Markets & Finance

Why Emulex Shines in Storage Networks


By Richard Stice We at Standard & Poor's think Emulex (ELX) is poised to take advantage of the increasing demand for data storage products. The stock is the top pick in our Computer Storage & Peripherals group due to the continued expansion of network-storage architectures, its leading market-share position, and, in our view, its favorable valuation. Emulex carries S&P's highest investment recommendation of 5 STARS, or buy.

Incorporated in 1979, Emulex is a leading designer, developer, and supplier of a broad line of "host bus adapters" and application-specific computer chips that provide connectivity for storage area networks (SANs), network-attached storage (NAS), and redundant array of independent disk (RAID) storage. Host bus adapters are data-communication products that enable servers to connect to storage networks by offloading communication processing tasks as information is delivered and sent to the SAN.

Emulex products are based on internally developed application-specific chips and embedded firmware and software technology. They offer support for a wide variety of SAN protocols, configurations, system interfaces, operating systems, and applications.

BIG-NAME CUSTOMERS. Recently, the vast majority of revenues (99% in the fiscal fourth quarter of 2003, ended June), have been based on Fibre Channel technology. This was introduced in 1994 as a way of interconnecting multiple host servers and storage devices, and it became the first storage-networking technology to be widely adopted by the leading server and storage manufacturers.

Emulex' key customers include some marquee names in computer hardware: IBM (IBM), which accounted for 26% of sales in fiscal 2003, Hewlett-Packard (HPQ), with 23%, and EMC (EMC), with 22%. In addition, 40% of June-quarter 2003 revenues were international and consisted of Europe and the Pacific Rim. This is an increase from 37% in the same quarter of fiscal 2002.

In recent years, the volume of stored electronic data in enterprises has expanded significantly, due largely to the growth of data-intensive applications such as online transaction processing, data mining, data warehousing, multimedia, and Internet applications. As a result, both the capacity and number of storage devices in enterprises have increased.

HOPEFUL TREND. In the late 1990s, in response to the increasing need for storage scalability, manageability, and reliability, enterprises began to deploy SANs. These configurations transform dedicated servers and storage devices into network resources, thereby greatly improving the performance and scalability of enterprise storage. Moreover, in subsequent years, NAS appliances have gained acceptance in the storage marketplace. In the NAS architecture, data is converted from block form to files before being delivered to servers or PCs.

We believe the benefits of these two systems (SAN and NAS), which make up the broader network-storage category, have enabled them to supplant the traditional direct-attached storage systems. In the first quarter of calendar 2003, according to industry researcher International Data Corp. (IDC), network storage for the first time represented more than half (53% revenue share) of the total market for external disk-storage systems -- an increase of 5% from the previous year. We believe this trend bodes well for Emulex because it supplies key components for network-storage arrangements.

In our estimation, Emulex is poised to take advantage of the increasing demand for storage products. It's the world's leading Fibre Channel supplier of host bus adapters, achieving a revenue market share of 47% in 2002 (up from 40% in 2001 and 35% in 2000), based on IDC data. Also, on a revenue basis, Emulex garnered over 50% more than its nearest competitor. IDC projects that this total market will grow at a compound annual rate of 8.5% from 2003 to 2007, reaching approximately $880 million.

BRAINPOWER. We believe Emulex' leading market position should remain intact in the future. We think its dominant share will help offset pricing pressures. Moreover, we view the industry as having high barriers to entry, given the technological sophistication and intellectual property needed to be competitive. As of June 30, 2002, Emulex had 27 patents issued, four patents allowed, and 18 patent applications pending in the U.S. In addition, it had numerous patent applications pending abroad.

Emulex has increased its research and development spending notably in its last three fiscal years. In fiscal 2003, it spent $58.8 million on R&D, up from $45.5 million in fiscal 2002 and $26.2 million in the preceding fiscal year.

Its execution has been solid, in our opinion. Gross margins have expanded for nine consecutive quarters, reaching 64% in the June, 2003, quarter. In addition, operating margins have expanded six of the last seven quarters.

