Ugly 2001 Slowly Coming Into Focus at EMC

The beer goggles are starting to come off at EMC (EMC Quote). And the more visibility improves, the worse things look.

EMC released its preliminary first-quarter results Wednesday, and, as the Hopkington, Mass.-based storage systems giant correctly surmised, the numbers were hardly worth waiting for. EMC said it expects first-quarter earnings to be 18 cents a share, two pennies below the Thomson Financial/First Call consensus estimate -- a benchmark, it should be noted, that has been falling steadily all year. The company also said that revenue will total $2.35 billion, up 29% from the same period last year and about $100 million below what analysts were looking for.

The company gave the customary explanation for the shortfall: tightened IT budgets amid a dramatically slowing economy. "We made the choice to sprint to the end of the quarter," Chairman Mike Ruettgers said on the conference call that followed the release Wednesday. "Unfortunately, we were not able to out-execute the economy and a late-quarter investment pause."

This isn't exactly the pause that refreshes. "Pipelines, they're not growing," said Robertson Stephens analyst Dane Lewis. "Nobody's deploying new B2B or supply-chain software. All this new application stuff if being pushed out, and new storage is being pushed out, too." (Robertson Stephens hasn't done underwriting for EMC.)

Us and Them

No one who's not on the New York Yankees roster would deny that the economy has gotten sluggish. But there's also the question of competition, a question begged by the shellacking taken by EMC's gross profit margins. With every enterprise hardware company and his maternal third-cousin piling into the storage sector, nearly everybody expected EMC's margins to fall from the fourth-quarter's lofty 59%. But nobody was really prepared for an almost four percentage point decline in gross margins, which EMC said will come in at 55.1% for the first quarter.

One company that could be giving EMC problems is Hitachi (HIT Quote). Hitachi's burgeoning storage business includes the mid-range Thunder servers, the high-end 9900 series, and an older line of high-end servers that the company is discounting aggressively. "We've had a policy over the last several quarters to be more competitive with Hitachi," Ruettgers said on the conference call. "There was no particular change in the quarter relative to that."

But from a much smaller revenue base, Hitachi is growing its storage segment much faster than EMC's more mature business, despite claims by EMC's management that its company's growth continues to outpace any of its competitors. Wit Soundview analyst Gary Helmig estimates that storage revenue at Hitachi, which reports its financial results on a bi-annual basis, grew from $250 million in the fourth quarter to around $450 million in the first quarter. (Wit Soundview hasn't done underwriting for EMC.)

"That's a $200 million sequential increase," said Helmig. "Just half of that business would have made up the difference on EMC's revenue" for the first quarter.

Ordinary Men?

The first quarter is the least of EMC's problems. Breaking from an almost total devotion among tech executives to the cult of limited visibility, Ruettgers said he thinks most of the company's customers have finished reworking their budgets for tech gear. And what the company seems to have gleaned from those budget revisions isn't pretty.

EMC said it expects its growth rate for 2001 to stay north of 20%, putting the final nail in the coffin of the company's former $12 billion sales target, which would have represented 35% growth. Meanwhile, thanks to the pressure that aggressive pricing will take on margins, earnings-per-share will show just "modest" growth for the year. Analysts had been expecting EMC to earn 94 cents a share in 2001, up 18% from 2000's 79 cents a share.

It wasn't the promise of "modest growth" that turned EMC into one of the market's hottest tech stocks over the past few years, taking its price-to-earnings ratio as high as 160 in 2000. Back then, storage was popularly thought to fit under the rubric of nondiscretionary spending.

"For the last six months, Ruettgers has been saying that storage was 'recession proof,'" said Helmig. "That's a quote, 'recession proof.' Now they're saying the economy is knocking them off the course and that they're doing great in tough times. They're still showing growth, but it certainly isn't anything like what they expected to do."

Weaker Stock

EMC's stock, off 47% so far this year, was lately down $1.65, or 4.8%, to $32.75 -- not huge damage, considering the scope of today's warning. After all, if one assumes it will be able to grow earnings-per-share by 8% in 2001 -- by no means a foregone conclusion -- EMC still trades at about 40 times forward earnings.

How much more the stock has to fall depends on whether, and how strongly, earnings rebound in 2002 and beyond. And that's the sort of tough question that has yet to get answered in this grand sector. Infrastructure stocks like Network Appliance (NTAP Quote), Sun Microsystems (SUNW Quote) and Brocade (BRCD Quote) were all moving higher in afternoon trading.

"What do you pay for a company growing earnings 10% year-over-year?" asked Lewis. "What's the real growth rate for these companies? That's what people are trying to sort out."