Storage industry takes a hit

Shares in storage technology companies drop after Brocade Communications' latest earnings report sours analysts' outlook on storage stocks, leading to a round of downgrades.

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Shares in storage technology companies dropped Thursday after Brocade Communications' latest earnings report soured analysts' outlook on storage stocks, leading to a round of downgrades.

Shares of Network Appliance, EMC and others took a hit. EMC dropped $6.95 to a new 52-week low of $42.95, Network Appliance was down $2.94 to $31.38, and McData sank $3.19 to $22.13.

Brocade, recently singled out as one of the more promising stock picks in tough economic times, was down $9.75 to $34.94. It reported strong first quarter earnings of 13 cents a share on revenue of $165 million but cut its earnings and sales outlook for 2001.

According to analysts, Brocade's report shot down the last hope for the storage sector, which was supposed to be able to weather a slowdown in information technology spending. Brocade makes switches for storage area networks.

Other storage-related companies, including Emulex and Finisar, have warned of a slowdown, but many investors assumed Brocade would remain above the fray.

Predictably, Brocade's warning that sales in the second quarter would be flat sequentially didn't go over well, even though investors were expecting bad news. Brocade's stock has lost 65 percent of its value over the past four weeks.

"Despite the sell-off and our belief that the stock will outperform over the long term, we are downgrading," said Morgan Stanley analyst Christopher Stix, citing a longer-than-expected recovery period for the sector, which is unlikely to occur until late 2001.

Stix reduced his rating to "outperform" from "strong buy" and revised estimates to be more cautious than the company's guidance. Stix expects fiscal 2001 revenue will be $700 million, down from $810 million. Stix cut fiscal 2002 revenue estimates to $980 million, down from $1.21 billion. He also lowered his price target to $45 from $65.

Stix cautioned that this is only the first wave of bad news in the storage networking sector. "It is not unlikely that further negative data points will emerge in the near future," Stix wrote.

In the long run, many analysts were upbeat about Brocade. Robinson-Humphrey analyst Frank Gristina called Brocade's news a "hiccup" rather than a "heart attack" for the storage industry, and maintained his "outperform" rating.

Other analysts maintained their "buy" ratings while lowering estimates slightly, including Robertson Stephens' Ara Mizrakjian and FAC\Equities' Mark D. Kelleher.

Discussions with 15 systems integrators have led Gristina to remain confident that sales will come through in the third and fourth quarters. Only one of those companies admitted to seeing current weakness in the pipe, and the problem was deferrals, not cancellations. Gristina said this is proof that the sales cycle is just extending.

While a sell-off in storage-related names can be expected today, Gristina wrote, Brocade is a definitive bellwether for the networked storage industry.

Brocade's outlook even dinged EMC, the storage industry leader. The company beat fourth-quarter estimates and said it saw no slowdown last month, but was still downgraded by Morgan Stanley.

"While we were willing to live with some of the other storage disappointments in recent days, Brocade's announcement that its near-term visibility is down dramatically is very worrisome," Morgan Stanley analyst Gillian Munson wrote in a research note.

Munson lowered her rating on EMC to "neutral" from "outperform" but said she believes EMC will make first-quarter targets. EMC on Thursday morning cut its 2001 growth rates.

McData also took a hit Thursday. Robinson-Humphrey's Gristina downgraded the stock to "outperform" based solely on bad signs from Brocade.

Stumbling sales
"We believe that when McData reported and gave guidance in January, it did not have the benefit of seeing the extension in the storage sales cycle other companies have recently seen and adjusted for," the analyst wrote.

He added that the company will likely have to give more conservative near-term guidance, or it will be hard-pressed to meet estimates.

Network Appliance was also downgraded. The company managed to top estimates in its most recent quarter, but analysts said Brocade's warning may point to problems.

Montgomery Securities Shaw Wu downgraded Network Appliance to "market performer" from "buy."

"We are concerned with near-term visibility in the next couple of quarters, owing to the general softness of the U.S. economy and the warnings of other leading technology companies," Wu said.

While Wu did not reduce estimates, he said that "there may be some risk to our estimates stemming from the uncertain economic environment." He remained bullish on the long-term prospects for the stock, but also said that it can't recover until the economy does.