Jitters Ahead of Network Appliance Earnings

The storage market is becoming increasingly competitive, as Veritas and EMC are discovering.
By Bill Snyder ,

Will

Network Appliance

(NTAP) - Get Report

be the latest tech stock to suffer a "sell the news" reaction to its forthcoming quarterly results? It may, judging both by Friday's market action and the recent experience of storage software leader

Veritas

(VRTS) - Get Report

.

Although Network Appliance rallied off Friday's intraday lows of $21.14, the storage hardware vendor closed down 3.5% at $21.70 and was off 6% at one point on no particular news -- other than apparent nervousness over its third-quarter earnings release, scheduled for after the close Tuesday.

"There was a fair amount of negative chatter into

January's quarter-end," said Goldman Sachs analyst Laura Conigliaro in a note to clients. Nonetheless, she figures the Sunnyvale, Calif., company will deliver another "standard solid NetApp quarter." (Goldman does not have a current investment banking relationship with Network Appliance.)

A solid, or in-line, quarter equates to a 10-cent-per-share profit on sales of $290.76 million in the January quarter and guidance for an 11-cent profit on sales of $304.6 million in the April quarter, according to consensus estimates gathered by Thomson First Call.

The fourth-quarter revenue forecast equals a growth rate of 4.8%, but with Network Appliance trading at 42.55 times expected 12-month forward earnings, that might not be enough to support the stock's current price.

EMC

(EMC)

, the 800-pound gorilla of the storage sector, is trading at a forward price-to-earnings ratio of 29.51 while Veritas is trading with a P/E of 30.09.

It's worth noting that late last month Veritas posted record revenue, turned from a sizable loss to a profit, and grew year-over license revenue, a good measure of growth in the software business, by 17%. But Wall Street was expecting more -- one analyst had forecast license-revenue growth of 25% -- and the stock tanked. Since reporting its fourth-quarter results on Jan. 28, Veritas is off 10%, while the

Nasdaq Composite

overall has been flat.

Like EMC, Network Appliance is working to lift its software business, acquiring privately held Spinnaker Networks in November for $300 million in stock. Although the Spinnaker deal still hasn't closed, a positive sign on Tuesday would be an increase in the percentage of Network Appliance's revenue contributed by software beyond the 29% reported in the second quarter.

Also important to listen for will be management comments on

IBM's

(IBM) - Get Report

new network attached storage product. Analyst Cliff Su of Lazard said the competitive product could, in a worst-case scenario, cost Network Appliance $170 million in business this year. But "in our opinion, that's not likely," Su added in a note to clients. "For now, we believe that the IBM Gateway 500 is something for NetApp investors to monitor, but is far from a selling event." (Lazard has had an investment banking relationship with Network Appliance.)

Competition Heats Up

While Network Appliance executives look over their shoulders at IBM, Veritas faces increased competition in software from EMC, whose threat helps explain Vertias' recent slide.

With money to spare, the Hopkinton, Mass., storage giant last year gobbled up Legato and Documentum in moving toward the higher-margin software business.

Legato is far and away the greater threat since, unlike Documentum, it competes directly with a core Veritas business -- data backup and recovery.

None of the major storage players break out revenue from backup, but market researcher IDC estimates that Veritas maintained a commanding lead in the third quarter of 2003 -- the most recent data available -- with $243.48 million, a market share of 36%. Taken together, Legato, which was then independent, and EMC accounted for $71.39 million or a combined share of just 10.7%.

Few analysts think EMC/Legato has narrowed the gap much since those numbers came out. "It remains to be seen how receptive customers are to buying a

software solution from a storage hardware vendor," said Oppenheimer analyst Sanjiv G. Hingorani. (Oppenheimer does not have a current banking relationship with Veritas or EMC.)

But Legato's technology is highly regarded, and now that its weak financial position is history, there's a chance that it can take market share from Veritas by selling into EMC's enormous customer base. Indeed, when EMC reported its fourth-quarter earnings in January, the company said Legato's revenue set a record, although it refused to break out exact numbers.

Veritas also did well in its most recent quarter, growing what it calls its core revenue, a majority of which is backup, by 12% year over year.

For now, it appears that EMC and Veritas did well without taking market share from each other.

It isn't altogether clear that success in the backup market is a zero-sum game, said Steve Duplessie, founder of the Enterprise Storage Group, a specialized market research company. "With the dot-coms gone, there are fewer opportunities to corral new customers, but the installed base needs more

backup capacity," he said. That's because businesses not only produce more data each year, but new government regulations mandate that more of it be kept for longer periods and that it be easily accessible.

"Right now, backup is a good place to be," Duplessie said.

IDC will report fourth-quarter storage sales in March. Since Legato was part of EMC for nearly all of that period, those results will give a much better indication of how worried or not Veritas investors need to be about EMC.

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