Bear Stearns recommends three of five storage network converts for hedgers

By Ronda Fears

Nashville, April 21 - While storage networking has suffered from the cutbacks in information technology spending, Bear Stearns & Co. convertible analysts said in a report Monday that there are a few attractive opportunities - for hedged investors only, however.

"Besides challenging demand environment, the group faces intensifying competition owing to overlapping product lines, narrow product differentiation and new entrants into the space," said analysts Rao Aisola, Sarah Gallagher and Matthew Hempel in the report.

"That being said, the sector still has some of the more attractive profit and growth opportunity profile within the technology universe."

Yet, they noted, "With valuations at existing levels and the potential for price wars eroding margins, we are unable to recommend the group for outright investors. However, we do believe that selective relative value opportunities exist in this space for arbitrage investors."

Considered were the convertibles of Adaptec Corp., Brocade Communications Systems Inc., Computer Network Technology Corp., Emulex Corp. and McData Corp.

The analysts are recommending the Adaptec 3%, Brocade 2% and Computer Network Technology 3% convertibles for arbitrage investors, citing relatively strong credit profiles, potential for credit improvement and potential consolidation within the group.

Adaptec

The Bear Stearns analysts recommend swap investors avoid the 4.75% due 2004 and buy the 3% due 2007 on a 60% hedge. They note that Andy Neff, Bear Stearns data storage equity analyst, has a "peer perform" rating on the equity.

In the most recently reported quarter, fiscal third quarter, Adaptec reported earnings per share of 3c versus 8c a year before, on a 3% gain in revenues to $109 million. Neff said Adaptec remains well positioned and while it continues to have a strong balance sheet with nearly $370 million in net cash there are few near-term earnings or valuation catalysts.

Adaptec maintains an adequate credit profile to continue to ride out continued weak overall IT spending. With $725 million in cash against long-term debt of $333 million, the company is net cash positive and the long-term debt to equity ratio is a modest 55%. The next obligation will be the maturity of the 4.75% convertible ($202 million on Feb. 1, 2004), which can easily be paid down with cash balance on hand, barring any future acquisitions.

The 4.75% convert does not offer compelling valuation, the convertible analysts said, adding that "given our bearish to neutral stance on the common, we have reevaluated the risk/reward parameters of holding below investment grade rated bonds to maturity."

The better trade, they said, is to swap out of the 4.75s into the 3s on a 60% hedge, as "this strategy eliminates any risk of yield curve inversion on the near term maturity by rolling over into a security which is more easily hedged."

