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Steer toward storage

After sailing through the profitable sea of personal computer and computer system stocks, investors should take note that there may be storm clouds on the horizon.

After sailing through the profitable sea of personal computer and computer system stocks, investors should take note that there may be storm clouds on the horizon. Though many may emerge unscathed, savvy investors should veer their investment ships toward the storage sector, or, in particular, systems storage markets.

After all, potentially hazardous rocks litter IT these days, especially in the PC market. Specifically new inventory models, new channel-OEM relationships, and lower prices, are all causing significant turmoil in the market.

And then there's Compaq, the largest PC vendor, which is in the midst of digesting Digital Equipment-a deal deemed the largest technology merger in history. Even recent winners, such as Dell, are setting their sights for China and Brazil to satisfy growth aspirations.

These are not normal times--even in these fast-moving, constantly-changing technology markets.

Possible repercussions from Year 2000 (Y2K) fixes are still being sorted out. Some pundits believe IT spending will screech to a standstill in the second half of 1999, while others believe that to fix the problem, significant spending will be called for well into the next century. I, however, am not overly concerned about the affects of Y2K and do not expect to see any severe spending shifts.

But I do believe these issues will not be clearly resolved until mid-1999, and given their existence, will likely burden the stock performance of many of the PC and system players.

This is a time when perception and panic may overshadow reality.

Today, investors should steer their course toward storage, where three key market attributes stand out.

The first is growth prospects. Demand for storage is accelerating, and unlikely to be severely affected by economic softness.

The second is the possibility of gaining market share. The dominant storage players still have less than a 20-percent share of the market, which gives them ample room to capture more territory.

And third is the promise of new technologies. System storage is becoming as critical an element in IT infrastructure as networking and server equipment.

My favorite picks are EMC Corporation

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which is the dominant enterprise storage supplier in the market today, and Network Appliance, which is a smaller, and faster-growing supplier of network-attached storage.

Both companies have performed well this year, and I believe they will continue to outperform the market.

The companies are trading at price-to-earnings multiples of 1999 earnings per share that are lower than their respective growth rates. EMC's growth rate is estimated at 30 percent, while Network Appliance is expected at 50 percent. And they are both experiencing healthy near-term demand. Additionally, each has developed new products and strategies to enable them to gain market share over the next 12 to 18 months.

As customers move to data-centric organizations, I believe spending on storage has nowhere to go but up.

System storage is data storage, at the server level. This makes it easy to see the reason why demand is skyrocketing. Server-based applications such as ERP, data warehousing, and data mining all require larger amounts of data, which needs to be stored on-line. The proliferation of networks that enable users to share and store files or e-mails on a server, and the Internet itself, are all driving the demand for storage capacity to growth levels of 100 percent yearly.

One note, however. While this doesn't directly translate into revenue growth as the cost of components fall, the net result is a large--and growing--market.

The system storage segment is especially intriguing, since much of the product is provided by computer vendors who sell storage compatible with their own machines. This has opened up a unique opportunity for new vendors to supply system storage that works with all computers--not just those from a single computer company. The net result is that EMC, the largest of these independent players (who doesn't supply computers), has gained tremendous market share, while computer vendors such as IBM, Sun Microsystems, and Compaq have found themselves in a disadvantaged position.

On top of this, technological innovation is allowing focused vendors to further differentiate themselves from computer system suppliers.

Take software, for example. Customers want to centralize data, move it to distributed locations, back it up, and have disaster recovery sites-all of which requires software. This software can, and is being supplied now, by systems storage vendors.

Another new application for storage technology is evident at companies that supply parts of the Internet backbone via Web caching--storing copies of frequently used web pages (more data!) near the end-user to speed performance, and lower costs involved in transmitting the data. Here again, system storage vendors like Network Appliance have combined software and storage hardware to provide a turnkey solution.

Finally, a vendor group has proposed a whole new method of supplying storage known as Storage-Area-Network or SAN. This method involves faster and more flexible connections between storage systems and servers that process the data.

Although this new method may open the market up to new entrants, existing system storage vendors, such as EMC and Network Appliance, should remain at the helm.

BT Alex. Brown maintains a net primary market in the common stock of Network Appliance, Inc. And in the past three years, BT Alex. Brown, or a predecessor, has managed or co-managed a public offering of EMC and Network Appliance. EMC and Network Appliance stocks are optionable. EMC has a convertible issues outstanding.

Rueppel is a research analyst with BT Alex Brown. This column is not a publication of BT Alex Brown, and may not represent Rueppel's complete or current opinion with respect to any company. Persons who want to make an investment decision with respect to any company mentioned by Rueppel should obtain a copy of Rueppel's current and complete opinion as contained in the most recent publication of BT Alex Brown. Rueppel's opinions are not intended as an offer or solicitation, nor as the basis for any contract for the purchase or sale of any security, loan or other instrument.