Network Associates (Nasdaq: NETA) dropped a bombshell on Wednesday, issuing a fourth-quarter earnings warning and a shakeup in upper-tier management. The company attributed the earnings shortfall primarily to its distribution channel, which had been overloaded with inventory and forced returns of some software. Shares were hurt badly in response, the company losing over $1 billion in market capitalization.

Network Associates' problems came about because it stuffed its distribution channels with more inventory than could be sold in a normal amount of time. In the past, the company recognized revenue once its software was purchased from distribution partners. Now, it will recognize a sale once the product is sold to the end-customer. As a result, Network Associates will be forced to wait for the inventory already booked as revenue is sold to the end-user.

Though the reasons given for the mishap were company-specific and not industry-related, investors nevertheless wondered whether anti-virus rival Symantec (Nasdaq: SYMC) could experience a similar shortfall. As a result, the company experienced some recent volatility, propelling CEO John Thompson to immediately issue reassuring remarks that the business was in good shape and its competitor's execution problems were not indicative of the entire industry. (The Motley Fool examines the network security market in Industry Focus 2001.)

In a press release, Thompson said Symantec's revenue recognition policy reflects end-user demand. In addition, he said Symantec continues to enjoy strong relationships with its channel partners and that the company was confident in its future, with the enterprise business gaining momentum and the consumer business still strong.

What are the long-term implications?
Network Associates was quick to add that the disappointing results were a one-time event and didn't reflect a change in demand. While that might be the case, the aftermath of this event could have additional effects. In Paul Larson's coverage of Network Associates' news earlier this week, he pointed out that in 1999 the company was forced to restate earnings, which spurred numerous class-action lawsuits against the company. This week's news could likely do the same.

Not only are the legal issues noteworthy, so are the business ones. Network Associates is currently top dog in the enterprise anti-virus market. Symantec has its own stranglehold on the consumer anti-virus market, but the company is attacking the enterprise segment vigorously. It has an uphill battle to steal market share from Network Associates, but has done well with enterprise revenues comprising roughly half of its total top-line.

The anti-virus market is one of the hottest segments in security software. The evolution of email and wireless has created even greater demand and businesses are unwilling to leave exposure to viruses to chance. Symantec and Network Associates are the two current leaders and the space is big enough for both companies to succeed. Motley Fool Research's Internet Report on Network Security points out that some enterprises are unwilling to leave exposure to viruses to chance and have begun employing remedies from more than one vendor. That bodes well for Symantec, as it chips away at Network Associates' market share.

Investors willing to look past Network Associates' previous problems got burned this week. The company's comeback trail will be lengthy, particularly considering potential legal risks and investors' doubts. Though the company is still the de facto standard in the enterprise market, its name has been tarnished. Given Symantec's leading position in the consumer space and Network Associates' difficulties, the door has been left open to make further gains in the enterprise game. If that's the case, Network Associates could be in deeper trouble than it's anticipating.