IBM pulling back from its ultra-aggressive pricing stance of recent quarters. As a result, we believe EMC is likely to achieve its target of sequential revenue growth in Q2, with current consensus estimates of $1.37B in revenues (5% qtr/qtr) and a loss per share of $0.02 in EPS versus our $1.39B (7% qtr/qtr) and a $0.02 loss per share).
*ALTHOUGH EMC STILL HAS WORK TO DO, ITS POSITION IS ALREADY MUCH IMPROVED. After a turbulent 2001, EMC is again on a pricing par with its competitors. EMC is selling Clariion better and should see the effects of Dell selling Clariion by H2. We think market share has also stabilized after a brief period in which EMC was losing share to both Hitachi and IBM.
3. EMULEX (RL, ELX, $22.76)
INVESTMENT THESIS: Emulex and Qlogic are continuing to gain share from the remainder of the market, with both having collective market share of around 63% in 2001 and an estimated 74% in 2002. At the same time, market growth is gradually improving.
*DESPITE ALL THE NOISE, EMULEX IS LIKELY TO POST IN-LINE JUNE QUARTER RESULTS. We see the earlier Quantum and Gadzoox preannouncements as having little relevance on Emulex's demand picture. Our checks lead us to conclude that demand was probably sufficient to deliver on our $71M revenue estimate, higher than the company's target of sequentially flat revenues. (March quarter revenues were $69.6M.)
*TO ACHIEVE OUR $71M REVENUES ESTIMATE IN THE FACE OF A NUMBER OF HURDLES, JUNE QUARTER FIBRE CHANNEL HBA REVENUES WILL HAVE TO GROW AN IMPRESSIVE 7%. Not to be forgotten are the number of obstacles Emulex needed to hurdle this quarter to achieve roughly flat sequential revenues: -Emulex had been supplying IBM with FICON HBAs for IBM's storage system, Shark. These target-side HBAs have been transitioned into FICON ICs in the June quarter. Emulex will have to absorb a hit of about $2.5M for moving from $800 HBA cards to $100 FICON ICs. -The company's traditional networking business is going away. This business is expected to drop from $1.1M in revenues in the March quarter to virtually zero in the June quarter.
- Emulex had not experienced any HBA price erosion over the last several quarters. With customers hitting volume-driven price reduction targets on the 2Gb line this quarter, Emulex will likely see its more standard 3-5% sequential quarterly price declines.
4. HEWLETT PACKARD (MO, HPQ, $15.71)
INVESTMENT THESIS: With HPQ now trading at a CY'03 P/E of 11.6x, below its pre-bubble range of 12-22x and at a significant discount to IBM (15.5X) and SUNW (18x), downside would seem to be limited. Although IT spending continues to be a source of concern, we view HPQ as somewhat defensive even in today's environment, given the cost-cutting aspect to the story and the increasing contribution from consumables.
*THE SLUGGISH IT AND CONSUMER SPENDING ENVIRONMENT IS LIKELY TO PRESSURE JULY QUARTER RESULTS. We recently lowered our July quarter revenue and EPS estimates to $16.6B and $0.13 respectively, to reflect the continued weak IT spending environment. The imaging business should remain HP's standout area in terms of revenue growth and operating profit as a result of the combination of relative strength in all-in-one devices and PhotoSmart printers, along with a growing percentage of consumables revenue. At the same time, PCs, enterprise computing and services, will be under pressure due to integration issues as well as the depressed spending environment.
*HP's PC BUSINESS REMAINS THE MAJOR AREA OF WEAKNESS. We expect the PC business in aggregate to be down close to 20% sequentially, with the bulk of the decline coming from the consumer business, where most of excess channel inventory sits. The commercial PC business should be soft as well as a result of seasonality, merger-related revenue losses, and general IT spending weakness. Some of the slowdown in HP's business is seasonal, yet there are also a number of other factors weighing on the consumer PC business specifically, including a sustained focus on the consumer space from HP's largest rival, Dell, as well as increased competition from retailers like Best Buy, who have recently introduced their own branded PCs.
*ENTERPRISE COMPUTING AND SERVICES CONTINUE TO FEEL THE OVERHANG OF A WEAKENING IT SPENDING ENVIRONMENT. HP has been very clear about its intention to discount as necessary to keep key accounts.
5. IBM CORPORATION (RL, IBM, $72.12)
INVESTMENT THESIS: IBM is a much stronger competitor today and hence should generally be a market share gainer rather than loser, with better top and bottom line growth opportunities following recent restructuring initiatives (e.g. HDDs). At 0.7x, we believe IBM's relative multiple is low enough to suggest reasonable upside over a 12-15 month timeframe.
*THE SLUGGISH IT SPENDING ENVIRONMENT CONTINUES TO WEIGH ON IBM HARDWARE AND SERVICES BUT PROBABLY NOT ENOUGH TO UNDO THE QUARTER. We expect reported revenue to be up 6% sequentially, with the improvement a result of some positive seasonality and currency. Our EPS estimate of $0.81 (which excludes our estimate of a $0.05 benefit from the elimination of HDDs) reflects a more meaningful sequential improvement. This is driven by a moderate increase in gross margin as a result of a more favorable mix as well as management's continued focus on tight cost controls. After the last 2 quarters, in which services bookings jumped to $15 billion/quarter from the prior $10 billion level, bookings could end up slightly lower, possibly around $13 billion or so. Notwithstanding, IBM's outsourcing business seems generally healthy, with a couple of sizeable deals, one possibly a record-setter, potentially slipping out of the quarter although we gather still in the final negotiation stages. This would continue to provide the potential for IBM to experience double-digit services revenue growth in the December quarter.
