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Ills In Store for Network Appliance

The company will smart from its failure to gauge the extent of the slowdown in storage-gear spending.

Network Appliance

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shares continued their slide Thursday, after the company issued a weak forecast for first-quarter sales and profit.

For Network Appliance's failure to foresee a slowdown in spending on data storage equipment, investors

punished the stock in extended trading after Wednesday's report, sending shares cascading nearly 20%.

Shares lost $5.72, or 15%, to $32.36 midday Thursday.

Though Network Appliance announced fourth-quarter results in line with expectations, the company was clearly caught off guard by what Chief Executive Dan Warmenhoven called an "air pocket that's flowing through the system."

During the quarter, he said, the sales cycle lengthened unexpectedly as customers took longer to commit to spending on new gear for their computer networks.

As a result, the backlog that Network Appliance relies on for first-quarter revenue is far below expectations, causing the company to issue revenue guidance that disappointed analysts and investors.

Network Appliance also forecast profit that widely missed analysts' targets, underscoring the extent to which management failed to anticipate the slowdown in purchases.

In the fourth quarter, Network Appliance hired 489 people, above its average of 390 for the prior three quarters of 2006.

This bloated its operating expenses and dented profits. Consequently, the company pegged first-quarter operating margins at around 12.5%, below the range of 15.8% to 16.4% that it announced to analysts in March.

"It seems they got a little ahead of themselves in hiring," said Jawahar Hingorani, an analyst with Standard and Poor's. "Sales will have to play catch-up for a while before they get profits back in line with their operating model."

Hingorani downgraded Network Appliance to a "sell" rating on May 14. He says that in a slower spending environment, IT managers may turn to Network Appliance's larger competitor,

EMC

(EMC)

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, which offers a range of products and services beyond data storage.

"IT managers can simply extend contracts with EMC rather than start new ones with Network Appliance," he said.

Shares of EMC gained 42 cents or 2.5% to $16.47 midday.

Cash flow from Network Appliance operations rose when compared with the fourth quarter last year, but was about $45 million below its potential level because the slower sales cycle lengthened the time required to collect cash from transactions.

Each day added to the billing cycle lowers cash flow by almost $9 million, said Chief Financial Officer Steve Gomo.

Management was clearly in a defensive posture during a conference call with analysts. CEO Warmenhoven stressed that Network Appliance's win rate against EMC was unchanged, and that it won a greater proportion of engagements when competing against

Hewlett-Packard

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.

H-P's shares were off 17 cents at $45.45 in midday trading.

The company reduced its first-quarter hiring plans to 200 to 250 people to cut operating expenses. Also, Warmenhoven said that increasing sales of software subscriptions can help tie the company to customers for years.

"We do not believe that the opportunity has gone away for us to sustain, essentially, the 30% range year-over-year growth rate," said Warmenhoven.

But a return to growth in line with expectations requires a turnaround in sales, which is still uncertain in the near term. A Citigroup report released on Thursday uncovered a drop from last year in the number of chief information officers planning to increase spending on storage gear.

The trend is consistent in both the U.S. and Europe, which are Network Appliance's largest markets.

Warmenhoven sees a worrisome trend. Data security, he said, has shifted from securing data within the data center, which is Network Appliance's specialty, to securing data on mobile devices such as laptops "that can walk out of the door."

The CEO did not say if or how Network Appliance would adjust to this trend should it persist.