IT Slowdown Worries Hammer CacheFlow and Its Caching Peers

The IT spending slowdown story continues to play out among Internet infrastructure companies. Thursday, following Inktomi's (INKT Quote - Cramer on INKT - Stock Picks) preannouncement of a fourth-quarter earnings and revenue shortfall, wary investors were turning their sights on Internet caching.

Caching involves managing the way information flows over the Internet and a company's internal networks. Inktomi makes caching software, and news that many of its customers had developed second thoughts about how much caching software they would actually buy has sent that stock down 23%. CacheFlow (CFLO Quote - Cramer on CFLO - Stock Picks), a hardware company that makes low-cost caching appliances, was falling apart in turn, down 25% in the wake of a downgrade by Morgan Stanley Dean Witter analyst Christopher Stix. Network Appliance (NTAP Quote - Cramer on NTAP - Stock Picks), whose large business in storage-server appliances reduces its exposure to caching, rose 3.2%.

Stinktomi?

Here's the problem: On last night's conference call, Inktomi CEO David Peterschmidt described a scene in which customers made last-minute decisions to cut capital spending, a problem he connected to broader economic conditions. Because of Inktomi's focus on selling to dot-com customers, mainly Internet service providers, it's tempting to dismiss as mere posturing the company's attempt to ascribe its miss to a larger capex slowdown.

But Peterschmidt isn't the only one crying fire.

In his report, Stix cited a Morgan Stanley survey of 150 chief information officers, just 1% of whom planned to deploy network caches in the next three quarters, while 20% planned to do so over two years. That reticence to devote budgets to caching software and hardware, unthinkable just a year ago, when stocks like CacheFlow and Inktomi were soaring along with the rest of the Internet infrastructure, led Stix to cut his compound annual growth forecast for sales in the caching market over the next three years to 67% from 76%.

Weakness in the content-management sector makes sense to Dane Lewis, the Robertson Stephens analyst who Tuesday downgraded a slew of Internet infrastructure stocks on fears of slowing capital spending. Like everyone else trying to gauge the gravity of the IT spending slowdown, Lewis has been relying largely on anecdotal evidence. But the tales he's been hearing aren't comforting: IT managers talk of delaying deployment of products, extending sales cycles and falling prices.

Flooding the Joint

Compounding things, some infrastructure gear bought by now-defunct dot-coms has started to come back on the market to compete with new servers and storage devices. One salesman Lewis talked with described how he had lost a potential customer to that very phenomenon: "They ended up buying a Sun (SUNW Quote - Cramer on SUNW - Stock Picks) box for 50 cents on the dollar."

The fear is that such an atmosphere leaves everyone, including CacheFlow, vulnerable. "I think they'll miss the January quarter and take down guidance," says Lewis.

Bulls continue to hold out hope that the development of streaming media on the Web will spur the demand for caching equipment. Streaming media relies on the efficient transport of data to work properly, as any delay in the way data packets of video or sound are transmitted or assembled is capable of spoiling the show. Industry observers expect the proliferation of streaming media to spur a boom in caching devices that allow media companies to keep streaming content on their network's "edge," closer to where most users make their connection.

But as with the debate over the arrival of broadband, the ubiquity of streaming content seems to be always imminent. In the meantime, expect questions about IT spending to pester caching companies.

"My contacts -- IT buyers, salespeople, other people in the channel -- everyone is very pessimistic," says Lewis. "And all my companies are saying, 'It's fine, no problem.' It just doesn't square. Then you look at the multiples, and it's like, wait a minute, people aren't pricing this into these stocks."

They did some of that today.