Emulex: A Cash Stash from Data Storage


By Richard Stice, CFA Our outlook for the computer storage and peripherals group is positive as we see a number of favorable catalysts, including the onslaught of newly created data, the proliferation of consumer-electronics products, and more onerous regulatory requirements pertaining to information archiving.

While we view these characteristics as compelling, however, this group's performance has been lackluster so far this year. Year to date through Aug. 12, the S&P Computer Storage & Peripherals Index declined 11.4%, compared with a gain of 1.5% for the S&P 500 Index. We believe part of the 2005 shortfall may have resulted from investor profit-taking, as this basket of stocks handily beat the S&P 500 in each of the previous two years.

HEFTY MARKET SHARE. One of the key trends within data storage has been the build-out of network-based architectures. In the past, storing data was confined to a company's primary server. Over the years, this type of configuration became problematic as the amount of information began to swell. This not only slowed down the overall performance of the network but also prevented access to critical data elements in cases when an overloaded server went down.

The evolution to network-based technology eliminates both of these problems by removing data processing from a company's primary server. This type of design has become the preferred method in the marketplace and, according to research firm IDC, now accounts for about two-thirds of all installation environments. Moreover, IDC projects that by 2009 this technology will represent nearly 90% of the market.

We view Emulex (ELX

; ranked buy; recent price: $19) as a major beneficiary of this development. The company makes components used in the creation of networked storage arrangements, including host bus adapters (HBAs) and embedded storage switches. Within the HBA market, the company is one of two principal suppliers and boasts a market share in excess of 40%.

PACIFIC-RIM BONANZA. Emulex recently reported quarterly and annual results for its 2005 fiscal year (ended June) that we think support our contention of favorable growth prospects for this technology and the data-storage industry as a whole.

For the June quarter, Emulex generated a record revenue total of $108.2 million, along with record unit shipments of HBAs and switches. Growth was broad-based along geographic lines, with all major regions exhibiting double-digit percentage increases, including a rise of more than 100% in the Pacific Rim. We were also encouraged by the steady gross-margin performance, which came in above the 60% level for the 12th-consecutive quarter.

We believe other recent developments bode well for Emulex' future growth opportunities. The first is the company's announcement in July of an original equipment manufacturing (OEM) agreement with Sun Microsystems (SUNW

; hold; $4). This pact allows Sun to brand, sell, and support Emulex's host bus adapters. We consider it a positive step toward the further diversification of Emulex' revenue base.

STRONG CAPITAL STRUCTURE. Second, the industry is in the process of shifting to 4-gigabit-per-second solutions, which will double current transmission speeds. Emulex began generating revenue from these products during its June quarter. We believe this new technology will spur additional demand, as customers can now retrieve data at a faster rate.

We're also impressed with Emulex' capital structure. The company has served as a consistent generator of free cash flow over the past year and possesses net cash and investments in excess of $3 per share. In addition, Emulex maintains a high single-digit current ratio, and its rate of days sales outstanding (DSOs) has continued to drift lower as a result of improved linearity and account collections.

For fiscal 2006, we're forecasting net revenues of $464 million, an increase of 24%, and operating earnings per share of $1.16, which corresponds to a 35% rise from the 86 cents achieved in fiscal 2005. Our fiscal 2006 Standard & Poor's Core EPS estimate is 72 cents, with the difference from our operating estimate attributable to projected stock-based compensation expense.

BUY IT. Our 12-month target price of $25 is based on an equally weighted combination of two valuation metrics. The first is a relative price-earnings measure that equates Emulex with the S&P Computer Storage & Peripherals subindustry, and the second is based on an intrinsic-value calculation utilizing discounted cash flow analysis.

Given our view of favorable industry trends, an advantageous market position, and a number of catalysts for future growth, we advise purchasing shares of Emulex.

Risks to our recommendation and target price include a slowdown in demand for storage-networking equipment, the inability to successfully manage the shift to 4-gigabit-per-second product lines, and loss of market share.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM") which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS") which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from ELX during the past 12 months.

SUNW is not a customer of S&P or its affiliates.

Disclaimers

This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results. Stice is a technology equity analyst for Standard & Poor's


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