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EMC in storage showdown
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October 2, 2001: 10:32 a.m. ET
Hitachi Data Systems hurting EMC margins and going after market share.
By Beverly Goodman
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SAN FRANCISCO (redherring) - Empires always face difficult challenges. Just ask storage sovereign EMC. An unexpected insurgence in the wake of a weak economy has pitched the market leader into a price war with an unlikely competitor -- Hitachi Data Systems (HDS). Investors, long content to place their fortunes with the king, should begin to question their confidence.
EMC (EMC: down $0.02 to $11.08, Research, Estimates) has long been the leader in the enterprise data storage industry, selling hardware, software, and services. The company's flagship product, Symmetrix, was introduced in 1991 as the first disk-storage system that integrated software with large amounts of cache memory and arrays of industry-standard disk drives.
Since then, EMC's technology has remained better than that of would-be competitors like IBM (IBM: down $0.23 to $92.48, Research, Estimates) and HDS, and customers were willing to pay a premium for EMC products. Investors also seemed happy to pay a premium for the company's stock. During the '90s, EMC was second only to Dell Computer as the highest-performing stock on the S&P 500, and the shares even had a solid year in 2000, gaining 21.7 percent.
But those were the days of wine and roses; today it's the war of the roses. Tight budgets have forced IT managers to concentrate almost solely on getting the best return on their investment. It's tough to imagine any company flourishing in this environment, let alone a fledgling competitor going head-to-head with an industry giant. In early 2000, when it decided to dump its primary mainframe business and exit its losing battle with IBM, few would have expected that HDS (a wholly owned subsidiary of Hitachi (HIT: up $0.76 to $66.97, Research, Estimates) would so quickly make inroads into EMC's territory. But that's exactly what it has done.
Playing the field
HDS pushed into networked storage to undercut EMC in price and to team up with EMC's competitors to erode the giant's market share. "They flooded the market with cheaper, reliable, and interoperable systems," says Lehman Brothers analyst Scott Foster. In an effort to achieve interoperability, HDS has partnered with almost all of EMC's competitors.
On the hardware front, HDS forged something of a truce with storage systems makers IBM and Compaq Computer (CPQ: down $0.43 to $7.90, Research, Estimates) (which resells IBM's Shark storage system under its own brand), and data switch makers Brocade Communications Systems (BRCD: up $0.30 to $13.20, Research, Estimates) andMcData (MCDTA: up $0.43 to $8.29, Research, Estimates) . The companies have agreed to make their microcode available to each other. As a result, IBM's Shark product line and HDS's similar 9900 system will be able to share data and software. So will products from Compaq andHewlett-Packard (HWP: down $0.45 to $15.15, Research, Estimates) (which also resells modified versions of IBM and HDS machines under its brand name).
In August, HDS struck a deal with Sun Microsystems (SUNW: up $0.07 to $8.20, Research, Estimates) in which Sun will resell HDS's Lightning high-end storage array. That's good news, says A.G. Edwards & Sons analyst Shebly Seyrafi, as users of Sun's best-in-class Unix servers will finally have a superior alternative to Sun's midrange StorEdge T3 disk array, which lags almost the entire market in performance and features. HDS, in turn, will benefit from Sun's extensive sales force and client base. "That will make a meaningful difference," Mr. Seyrafi says. "Plus, this deal will make HDS an arms supplier to all of EMC's biggest competitors."
HDS is also expanding its software business both internally and through an escalating relationship with market leader Veritas Software (VRTS: up $1.24 to $19.55, Research, Estimates) . Of the three types of storage management -- platform, systems, and network -- HDS has proprietary technology for the first two, and Veritas excels in the third, according to Merrill Lynch analyst Hitoshi Shin. EMC also uses Veritas products, but has customized the software for its network management system. HDS, however, will continue its strategy of interoperability without customizing the software.
HDS looks for market share
In its emerging role as a pure-play storage company, HDS is doing exactly what it needs to do: focus on market share at all costs. The strategy appears to be working. In first quarter 2001 HDS posted revenue growth of 145 percent from its storage business, finishing its fiscal 2001 (ended March) with $1.6 billion in sales. Its 7.7 percent market share might seem paltry when compared to EMC's 36 percent, but it's still double the 3.9 percent share it had a year earlier.
