By Amey Stone On Feb. 7, shareholders in data storage giant EMC (EMC) will get a nice gift. For every share they own, EMC plans to distribute 0.0369 shares of McDATA, a fast-growing former subsidiary that makes switches for top-of-the-line storage networks. EMC is distributing all its remaining stock in McDATA, totaling about 75% of the company. McDATA, which went public last August at $28 a share, is now around $57.
For EMC shareholders, the McDATA stock is worth holding onto. The Broomfield, (Colo.) company has posted stunning growth. Sales in 2000 climbed to $249 million from just $95 million in 1999, a 160% gain. Earnings -- yes, there are plenty -- grew to $31 million, or 28 cents a share, up from a loss of $1.6 million, or 2 cents a share, in 1999. CEO Jack McDonnell projects revenue growth of 80% in 2001, up from his earlier 40% prediction. McDATA's fourth-quarter earnings, reported Jan. 24, beat the Street's estimates, prompting many analysts to raise growth forecasts and Merrill Lynch to upgrade the stock to buy from accumulate, noting stronger-than-expected demand for its products.
But for current McDATA shareholders, the flood of new stock on the market will take some digesting. EMC will distribute 81 million McDATA shares, while only about 14 million trade now. And more are on the way. On Feb. 4, lock-up restrictions expire on about 12 million shares that were held by insiders following the IPO. McDonnell says senior management has voluntarily agreed to postpone any sales for another quarter to keep even more shares from hitting the market at the same time.
DON'T TRY AT HOME.The impending distribution is already creating extreme volatility in the share price, which frequently swings 10 points in a single day. Short-sellers are into the deal, which has created some short-squeezes -- where the stock price spikes up as short-sellers rush to cover their positions. Do not, and this is worth repeating, do not try to play this risky game.
The simple truth is that as well as McDATA is doing, many EMC shareholders are likely to sell their new stock. Some probably will simply see the new shares as a nice windfall and won't want to add another high-price data-storage stock to their portfolios. Although this category has held up well in the Nasdaq bear market, concern is building that it won't be immune to a slowdown in technology spending as the economy continues to cool. And McDATA, like other hot names in the sector, is far from cheap. At $57 a share, it's trading at about 120 times analysts' 2001 earnings estimates, vs. the S&P 500's forward price-to-earnings ratio of about 24.
Plus, many mutual funds that own EMC, including all S&P 500 index funds, will need to unload the McDATA shares because they don't fit with their investment strategy. EMC has a market cap of $175 billion, while McDATA's is $6 billion -- too small for large-cap and most index funds.
TOUGH RIVAL. McDonnell has been on the road telling major EMC shareholders the McDATA story in hopes portfolio managers will hold onto the shares or shift them to a more suitable fund if they can't maintain them in a large-cap or index fund. He's also talking to institutional investors that don't own EMC stock. McDonnell hopes they'll buy McDATA shares that come on the market. Yet even he acknowledges that with so many new shares, there's going to be some volatility.
Meantime, McDATA is facing its own risks as it expands its product line deeper into the increasingly competitive market for switches that go into storage-area networks. McDATA now has nearly 100% market share for high-end "director" class switches that go into the backbone of storage-area networks. But Brocade Communications (BRCD), which was one of the top-performing stocks last year and has shown dramatic market-share gains in its own mid-tier segment of the switch market, is launching a director-class product. And smaller switch-maker InRange Technologies (INRG) also has a competitive product on the market now.
At the same time, McDATA, has introduced switches that go head-to-head with Brocade's current products. McDonnell says that's part of the company's strategy to offer customers a suite of products that can be used throughout a company's network, not just at the backbone. He believes McDATA, which got 73% of its revenues from EMC in the recent quarter, will attract more customers -- including ones that compete with EMC -- now that it is completely spun off from its former parent. Already, McDATA has landed one major new customer that will add "significant" revenues in the first quarter, says McDonnell, and he expects another later in the year.
OPEN WINDOW? Given the battle for share that's just getting under way, Wit Soundview analyst Glen Ingalls recommends that investors interested in this hot market segment invest in Brocade, which has more customers and is a fierce competitor. "If the stocks are at similar valuations, I'd bet on the company with the larger installed base and the greater lead on the market," he says. But John Webster, an industry analyst and info-tech adviser with Illuminata in Nashua, N.H., says many IT buyers want to use multiple vendors, and McData has a top reputation.
And while McDATA is certainly pricey, the EMC share distribution could change that. Near $60 a share, McDATA is expensive, but nearer to $50 it could get attractive. Given the coming the flood of new shares, it may hit that point. Trading McDATA stock will be extremely risky over the next few weeks, but this window could prove an attractive entry point for long-term investors willing to take the plunge now. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.
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