Storage Companies Still Smiling as the Bits and Bytes Keep Piling Up

Internet commerce. Personal computers. Unix servers. Telecom equipment. It's getting harder and harder to find a sector that hasn't been ravaged by slowing growth.

And then there's storage. As company after company is forced to lower its guidance for 2001, enterprise storage names like EMC (EMC), Network Appliance (NTAP) and Veritas (VRTS), along with storage-network switch makers like Brocade (BRCD) and McData (MCDT), still claim that growth is showing no signs of abating.

But as the number of credible hypergrowth stories gets smaller, the stakes get larger.

The main evidence that the storage business is still booming comes from customers, who have indicated that, despite the uncertain environment, the percentage of their budgets allocated to storage remains unchanged. But there's a logic behind that evidence that makes the story still compelling. There are a lot of areas where IT managers can pare back or delay purchases. With T1 network lines doing more to ease bottlenecks at workstations than microprocessors ever could, employees will do just fine using their Pentium II machines for six more months. Windows 95 may be crashing every 45 minutes, but the Windows 2000 deployment can wait another quarter as long as the workers can be persuaded to lay off Napster. As for servers, even a slower-than-optimal network can be tolerated if budgetary discipline demands it.

But no matter what you do, the data just keep piling up.

"I'd never say we're bulletproof," says John McDonnel, chairman and CEO of McData, which spun off from EMC last year. "But we talk to a lot of large-enterprise customers, and they say that the expansion of their storage capacity is just not an option. They just have to do it. They gather information every day and need more access and availability."

McDonnel's is the dominant perception of the storage industry on Wall Street right now. And ironically, that sense of the relative immunity of storage to the problems so many other tech companies are facing may have made the storage group one of the most dangerous sectors around. Even with the spirited selling of the past few months, valuations in that sector remain at heights that seem anachronistic against the backdrop of 2001's supposed return to fundamentals. Because of that, sudden news of significantly slowing growth at any storage company will be judged extremely harshly.

Last of the Hypergrowth Stocks
Company	Forward price-earnings ratio	Estimated 2001 sales growth	Estimated 2001 earnings growth
Brocade (BRCD)	164	159%	121%
EMC (EMC)	74	34%	30%
McData (MCDT)	121	44%	47%
Network Appliance (NTAP)	137	93%	95%
Veritas (VRTS)	106	45%	48%
Source: First Call

Investors have learned that the bad news is always sudden. The unfortunate truth of the matter is that discretionary spending and nondiscretionary spending are not, as many have treated them, discrete and immutable categories. It's one thing for customers to say that they don't plan to cut back on spending. But when budgets come under review, even if a corporation can't afford not to invest in storage capacity, its pricing can become important.

The fears aren't outlandish. On its recent earnings conference call, EMC indicated to analysts that gross profit margins could decline by as much as a few percentage points in 2001. Network Appliance lost more than 15% of its market cap last week on fears that it is starting to feel pricing pressures. The increasing competition in the storage market -- deep-pocketed purveyors of Heavy Iron like Compaq (CPQ), Hewlett-Packard (HWP) and IBM (IBM) are all piling into that high-margin business -- can only amplify the problem.

"Time will tell," says George Elling, who covers the storage industry for Lehman Brothers. "The demand for storage is phenomenal right now, so at least they have a cushion. If budgets get cut a lot more, there's a question of what projects get deferred. Storage certainly wouldn't be immune. For the time being, it's one of the projects that you need to get done."

"Storage will grow regardless of economic expectations," says McData's McDonnel. "The only question is how fast."

The only question, indeed.

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