By Megan Graham-Hackett The server market continues to post solid growth, but we at Standard & Poor's believe the sales mix and competitive dynamics present challenges as vendors duke it out.
In the second quarter of 2005, server revenues grew 5.6%, according to technology market research firm IDC in Framingham, Mass. This level was in line with our expectations, and while unit-shipment growth remains in the double digits, at 10.9%, it was the lowest in more than two years.
UNIX FACTOR. The past several years has seen a steady shift toward volume servers (more of an entry-level product) and away from midrange and higher-end machines. The high level of demand for volume servers, which rose 10% and 18% in terms of sales in 2003 and 2004, respectively, came from small- to midsize businesses that boosted spending on tech equipment, as well as from large corporations that needed to add incremental capacity to existing computing infrastructures in an attempt to better control spending, in our opinion.
The industry, however, is now facing tougher year-over-year comparisons for this category, and the demand pendulum is swinging back toward midrange and high-end Unix servers.
Overall, high-end enterprise servers posted a 3% decline in second-quarter revenues, based on IDC data, reflecting, we believe, difficult comparisons on year-ago strength in IBM's (IBM
; recent price: $80) mainframe computers.
BLADE'S SWIPE. Nonetheless, certain higher-end server categories are now staging something of a recovery. In the second quarter of 2005, high-end Unix server revenues grew 19.2%, while midrange servers posted 15.6% growth. In contrast, volume Unix servers fell 19%, according to IDC data.
IBM led the Unix category with a 31% share, while Hewlett-Packard (HPQ
; $28) and Sun Microsystems (SUNW
; $4), which have consistently battled it out in this area over the past several years, posted shares of 30% and 29.5%, respectively, according to IDC.
On the other end of the spectrum, the server-blade market continues to post impressive growth rates, with revenues up 87.9% and unit shipments up 67.1%, based on IDC data. (A blade is basically a server module rack-mounted or stacked in a cabinet -- the chassis provides the power supply. Each blade has its own CPU, memory, and hard disk.) Still, this category accounts for only about 3.6% of quarterly server-market revenue.
Overall, IBM continues to capture the top spot in servers, but Dell's (DELL
; $34) revenue-growth pace amounts to double that of the nearest competitor.
HP'S TRACTION. IBM maintained its position as the leader in overall server-market revenues in the second quarter of 2005, according to IDC, but revenue growth of 4.1% was below that of the industry, and its market share declined about 50 basis points, to 31.9%. Still, this level is nearly 350 basis points above the next largest competitor, and we believe the marginal year-over-year share loss reflects difficult comparisons, as IBM benefited a year earlier from strong demand for its new mainframe.
HP posted solid revenue growth of 11.5% in its July quarter, but we believe that, in contrast to IBM, this growth reflected relatively easy comparisons. Still, HP, which reported earnings in August, showed better traction than we were expecting with Itanium-based servers (based on the Intel INTC
chip, which HP co-developed). HP remains in the No. 2 position but posted a market-share gain of 150 basis points, to 28.5%, according to IDC.
While the server product mix seems to be shifting toward Sun's traditional sweet spot, its June-quarter revenues declined 5.3% year-over-year. The recent introduction of Sun's Galaxy server line of Opteron-based 64-bit servers is its latest attempt to win back an eroding customer base and expand into new accounts, as it capitalizes on the continued drive toward smaller, faster, cheaper servers that promise less heat dissipation than comparable ones.
WINDOWS STRONG. Dell's share rose 140 basis points to 10.5%, behind Sun, although these vendors have been in a dead heat for the No. 3 spot in recent quarters. Dell's 22.3% revenue growth in servers looked impressive, in our opinion, given the industry's product-mix shift away from volume servers.
In terms of unit server shipments, Dell posted 25% growth from the second quarter of 2004, while HP's shipments rose 6.4%. We believe Dell's performance reflects the strength in Windows-based servers (a market that grew 14.3% on a revenue basis). Dell announced this month that it would no longer make Itanium-based servers, but we understand this was not a material percentage of its server sales.
Among the various types, Windows-based servers now account for about one-third of quarterly server revenue, at $4.1 billion, according to data from IDC. This compares with Unix's $4.3 billion in quarterly revenue. While Windows-based server units rose 10.9%, and revenues grew 14.3% year over year, reflecting a more favorable mix shift to mid- and high-end systems.
QUADRUPLE THE MARKET. Linux server revenue continues to grow at a rapid pace and has accelerated recently. With second-quarter revenues increasing 45%, to $1.4 billion, Linux servers now represent nearly 12% of the overall market, based on revenues. While IBM has made much about promoting its Linux lineup, HP has maintained its No. 1 market-share position in Linux servers at 24.3%, ahead of IBM's 20.3%.
Our top pick among computer-hardware stocks remains Dell, which we rank as a strong buy. We would have liked to have seen a better performance from Dell in the blade area -- its new offering may take time to catch on. And it doesn't have an Opteron -- AMD's (AMD) chip for the x86-64-bit server market -- server, which some industry watchers perceive as a competitive disadvantage.
Still, Dell continues to take market share, and its server revenue growth was four times higher than the market's in the second quarter.
RELEVANT RISKS. We believe the cost consciousness on the part of IT customers will continue. And based on Dell's competitive cost structure (we view it as the low-cost provider in the computer-hardware industry), we believe the company should benefit from this trend and continue to outpace the market as it gains share.
Based on our discounted cash flow (DCF) and price-to-sales analyses, we have a 12-month target price of $49 for Dell. Our DCF model assumptions include a free cash-flow growth estimate of 11% over the next 15 years and a weighted average cost of capital of 12%.
Risks in regard to our target price for Dell include failure to capture emerging growth opportunities overseas and in services and printing, a slowdown in technology spending, and any sudden market-share losses in servers and PCs.
We have hold opinions on the other leading server vendors -- HP, IBM, and Sun -- which means we expect the stocks to perform in line with the broader market. In our view, Dell is showing faster growth in the server market, and its shares look more attractive than the rest.
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.
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.
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.
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.
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Analyst Graham-Hackett follows computer hardware stocks for Standard & Poor's Equity Research