LOWERING DEBT. We consider Emulex' financial condition to be solid. Its balance sheet had cash and investments totaling $385.6 million as of June 29, 2003, or over $4 per share. Emulex has also reduced its long-term debt, which consists of 1.75% convertible subordinated notes, by almost 40% since the end of fiscal 2002. The percentage of long-term debt to total capital is below 19%.

Emulex has generated a steady amount of free cash flow, producing $45.3 million in fiscal 2001 and $81.5 million in fiscal 2002. We project further growth for fiscal 2003, with free cash flow estimated at around $90 million.

June-quarter 2003 operating earnings per share came in at 23 cents, one penny above our estimate, vs. 16 cents in the year-earlier period. (Figures for both periods are before goodwill amortization charges.) EPS under generally accepted accounting principles were 22 cents, vs. a loss per share of 14 cents. Revenues increased 16%, boosted by strength in Emulex' midrange offerings. Moreover, each of major geographic service areas experienced double-digit sales growth over the prior-year period.

WIDER MARGINS. We project that fiscal 2004 revenues will increase 21%, reflecting our view of further market-share gains, the benefits of new-product introductions, and international expansion. Also, we believe a pickup in info-tech spending is likely, particularly for storage-related products, as companies have made this a top priority.

We see gross margins at Emulex widening, as a result of higher volumes, lessening pricing pressures, and a favorable product mix, with higher-margin products representing a greater proportion of sales. Our gross-margin target is 64.4%, compared with the 62.6% reported in fiscal 2003. Interest income may decline modestly, as our expectation of stabilizing interest rates is outweighed by likely increases in capital spending. (Emulex is now building a new headquarters.) We forecast operating EPS of $1.02 for fiscal 2004, vs. 84 cents in fiscal 2003 (excluding special charges of 5 cents).

On a per-share basis, we project Standard & Poor's Core Earnings of 52 cents in fiscal 2004, after adjusting by 50 cents for stock-based compensation expense. This represents a difference of 49% from our operating EPS estimate for the year. While this percentage is above the average of Emulex' peers, we note that it's down from fiscal 2002 as well as from our estimated fiscal 2003 results.

CONSERVATIVE CALCULATION? In addition to this forecasted expense reduction, two other adjustments to the S&P Core EPS figure will be made for fiscal 2003. The first relates to a gain on the repurchase of convertible subordinated notes, and the second is a charge associated with settlements for securities class actions and derivative lawsuits.

Our valuation of Emulex shares involves two measures, p-e-to-growth (PEG) and

discounted cash-flow. Based on our calendar 2003 EPS estimate of 92 cents and an expected five-year earnings growth rate of 21%, the shares trade at a PEG of 1.1, vs. the 1.4 figure for the S&P 500-stock index. Applying the S&P 500's ratio results in a share price of $27 for Emulex. We believe our calculation could prove conservative as we view Emulex' growth prospects as being worthy of an above-market PEG rate.

We think Emulex will keep experiencing growth in free cash flow given its leading position, the market trends in data storage, and our view of a strong balance sheet. Our discounted cash-flow model assumes a

beta of 1.25, a weighted average cost of capital of 11.8%, an accelerating growth rate through the fifth year (with a peak of 21%), followed by a steady deceleration thereafter and an expected growth rate of 3% in the following years. Based on these inputs, we arrive at an intrinsic value of $27 a share for Emulex.

Combining the two valuation measures yields our 12-month target price of $27.

Some risk factors may prevent Emulex from achieving our earnings estimates and target price. In our view, they include: a prolonged downturn in IT spending; a lack of development and growth within the storage networking market; the loss of a key customer; the entry of new competitors into the marketplace; aggressive pricing and the introduction of competitive products; the inability to keep pace with technological change; and the failure to obtain additional financing. Analyst Stice follows computer storage and peripherals stocks for Standard & Poor's


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