Slowdown Scare Sinks Storage Stocks

Updated from 12:02 p.m. EST

Following Tuesday's first-quarter warning from McData (MCDT Quote - Cramer on MCDT - Stock Picks), fears are building that the storage networking company's former parent, EMC (EMC Quote - Cramer on EMC - Stock Picks), may do the same.

McData, which makes switches and software for storage area networks, sells about 75% of its merchandise through EMC. EMC acquired McData in 1995, but distributed the stake to EMC shareholders in 2001.

Citing McData's warning and signs of continued weakness in data storage demand, J.P. Morgan cut its 2002 estimates on EMC to a loss of 2 cents a share from an earlier forecast of a penny profit. Morgan said it remains "cautious" about EMC's shares, but the firm kept its long-term buy rating on the stock. Earlier this week, Goldman Sachs lowered its 2002 estimates for EMC.

The worry was certainly spreading. Robertson Stephens analyst Dane Lewis said he thinks EMC could post a "significant" shortfall. "Storage demand drivers have really hit a wall," he said. Another analyst who preferred not to be named said EMC could miss its revenue targets by as much as 20% to 30%.

Still, all might not be lost. Nitsan Hargil of Friedman Billings & Ramsey said he had conversations with EMC executives on Wednesday and that they weren't giving any indications they would lower their expectations.

EMC was lately falling 1.4% to $11.39, and McData was dropping 26.7% to $11.67. Other data storage outfits were also being punished. Brocade (BRCD Quote - Cramer on BRCD - Stock Picks) was down 4.3% to $25.17, and Network Appliance (NTAP Quote - Cramer on NTAP - Stock Picks) was off 7.8% to $20.04. QLogic (QLGC Quote - Cramer on QLGC - Stock Picks) was losing 5.1% to $45.30, while Emulex (EMLX Quote - Cramer on EMLX - Stock Picks) was dropping 8.6% at $34.06.

The data storage sector has been under pressure of late as concerns mount that the first quarter will yield disappointing results. The group rallied last fall on hopes that the first quarter would point to a turnaround in data storage sales, but instead, demand seems to have remained weak.

Despite early signs the economy is improving, IT managers are still trying to get the most out of the technology they already have, and demand has shifted to mid-range products from the higher-end products on which EMC focuses, Lewis said. The company is also facing intense pricing pressure from IBM (IBM Quote - Cramer on IBM - Stock Picks), Hitachi (HIT Quote - Cramer on HIT - Stock Picks) and other companies, several analysts said.

In the fourth quarter, EMC saw revenue surge 25% from the third quarter, but the company has said that revenue in the first quarter, which tends to be seasonally weak, will fall 5% sequentially, at best. If customers are cautious about their spending, the decline could be even worse. The increase in the fourth quarter, which is usually strong, came on the heels of a rough third quarter.

The company lost 3 cents a share on revenue of $1.51 billion in the fourth quarter. Analysts, on average, are expecting a first-quarter loss of 3 cents a share on revenue of $1.41 billion, according to First Call. EMC is expecting to turn a profit by the third quarter, and "that's probably the best bet," said Hargil.

For the full year, Lewis expects EMC to break even on revenue of $6.5 billion, but he said those estimates would probably come down. Last year, EMC posted $7 billion in revenue. The initial expectations had been around $12 billion before the drop in technology spending proved so resilient. Lewis also said the company might have to cut more staff this year if the slump continues on top of thousands of workers who were let go last year.

McData said Tuesday that it now expects to post a first-quarter loss and lower revenue because of sluggish spending on information technology. Instead of breaking even, or turning a profit of as much as 2 cents a share, as McData previously expected, the company now sees a loss of 2 cents to 4 cents a share. McData also lowered its revenue outlook to between $73 million and $78 million, from $85 million to $95 million.