Adaptec 4.75% convertible due 2004

Price:	100.75%
Common price:	$6.48
Conversion price:	$38.09
Conversion premium:	527%
Current yield:	4.73%
Delta:	0%
Yield to maturity:	4.09%
100 day volatility:	69%
Call date:	Current
Call price:	100.68
Spread:	275 bps
Adaptec 3% convertible due 2007
Price:	88.25
Common price:	$6.48
Conversion price:	$15.312
Conversion premium:	122%
Current yield:	3.40%
Delta:	60%
Yield to maturity:	6.39%
100 day volatility:	69%
Call date:	March 9, 2005
Call price:	100.2
Spread:	580 bps
Brocade
	The Bear Stearns analysts recommend arbitrage investors buy the 2% due 2007 on a light hedge.
	Neff rates Brocade common shares as an "underperform" and said in a recent report there are two big question marks for the equity going forward - intensifying competition and lack of meaningful near-term catalysts.
	Competition in this sector has been well documented, Neff noted, as McData succeeded in the most recent quarter in taking around 5% market share away from Brocade and Cisco Systems Inc. is likely to start reporting contract wins over the next quarters. That said, he noted that Brocade still maintains a solid lead in the fiber channel switch market, with a 55% market share while McData currently comprises the bulk of the rest of the market.
	"The well documented entrance of Cisco into the market and the declining market share figures have led the brutal sell off in the stock over the past few months, destroying more than half of the company's market cap," Neff said.
	Brocade boasts a strong balance sheet, with almost $900 million in cash while the $350 million in convertible bonds is the only debt.
	Even with all the negative headlines for the company over the last six months, it still managed to generate $99 million in operating income over the past four quarters, the convertible analysts noted. Long-term debt to capital stands at 44.5%. Against a backdrop of economic slowdown, the analysts said "Brocade exhibited excellent operational discipline and its balance sheet has strengthened."
	The Brocade convertible has been "an arbitrageur's dream" over the past six months, the analysts said, as the credit has tightened by 15 points while the stock sold off by more than 50%.
	"We think the bond still has upside with a YTM of 9% and current yield of 2.56%, but the stock has modest downside in our opinion," the analysts said. "We would recommend a small hedge to (10-20%) to capture some volatility, while benefiting from a solid, cash generating credit."
Brocade 2% convertible due 2007
Price:	79.75%
Common price:	$5.42
Conversion price:	$43.75
Conversion premium:	545%
Current yield:	2.51%
Delta:	20%
Yield to maturity:	8.51%
100 day volatility:	78%
Call date:	Jan. 5, 2005
Call price:	100.8
Spread:	700 bps
Computer Network Technology
	The Bear Stearns analysts recommend arbitrage investors buy the 3% due 2007 on a lighter hedge of 50% versus the market hedge of 60%.
	Neff recently downgraded Computer Network Technology shares from an "outperform" to a "peer perform" rating, due to "near-term risks in integrating the Inrange acquisition, weak competitive position for Inrange's director switch in an increasingly competitive market, a weaker balance sheet and less compelling valuation."
	The company's credit statistics changed in light of the $190 million cash acquisition of InRange, the convertible analysts said, which effectively reduces the pro forma cash balance from $210 million to an estimated $50-$60 million. They also noted the company has struggled to generate meaningful positive free cash flow over the past few years, so the company's recent stated goal of cost savings in the next year of $10-$15 million from the acquisition, as well as being accretive by the end of the year, would be a credit positive.
	The convertible has dropped between 8-10 points as stock has lost around 30% since news of the acquisition last week. The loss of the cash cushion surprised some investors, the analysts said, but added that the market's reaction may be overstated.
	"At a lunch with management, the CFO stated they see the minimum cash amount they will maintain to be $45 million before they start generating cash again late this year/early next year," the analysts said.
	"The challenges and increased competition in the switch and fiber channel marketplace are well documented, but if the company hits its stated moderate goals for the pro forma company, these bonds offer an attractive risk/reward profile with a yield pick up of 4% and 11%+ YTM."
CNT 3% convertible due 2007
Price:	75
Common price:	$5.66
Converson price:	19.166
Conversion premium:	150%
Current yield:	4.00%
Delta:	60%
Yield to maturity:	11.21%
100 day volatility:	68%
Call date:	Current
Call price:	100
Spread:	700 bps
Emulex
	The Bear Stearns analysts recommend arbitrage investors buy the 1.75% convertible due 2007 on the market hedge of 70%.
	The common stock has shown patches of marked price volatility, while the company continues to post rising margins and stable pricing, the convertible analysts said, noting that Bear Stearns' equity research group does not currently cover Emulex. Based on 2003 earnings per share estimate and the current stock price, the price to earnings ratio is 24x, they said, which may seem high a few years removed from the glory days of the late 1990's but could prove to be conservative based on company's growth rate and other competitive advantages.
	The convertible is the only debt on the balance sheet and an issue the company has been buying back, reducing total face amount outstanding to $209 million from $345 million, the analysts said. The company has $556 million in cash and equivalents and last 12 months operating cash flows of $80 million. Debt to last 12 months EBITDA is 1.96x and last 12 months interest expense to EBITDA is a hefty 18x.
	The credit is solid and company has a track record of prudent balance sheet management, the analysts said.
	The convertible has had a nice run over the past few weeks, moving from the low 80s to the low 90s along with the common, the analysts said. Although the bonds are "busted" with a conversion premium of over 100%, they do trade on a 70% delta and offer a 4.75% yield to maturity and a positive carry combined with a very modest equity sensitivity.
Emulex 1.75% convertible due 2007
Price:	90
Common price:	$23.04
Conversion price:	$53.83
Conversion premium:	114%
Current yield:	1.92%
Delta:	70%
Yield to maturity:	4.75%
100 day volatility:	78%
Call date:	Feb. 5, 2005
Call price:	100.4
Spread:	300 bps
McData
	The Bear Stearns analysts recommend arbitrage investors sell or avoid the 2.25% due 2010.
	While the credit is improving, the convertible analysts said they see a few issues that cloud the rosy outlook the company is projecting.
	McData held an investors day a few weeks ago in which it said it expects to be at the high end of its previously targeted $92-$97 million revenue range with earnings of between 2c-4c per share, which would be a 8-12% decline from last quarter. The company also targets more than $1 billion in revenue in three to four years and reaching a gross margin level in the mid 50% area.
	Bear Stearns' equity research group does not currently cover McData, but the convertible analysts said the Bloomberg analysts' consensus forecasts EPS of 19c for 2003 and 32c for 2004.
	The recent convertible deal is the only debt for the company, compared to cash of $400 million, and the company has turned the corner on profitability and is projected to be a cash generator going forward.
	The analysts, however, questioned whether McData can compete in this extremely competitive market without an acquisition and whether there would be a hit to the credit in the event of an acquisition. There's also the matter of customer concentration, they said, as just two customers accounted for 79% of revenues in 2002.
	Given a lackluster credit profile, the analysts said the convertible is unattractive at current levels.
McData 2.25% convertible due 2010
Price:	121
Common price:	$9.79
Conversion price:	$10.707
Conversion premium:	35%
Current yield:	1.86%
Delta:	85%
Yield to maturity:	-0.74%
100 day volatility:	69%
Spread:	500 bps

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