Why We Like Storage-Management Software Stocks

We recently attended the Storage and Network World conference in Orlando and had the opportunity to talk with panelists, vendors, and IT managers. Those discussions confirmed our beliefs about a number of trends. Most important: Due to the increasing complexity of enterprise networks, firms that are developing storage-management software products are likely to outperform those focusing exclusively on making hardware components such as disk drives.

First, a little background. Firms that specialize in software-management services are enhancing hardware components to solve some thorny challenges. Among the headaches facing IT managers: explosive data-volume growth, data security, confounding regulatory archival requirements, and the implementation of disaster-recovery strategies. Making data management even trickier are the fragmented and snap-on storage systems built through business acquisitions or hasty decision processes. Disparate servers have trouble communicating with each other, making it difficult to efficiently use storage capacity or transfer data throughout a network.

 EMC  is one firm that has made changes to its product offerings to solve customer pains caused by patchy storage networks. EMC focuses on building software on top of its hardware solutions to augment storage-capacity utilization. By managing how and where data is stored on a network, the software improves the data-management capabilities of complex and incongruent systems. Another firm benefiting is  Symantec (SYMC). Software designed by firms like Symantec is used to automatically archive data.

Despite burgeoning growth opportunities from increasing data storage demand, we believe that data hardware component manufacturers will continue to operate in an unforgiving industry. To win customers, manufacturers invest heavily in R&D to produce innovative enterprise hardware. Some firms, such as  Seagate Technology (STX) or  Xyratex  (XRT)X, are able to outperform peers thanks to topnotch R&D capabilities and low-cost manufacturing processes. However, every day is hunting season in the technology-hardware industry, and technology advantages are quickly poached away. This forces firms to compete on price, making it difficult to guarantee returns from R&D investments. Without a low-cost manufacturing advantage over rivals, it will be difficult to earn consistently high returns on invested capital.

In summary, we believe that firms developing storage-management software that reduces complexity and improves security will thrive in the storage industry. Because hardware manufacturers are price-takers and face continuous product-development costs, it is difficult to earn consistent returns in the long run.

The two stocks that we believe will win from increased use of software solutions are:

 EMC
Rating: 5 Stars
Moat: Narrow
EMC has successfully evolved from a company providing leading-edge storage "islands" to a full-service company helping customers expand their storage capabilities. Early on, EMC recognized customers' need for intelligent software to solve the complexities of growing storage networks and regulatory changes. Today more than 50% of the company's revenue comes from software and services, compared with less than 30% a few years ago.

 Symantec 
Rating: 4 Stars
Moat: Narrow
Symantec provides security software to protect consumer and enterprise customers from viruses, spyware, and other malicious software designed to steal information or interrupt business. Symantec's Norton brand defines desktop security for enterprises scrambling to protect themselves from sophisticated attacks. Storage software, added through a merger with Veritas, represents further opportunity for Symantec.

In the more competitive hardware-component sector, we'd keep an eye on these firms:

 Seagate 
Rating: 3 Stars
Moat: None
Seagate's product technology prowess and acquisition of competitor Maxtor should help it retain its leading position in the disk-drive industry. Seagate constantly invests in new product development as customers demand product upgrades, such as higher storage capacity, faster seek times, and smaller sizes. Its vertically integrated manufacturing process allows it to produce disk drives at a lower cost than peers.

 Xyratex
Rating: 4 Stars
Moat: None
Xyratex builds innovative storage systems used to link old and new storage systems. As firms work to consolidate existing storage networks, Xyratex should enjoy robust growth. Xyratex also provides production and test equipment to drive manufacturers. As drive technology progresses, the time to test each drive increases, and as unit volumes increase, drive manufacturers will need to purchase more equipment to keep pace with demand.