Despite recent volatility in the stock market, and the carnage of storage stocks like Network Appliance and EMC, demand for storage systems and software remains explosive. The recent bloodshed in this sector gives long-term investors an opportunity to take another look and perhaps take advantage of current market conditions.
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In July, I wrote about the investment opportunity in storage area networks (SANs). SANs are high-speed, dedicated storage networks. Along with SANs, network-attached storage (NAS) has also caught fire. NAS appliances are thin servers, optimized for storage and file-sharing duties, and plugged into a local area network. High-end models contain proprietary software that provides data protection and storage management applications. Many investors mistakenly believe that SANs and NAS are competing architectures. But, in fact, executives from leading storage companies like EMC (NYSE: EMC) and Network Appliance (Nasdaq: NTAP) have repeatedly stated that NAS and SAN are complementary rather than competitive architectures. The rationale for NAS is the same as for SANs. The popularity of the Internet as a business medium has increased the value of information exponentially. World-class businesses realize that information about customers, suppliers, and partners provides a key competitive advantage. Storage systems that provide reliability, availability, and scalability of data allow firms to harness this information and capitalize on it. In addition to the importance of information as a source of competitive advantage, richer applications have created demand for storage systems. For example, streaming video and audio require substantial storage capacity. As a result of this increased demand, the storage sector will continue to sustain its explosive growth path for many more years. Market research firm Dataquest projects that IT spending for storage will grow 22.2% compounded annually through 2004, while PC spending is estimated to grow only 5.9% during the same time period. The problem with client-server architecture The client-server architecture has other chinks in its armor as well. For example, the cost of managing the network is extraordinarily high and adding new storage capacity requires additional server downtime. In addition, scaling the network creates unused storage capacity, since it is available only through one server rather than the entire network. Finally, the client-server architecture is homogenous, which means that only one platform is used, such as Microsoft's (Nasdaq: MSFT) Windows NT. Network-attached storage is the solution First, NAS appliances can eliminate the need for general-purpose servers that handle storage duties. This frees up the servers to handle other jobs, such as email, and improves network performance by placing the storage burden on the NAS appliance. Second, unlike direct-attached storage, users on the network can access stored data without having to go through a server. Third, NAS appliances are heterogeneous, meaning that they enable connectivity with multiple operating systems -- like NT or UNIX. Finally, additional storage capacity can be added to the network without server downtime, a crucial factor. There are potential pitfalls of NAS appliances, as well. For example, because the NAS appliance is connected to the local area network, the network inhibits its performance. In addition, as more NAS appliances are added to the network, it becomes exceedingly complex, mitigating some benefits of NAS' inherent simplicity. Finally, there are different types of NAS appliances, from very basic models to more reliable, high-end models that cost more than $100,000. System reliability has its price. Software is the secret sauce Where to invest Traditional server companies have a reason to feel threatened. NAS appliances will replace many general-purpose servers and the underlying business model is more attractive. While server manufacturers are watching their margins get squeezed by commoditized hardware, storage vendors are enjoying gross margins of 50% and higher, in no small part due to proprietary software applications that add value to the storage network and appliances. Storage prices will decline by 35% or more each year, but powerful software will likely keep margins high, even as the hardware becomes a commodity. The best long-term bets are likely to be companies that focus on storage. They're apt to capture the most mind share and market share. The NAS concept was pioneered by Auspex Systems (Nasdaq: ASPX) and Network Appliance, and both companies derive a significant portion of their revenue from NAS appliances. Network Appliance is the clear leader, with trailing 12-month revenue of $843 million and year-over-year revenue growth of 109% in its most recent quarter. But, things change fast. Storage stalwart EMC is moving aggressively in the NAS space. EMC's NAS revenue grew 189% to $133 million in the third quarter, and management is determined to become the leader in the NAS space. Although storage stocks have been extremely volatile, storage is no longer an afterthought in IT infrastructure spending. It's at the top of the list. As a result, leading storage companies are likely to sustain high growth rates and profitability for many years to come. Bear markets present an opportunity for investors to consider investment in storage stocks that possess long-term growth potential and which represent companies with attractive business models. Do you Fool around?
The traditional storage model within client-server architecture is direct-attached storage, a disk array attached to a server on the network. The problem with direct-attached storage is that, if a particular server goes down, users on the network cannot access the stored data attached to it. In this age, it is crucial to have immediate and continuous access to mission-critical information.
Although approximately 92% of storage is directly attached to the server, there is a clear shift toward dedicated networks and servers that are optimized for storage, such as NAS systems. The benefits of NAS are numerous.
Companies traditionally regarded as "box" makers like EMC and Network Appliance rely on storage software applications to add value to and improve the functionality of their products. For example, EMC generates approximately 15% of its revenue from software and invests 80% of its R&D budget in software development. Network Appliance outsources its storage systems manufacturing, relying on internal software development to create a competitive advantage in the NAS space. New software applications will continue to fuel the growth of SANs and NAS, while the cost of ownership will be driven lower and performance and functionality will improve. For more information on the storage software industry, check out Industry Focus 2001, which highlights the sector in-depth, along with 16 other industries.
The market for NAS appliances is expected to grow to $6.8 billion by 2003 according to Dataquest, presenting the possibility of 85% compounded annual growth, higher than the 22% growth for the total storage sector. It's no surprise, then, that major hardware manufacturers want a piece of the NAS action.
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