The company has improved its position by answering the needs of increasingly cost-conscious IT managers. "IT managers are taking a much longer look, wanting longer trials, and performing greater due diligence before making any big purchases," says Christopher McHugh, senior portfolio manager for Turner Investment Partners.
Such sniper focus on cost has forced EMC to respond with changes in pricing. "EMC has put the word out to its sales force that they're not to lose a deal because of pricing," says John Rutledge, manager of the Evergreen Technology Fund. Analysts say EMC has been reducing its prices by as much as 20 percent. "Now that price has become far more important," adds Mr. McHugh, "the gross margins EMC enjoyed for a long time won't return any time soon -- if ever."
EMC's overall gross margins were 47 percent in second quarter 2001, down from 57.9 percent in second quarter 2000 and 55.1 percent in first quarter 2001. Most analysts expect gross margins to stay below 50 percent for the foreseeable future. Because HDS isn't traded separately, there's no way to know how its margins compare to EMC's, but it's clear that EMC's are shrinking as a direct result of HDS's focus on the space.
EMC doesn't deny that prices have come down, but spokeswoman Dana Buchbinder says concerns of a price war are overblown. "Our view is that price wars happen with commodity products. We offer a complete solution," she says, adding that one reason prices have been reduced is because the cost of components for storage devices is lower.
To that end, it's important to remember that attempts to overthrow the king aren't always successful. And HDS's strategy isn't surefire. Skeptics all point to the same problem: there will be little distinction between the systems sold by Sun, HP, and HDS. "There will be serious channel conflicts," says First Albany analyst Mark Kelleher. "They'll be bumping up against each other's sales people." So, customers may have a greater reason to purchase EMC's hardware since its technology is different from that of its competitors.
EMC eyes software, integration
Not content to stand still, EMC is continuing to improve its offerings. Unlike HDS, EMC's strategy has been to offer its own superior integrated system of storage products, including hardware, software, and services. EMC has been aggressively focusing on software and says it will spend the bulk of its $1 billion research-and-development budget on software development this year. But customers have few complaints about EMC's technology -- what they balk at are its prices.
One thing EMC has not done is fight HDS by expanding its partnerships. EMC had initially participated in the talks with IBM, Compaq, Brocade, and McData, but hasn't agreed to release any microcode information. "Everyone's coöperating except EMC," Lehman's Mr. Foster says. "And they're going to lose. They're losing already."
EMC shareholders certainly don't consider themselves winners. Shares of the erstwhile market darling have dropped steadily since their high of $101.66 on September 20, 2000. At its September 28 price of $11.75, the stock was 88 percent off its high, and down 82 percent year-to-date. At 56 times 2002 earnings estimates of $0.21, though, it's still not cheap. It's tough to imagine EMC's stock moving up much in the near term.
HDS, on the other hand, makes up too small a part of its parent company -- just 2.5 percent of Hitachi's $66.8 billion in sales for fiscal 2001 -- to warrant purchasing Hitachi on the basis of its storage business. Hitachi, which is undergoing a significant restructuring, traded at 32.4 times fiscal 2002 earnings estimates of $2.07 as of September 28.
Investors are left puzzling over whether either EMC or Hitachi is a suitable storage-sector play. Mr. McHugh of Turner Investment Partners opted to dump the firm's EMC shares at the end of May due to the company's shrinking margins. "We thought their software business would help the overall margins, but it's too small a part of the revenue mix," he says. "Before we'd buy again, we'd have to see their margins stabilize and see what they do with their software strategy."
But Evergreen's Mr. Rutledge, who had 3.3 percent of his fund in EMC in August and planned to increase his holdings, says that EMC's long-term prospects are promising enough to warrant holding the shares. "During tough economic times, competition gets noisier, but EMC still has a full product offering and leading-edge technology that's miles ahead of any competition," he says. "In the near term, there's no denying that EMC's earnings will come under pressure, and it does appear to be richly valued, but I'm willing to hold it."
Not surprisingly, investors have begun to wish for an IPO of HDS. The idea of a spin-off also intrigues many analysts. "Because the HDS story has legs, there's a distinct possibility it'll IPO," says Mr. Seyrafi. "The disadvantage for Hitachi would be letting go of the crown jewels. But HDS could better compete against EMC and maximize its partnerships."
In the meantime, investors should not race to the front lines of this skirmish. It's likely to get uglier still.
Write to letters@redherring.com. 
© 1997-2001 Red Herring Communications. All Rights Reserved
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