Storage Set to Serve Up a Kind Quarter

Enterprise storage companies are likely to feed investors a meat-and-potatoes diet of solid results in the fourth-quarter earnings season. And there just might be a serving of dessert in the form of a significant acquisition by -- or of -- McData ( MCDTA).

Emulex ( ELX) kicked off the report festivities with an upside surprise on Wednesday, saying it now expects to post pro forma earnings of 19 cents to 20 cents a share in the December quarter, up from its previous guidance of 13 cents to 15 cents per share excluding items. The frothy preannouncement is also an indication that its rival in the host bus adapter market, QLogic ( QLGC), which has not yet reported or warned, is also in good shape for the quarter, analysts said.

Merrill Lynch analyst Shebly Seyrafi said he believes other companies are likely to follow suit. "Major OEM customers such as EMC ( EMC) and IBM ( IBM) appear to be having a seasonally strong quarter, while we believe that Hewlett-Packard's ( HPQ) storage and servers business has stabilized," he wrote in a note to clients.

Although their business is somewhat different, it's worth noting that the three major hard-drive vendors, Seagate ( STX), Maxtor ( MXO) and Western Digital ( WDC), raised guidance during the quarter.

Keep in mind, however, the fourth quarter is the year's strongest for enterprise storage, as well as most other tech sectors, while the first quarter is the weakest.

Seyrafi noted that stocks related to enterprise storage ran up 25% in December, while hard-drive makers appreciated by 21%. December earnings results should be good, but for now, he said, "the majority of the gains in share price are behind us."

Tape storage vendors have to worry about more than seasonality. They are under increasing pressure from newer technologies. StorageTek ( STK), for example, is being pushed to cut costs as its market erodes, but because it has good cash flow it has performed well on Wall Street, said Kaushik Roy, of the Susquehanna Financial Group. However, he noted, "the slowing pace of business bodes for a stock correction."

Broomfield, Colo.-based McData is hardly in need of another stock correction. It took a huge hit to its stock price in the first half of 2004, and despite a strong recovery still finished the year off 37%. One big reason: inexorable pricing pressure. The market for McData's major product -- switches used in network storage -- is limited to a handful of manufacturers, including IBM, EMC, Sun Microsystems ( SUNW) and Hitachi ( HIT); but Brocade ( BRCD), Cisco Systems ( CSCO) and a smaller player or two compete to sell them.

"The geometry of the business is terrible," said Punk Ziegel analyst Steve Berg. (His company does not have a banking relationship with McData.)

Last month, Berg published a scathing note on McData, which urged the company to make a major acquisition or put itself on the block. Since then, said Berg, no major buyers or sellers have emerged. Would management consider a takeover offer? "I'm convinced that management is sincerely concerned about shareholders and will do what's best for them," he said. For now, Berg thinks the stock is likely range-bound, and he doesn't see any immediate catalyst to change that, although he does believe the company will achieve its fourth-quarter targets.

Still, talk continues on Wall Street that the company needs to make an M&A move. At an investment conference hosted by RBC Capital Markets last week, a poll of 300 institutional investors and executives found that Brocade and McData were the most likely acquisition targets in the sector and Cisco and EMC were the most likely acquirers. Another possibility: a Brocade/McData merger, or even a purchase of one of them by Cisco.

Cisco jumped into the storage networking business in 2003, competing directly against McData and Brocade. The move garnered a good deal of attention, but after nearly eight quarters in the business, Cisco has little to show for its efforts. As of November, its share of the switch business was just 13.6% of the market, according to Berg's estimates.

But Cisco's presence does serve to drive prices down. After all, said one analyst familiar with the networking giant's efforts, "storage is a rounding error for them. They can afford to seed the market by selling very cheaply," he said.

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