Like those Japanese soldiers who held out for years in the Philippine jungle after their emperor had surrendered to end World War II, a few bruised but unbowed infantrymen of the dot-com wars cling to life today in the jungles of the

Nasdaq

, refusing to give up.

One of the most curious of the bunch is

Emulex

(ELX)

, a maker of data-storage networking device components. But it, too, may well be captured and marched away before long. (The fact that it recently moved over to the NYSE perhaps presages this.)

During the manic run in stock prices from 1997 to 2000, Emulex shares shot up 5,370% as the Nasdaq Composite gained 275% and the major general of storage stocks,

EMC

(EMC)

, gained 2,400%. In the early stages of the surge, few technology investors had ever heard of a Fibre Channel host bus adapter, Emulex's hallmark product.

But by the time the third month of 2000 rolled around, the buzz on that technology had grown so extreme that prices were regularly advancing as much as $5 daily, until they'd reached a high of $112.18 from a five-year low of less than a buck.

While demand for networking products waned amid recession, and the Nasdaq plunged 75% back to its 1997 level, Emulex has remained uniquely immune from harm. The company has maintained a 30% average annual growth rate in its reported earnings and stayed in investors' good graces with a blistering 1,040% advance from January 1997.

Among all technology stocks with a market capitalization of least $1 billion, Emulex has advanced the most from its five-year low. Only its chief rival,

QLogic

(QLGC)

, is close -- which is fitting, since Emulex spun off QLogic in 1994.

Bulls contend that Emulex derives its success by building the best set of electronic cards that connect storage devices in both the traditional and the new network-attached configurations. Most major makers of server and storage products use Emulex adapters -- and last week, the company got a boost from

IBM's

(IBM) - Get Report

announcement of a new storage platform called Shark, which is expected to expand its market.

Host bus adapters essentially enable servers to connect to storage networks by taking care of communications processing while data flows back and forth. Emulex's expertise is in developing software and a variety of application-specific integrated circuits, or ASICs, that boost system performance.

But bears claim that Emulex's accounting and corporate governance, while not improper, are stuck in the dot-com twilight zone, circa 1999. Bears point to special financial contortions that make quarterly reports look better than perhaps they should, a board of directors that's in management's back pocket, an auditor that was compensated more in the past year for consulting than for checking the numbers, and tons of insider selling, not to mention a relatively rich valuation and uncertain fundamental business prospects.

Seven Red Flags

If the Nasdaq mounts a rebound over the next few weeks or months, you can almost be certain that Emulex's strong relative performance will put it at the top of traders' buy lists, and shares could explode again from their current perch around $24.

Yet according to a new study of Emulex by Camelback Research Alliance, an Arizona firm that specializes in forensic accounting and provides stock-rating metrics to MSN, potential earnings quality issues would still put the company's recent success at risk. Here are a few of those issues:

Pro forma results.

In an era when investors are on the lookout for every sort of chicanery, you would think that no company could still present pro forma financial statements. Essentially, these are statements that show what quarterly results would look like were it not for a few pesky matters that executives do not think are relevant. They are contrasted with GAAP-basis statements, which rely on "generally accepted accounting principles" that everyone is familiar with, including amortization and depreciation schedules that tend to depress earnings.

Emulex management provides both pro forma and GAAP-basis earnings in its press releases, but emphasizes pro forma results that overstate the company's true profitability, in the opinion of Donn Vickrey, executive vice president at Camelback. Without boring you with all the details, let it suffice to note that Vickrey believes Emulex's pro forma net income for the nine months ended March 31 was 73% higher than his calculation of "baseline" earnings.

Much like the new Standard & Poor's "core earnings" figure, Vickrey's baseline earnings figure strips net income of nonrecurring and nonoperating items. However, he does not consider Emulex's accounting to be unusually aggressive. Michael J. Rockenbach, chief financial officer at Emulex, says the pro forma numbers give investors a better understanding of the company's real operational performance.

Undiversified customer base.

Although Emulex regularly publishes press releases announcing a new customer for its products, about 72% of its sales are made to just five customers -- and one of those, Compaq, was just merged out of existence. (Compaq's new parent,

Hewlett-Packard

(HPQ) - Get Report

, has certified Emulex for use in its products.)

Additionally, one product line, those host bus adapters, accounts for 95% of sales. A new line of Internet protocol networking products acquired in its 2001 purchase of rival Giganet amounted to less than 1% of sales of total net revenue in the March 2002 quarter. All these products rapidly become obsolete as well, and the company took a large charge (later partially reversed) for outdated inventory in its September 2001 quarter.

Cash flow issues.

Cash flow from operations and free cash flow at Emulex are strong and growing faster than net income. But tax benefits from stock option exercises accounted for a significant amount of Emulex's reported cash from operations. While this is proper under the law, these aren't the kinds of dollars investors would ideally like to see boost the cash flow line of an allegedly quickly-growing company. (For the nine months ended April 2001, for example, tax benefits from stock options exercises amounted to half of cash flow from operations.)