*CURRENCY HAS TURNED AND, BEGINNING IN THE JUNE QUARTER, SHOULD POSITIVELY IMPACT RESULTS. We are now assuming that IBM revenues will experience a positive impact of about 50 basis points in the June quarter versus our initial estimate of a negative 150 basis point impact. Thus, while we are expecting a 9.3% YoY decline in revenues in constant currency, we expect reported revenues to be down less, at $19.66B, reflecting an 8.8% YoY decline. Looking out to the September and December quarters, based on the dollar's continuing weakness, our assumptions of a 200-300bp favorable impact going forward could, if anything, turn out to be low, with a corresponding positive bottom line effect.
6. NETWORK APPLIANCE (MO, NTAP, $12.58)
INVESTMENT THESIS: While NetApp has done an excellent job in expanding its vertical markets and addressable base, slow IT spending remains an issue. With the introduction of block-based storage providing the means for NetApp to enter the broader, more mainstream market, competition will intensify even while NetApp's market opportunities grow.
*THE JULY QUARTER HAS THE EARMARKS OF A FIRST FISCAL QUARTER. We continue to hear of broad-based interest for NetApp products from customers in various industries. Still, deal closures seem more labored and overall business is flattish. With a solid backlog entering the quarter, revenues should not be much at risk unless bookings fall too far below NetApp's ability to be close to a one-to-one book-to-bill. This quarter's revenues are being driven by verticals such as government, life sciences, communications, and manufacturing.
7. QLOGIC (MO, QLGC, $39.88)
INVESTMENT THESIS: QLogic's business remains healthy given exposure to Sun and Dell on the fibre channel side, and Hitachi and Fujitsu on the SCSI side. Incremental business at Dell for Clariion and at Cisco, coupled with strength in its core business, should allow QLogic to continue to deliver sequential revenue growth. Similar to Emulex, QLogic should be a long-term share gainer in HBAs as the market consolidates down to the two leading suppliers.
*OUR CHECKS SUGGEST THAT ALL PARTS OF QLOGIC'S BUSINESS ARE AT LEAST TRACKING TO PLAN. QLogic seems likely to come in at least in-line with our estimates of $98.7M and $0.23 (revenues up 7% sequentially). While our checks point to the SCSI business being up sequentially, there is evidence of weakness in the overall enterprise disk drive market which may temper some of the SCSI business' sequential growth. Beyond just SCSI, the more important product lines of HBAs, switches, and ICs all seem to be tracking well, perhaps a bit ahead of plan. Sun should again be a highlight as Sun's fiscal fourth quarter is likely to pull along some additional business for QLogic.
*SEPTEMBER QUARTER ESTIMATES MAY HAVE TO COME UP A LITTLE. Sun is better managing the transition into its new fiscal year (beginning in the September quarter), which should provide additional stability in CY Q3 for QLogic. Given this added stability and a SCSI business that continues to post sequential growth, QLogic's prior target of 2-6% revenue growth in the September quarter could prove conservative. Beyond Sun, Dell should be starting to contribute incrementally, with Cisco ramping just behind.
8. STORAGETEK (MP, STK, $15.33)
INVESTMENT THESIS: StorageTek remains an expense story, with top line growth holding flattish. Longer-term, growth remains a challenge, as issues such as the prospect of some portion of the tape market being replaced by disk continues as an overhang.
*STORAGETEK's EXPENSE CONTROLS SHOULD ENABLE IT TO COME CLOSE TO ESTIMATES. Although StorageTek seemed to be roughly on track in mid-June, the fact that the company does around 60-70% of its business in the final month adds a high degree of uncertainty to top line conclusions. And while Quantum's preannnouncement has raised investor concerns, it is important to note that StorageTek does little to no business with HP Compaq, the assumed customer behind Quantum's shortfall.
*STORAGETEK UNLIKELY TO DELIVER EPS UPSIDE OF PAST QUARTERS. Given the timing of various cost reduction programs, our sense is that there is not a lot of cost-driven upside this quarter. Hence, unless StorageTek delivers revenue upside, it is unlikely that STK will beat EPS estimates dramatically this quarter. Conversely, if Storage Tek misses the top line, it will be difficult for the company to meet EPS estimates. Incremental cost programs should start to kick in again in 2H02.
9. SUN MICROSYSTEMS (RL, SUNW, $5.39)
INVESTMENT THESIS: Investor confidence in Sun is broken. While some investors may begin to wade back into Sun if our assumptions about the June quarter are correct, most will at least want to see Sun get through the September quarter. At $5.39/share, Sun's depressed stock price is bolstered by $1.25 in net cash, a conservative balance sheet, Sun's positive cash flow, and a first step turnaround in quarterly results.
*WE THINK SUN IS LIKELY TO MEET ITS JUNE QUARTER TARGETS. Sun went into the quarter with a target of showing slight revenue growth and nominal profitability. While hardly a stretch goal, under the current circumstances it was also hardly a lay-up. Based on what we are hearing, we are confident that Sun at a minimum met its targets. We believe that Sun held share and may even end up hitting or coming very close to consensus revenues for the quarter, targets that we believed had grown highly improbable over the course of the quarter. Our revenue forecast is $3.25B up 4.6% sequentially, with First Call consensus at $3.29B, up 6% sequentially.
*THE SEPTEMBER QUARTER HURDLE IS SUN'S NEXT CHALLENGE. Historically, Sun's fiscal Q1 is down about 11-14% sequentially. Given Sun's stated goal of maintaining profitability in the September quarter, the company will need to post a smaller than typical sequential decline, with our September quarter estimate at $3.09B (-5% qtr/qtr) and $0.00 versus the consensus estimate of $3.19B (-2% qtr/qtr) and $0.01, which we think are a bit too high. Sun's lighter-than-normal June quarter incentives suggest that the company did not pull much September quarter business into June results. |
