The Day Ahead: Dissecting a sector downgrade

Commentary: Robertson Stephens analyst Dane Lewis has a weird way of saying "Happy New Year". Lewis downgraded the Internet infrastructure sector and sent the Nasdaq reeling on the first trading day of 2001. And skittish investors just made matters worse.

While folks were busy ditching shares, it would have been nice if a few people took a deep breath for a few minutes. Whenever you see one of these broad sector calls, keep in mind that not all companies are created equal. Some are more equipped to weather tough times.

Few investors thought about that fact.

Citing a significant slowdown in information technology spending, Lewis cut the ratings of 12 Internet infrastructure and security stocks. And most of these stocks plunged 15 percent or more. Here's the hit list: CacheFlow, Quest Software, EMC, Veritas, Network Appliance, Inktomi, Network Engines, NetIQ, Netegrity, Certicom, Internet Security Systems and VeriSign.

Now Lewis' IT slowdown call wasn't exactly a "Eureka!" moment -- many analysts have been singing the slowdown tune. However, Lewis said he thought that the security and storage stocks would be immune from the slowdown, but changed his mind after a few spot checks.

It's the economy...

Lewis' reasons for downgrading the sector are easy to understand -- corporate customers aren't going to bail out these infrastructure providers. With macroeconomic concerns, the dot-com massacre and slowing spending, once-immune Internet infrastructure and security stocks are likely to be affected.

"While we believe storage and security remain near the top of IT spending priorities we believe these vendors in these segments will be impacted by the first half IT spending cuts," said Lewis in a research note. "We believe falling estimates or even in-line results will translate to lower valuation multiples."

Fair enough. But investors shouldn't paint every company with Lewis' research report. Do your homework. Look at the prospects, financials, customers and SEC filings.

For some of the companies on Lewis' hit list, the IT slowdown will be a speed bump. For others, the slowdown will be a sinkhole. Will CacheFlow handle a downturn as well as Inktomi? Will EMC do better than Network Appliance? Which stock is a long-term keeper, Certicom or VeriSign?

On Veritas, Lewis lowered his first quarter revenue target to $358.4m from $368.5m and earnings estimates to 18 cents a share from 19 cents a share. For the year, revenue was cut to $1.65bn from $1.74bn with earnings falling to 81 cents a share from 85 cents a share. "We note that this is not a company-specific call," said Lewis. Translation: good company, bad market.

Lewis said slower IT spending "presents less risk" to VeriSign's top line for the next couple of quarters. He also cited VeriSign's diversified revenue streams, but indicated that deferred revenue growth could slow down. By how much? Who knows, he didn't venture a guess on the revenue hit. "We believe VeriSign is very well positioned in all the markets it plays in," he said.

Other analysts reiterated their ratings. "We firmly believe that the 'broad brush' should not paint VeriSign," said AG Edwards analyst John Puricelli, who reiterated a "buy" rating.

EMC got creamed too, but Lewis hardly said the company was going to crumble. He cut his earnings targets slightly, but said the storage vendor is in a good spot. It may be a bit early to call down EMC -- the company has kept its margins high despite fierce competition. Demand for storage isn't going anywhere either.

Security stocks were hammered as Lewis cut Internet Security Systems and a few others. Check Point Software nearly fell 20 percent on Lewis' sector call. That's pretty dramatic considering Lewis maintained Check Point's "buy" rating and basically said it would thrive. "Check Point is one of the best positioned IT vendors in light of the upcoming slowdown," said Lewis.

You'd never know it judging from the investor reaction.

And then there's the whole issue of what qualifies as the long run. Lewis stated in his company-specific research notes that a lot of the downgraded players were in good shape long-term.

In some cases, the effects of an IT slowdown may not appear until the third quarter. A lot can change in that time. Keep in mind that this IT slowdown blindsided most tech companies. Rebounds can happen just as quickly.

"While there is little argument against an overall IT spending slowdown, the extent is the primary unknown," said Puricelli.

If long-term investing is defined by six months, you should by all means bail. If long-term is three to five years, it may be a different story.

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