Large goodwill overhang.

In December 2000, the company announced that it would acquire IP networking products maker Giganet in an all-stock deal that was valued at $689 million at the time, with Emulex shares going for $75. Goodwill -- the amount a company pays for another company over its book value due to expectations that some intangible assets will prove valuable -- was ultimately set at a mammoth $599 million.

As I explained in my

May 22 column, goodwill is carried as an asset on the balance sheet as if it were as concrete as a piece of machinery, and it has to be depreciated, or "amortized," over time. Goodwill worth $52 million was amortized in 2001, and one-fourth of the total goodwill is scheduled to be amortized each year over the next three years. However, it's fair to speculate that the remaining goodwill is probably worthless right now -- the technical term is "impaired" -- and Vickrey believes it would be sound accounting to write it all off immediately.

CFO Rockenbach said his team reviews its goodwill for impairment regularly and will announce its next move in August as the company prepares to shift to adopt the Financial Accounting Standards Board's new Rule 142. In the meantime, $473 million in intangibles sits on Emulex's balance sheet like a big lump. If the company does write off the whole amount to satisfy Rule 142 requitements, it would reduce reported earnings and negatively impact debt-to-equity ratios by reducing shareholders' equity, now at $795 million, by nearly 60%.

Auditors' independence.

The independence of Emulex's auditors may be questioned by skeptical investors because of the high level of compensation it receives from the company for nonaudit services, according to Camelback. According to its most recent report, Emulex paid KPMG $174,000 for auditing services but $1.25 million for nonaudit services. With so much consulting money at stake, other accounting firms have sometimes found it difficult to challenge companies' bookkeeping methods.

Board independence.

Only three of seven members of the board are clearly independent. Two board members have had recent consulting agreements with Emulex, and one had substantial loans from Giganet, according to company financial filings. The board's chairman, Fred Cox, has served in the past as Emulex's chief executive and owns 1.3 million shares of stock. The company's current chief executive is also on the board.

Heavy insider selling.

Since August 2001, directors and officers of Emulex have sold 537,880 shares and have made no purchases. Although there are many reasons for selling unrelated to earnings quality, when such strong selling follows a major price decline, it generally suggests that management does not foresee significant upside in the shares.

At the end of May, Cornelius Ferris sold $1 million worth of stock in the range of $27 to $32 per share, Chief Operating Officer Kirk Roller sold about $560,000 worth at around $32, and senior vice president Ronald Quagliara sold $775,000 worth at around $31.

How Long Can Emulex Hold Out?

Analysts at most major brokerages are generally optimistic on Emulex shares, maintaining their "strong buy" ratings and expecting the company to announce in-line results in its next report during the second week of August. Only the storage-technology team at Deutsche Bank Securities is relatively bearish.

In a July 10 report, the team said that while it believes Emulex will not disappoint in August, the company still faces a "rather difficult" market, and prices have still not reached a compelling valuation after falling 43% this year. Emulex's price-to-sales multiple is a lofty 7.9, well above its peers' average of 1.62 and its own historical record of multiples from 0.35 to 1.43 from 1993 to 1998. Its price-to-book value is 2.30, which isn't too bad until you consider that much of that book value is phantom goodwill related to that Giganet purchase.

Camelback gives Emulex a D, on a scale of A to F, for its risk of earnings quality problems in the future -- a level commensurate with expectations of stock underperformance vis-a-vis its industry peers over the next 12 months. (Current quality of earnings is rated as "average.") It also rates a 4 from MSN's StockScouter system on scale of 1 to 10, which forecasts mild underperformance in the future.

How long can Emulex continue to hold out? Perhaps not long, though it depends largely on demand at large enterprises for new storage networks. Net income at the company is negative at the moment, and no analysts are forecasting a robust rebound for its products in the second half of 2002.

During the terror-induced lows of last September, shares fell to around $9. With revenue per share at $2.97, that still worked out to a fairly rich price-to-sales multiple of 3. If Emulex's sales continue to lag, concern swells over the quality of reported earnings, and if the company is forced to write off half its book value to clean up goodwill -- a lot of ifs, to be sure -- then a decline to around $6 shouldn't come as a surprise.

Of course, bulls have won with this stock for a long, long time -- and could always look to the Japanese holdouts from World War II for a measure of hope. From 1945 to 1948, three years after the war ended, these holdouts regularly walked out of the Philippine jungles and surrendered. Seven armed with a mortar launcher gave up as a group in April 1947; 200 well-armed men gave up in January 1948. But the last guy didn't wave a white flag until 1974, when Lt. Hiroo Onoda, still armed with a .25 caliber rifle, 500 rounds of ammunition and several hand grenades, finally surrendered on Lubang Island.

At ease.

At the time of publication, Jon Markman did not own shares in any of the equities mentioned in this column.