EMC Playing Hardball With McData?

Increased competition in the high-end switch market seems to be straining the cozy relationship between McData Corp. (Nasdaq: MCDTA) and EMC Corp. (NYSE: EMC).

McData on Monday after the market closed confirmed that it failed to reach agreement with EMC on terms that would allow it to fulfill all orders in time to be recognized for the third quarter. As a result, McData lowered its revenue forecast for the quarter to $93 million to $95 million, down from its previous guidance of from $107 million to $112 million (see McData Lowers Q3 Guidance). EMC owned McData from 1995 until spinning it off in 2001.

The revised forecast comes one day after RBC Capital Markets downgraded McDatas stock, to Sector Perform from Outperform. According to RBC, the director market leader appears to have conceded its high-end switch pricing to EMC between 10 percent and 15 percent. EMC accounted for 62 percent of McData’s total sales revenue in the second quarter of this year.

McData's president and CEO John Kelley said in a statement that McData expects flat to sequential third-quarter revenue growth from two of its three largest OEM partners. Still, he said his company's relationship with EMC remains strong.

"We continue to work closely with EMC and value our strong, ongoing relationship," Kelley said.In the last 18 months, both Cisco Systems Inc. (Nasdaq: CSCO) and Brocade Communications Systems Inc. (Nasdaq: BRCD) have entered the high-end switch market to challenge McData’s dominance. The RBC report cites the heightened competition as a reason for EMC’s pricing strategy.

“EMC appears willing to risk damaging the McData relationship to achieve price and strategy goals,” RBC’s report says. “Once EMC has crossed this bridge for the first time, it becomes very likely they will return to use their economic leverage again. We also must conclude that the risk of EMC moving additional share of the director business to Cisco and/or Brocade has increased. In addition, we have to assume McData will decide to shift strategy away from an indirect route to market and its dependence on EMC.”

At EMC's analyst day this August, CEO Joe Tucci openly expressed his view that SAN switch prices should drop. "The margins in the Fibre Channel switching and director space are still pretty rich," he said. "We think those can come down... That's why you heard me applaud Cisco coming into the market." (See EMC Salivates Over Software.)

The release from McData today included a statement from Tucci, saiying, "We continue to see solid end-user demand for McDATA products, and we value and remain committed to our partnership with McDATA."

The pressure Tucci talked about in August would hit McData very close to home: In the second quarter, the company had director sales of $64.3 million, representing 60 percent of its product revenue in the second quarter.Other industry observers agree that EMC and McData are becoming more independent of each other.

“When McData was the only game in town for director switches, they were joined at the hip,” says Arun Taneja, founder of the Taneja Group. “But why shouldn’t EMC be looking at more than McData now? And McData can’t be beholden to EMC if they want to be an independent company.”

Taneja says it’s a good idea for McData to reduce the percentage of revenue it generates from EMC.

“They don’t want EMC to be 80 percent of their revenue,” he says, “because if EMC hiccups, then McData is going to have a heart attack.”

McData has been making moves to leave it less reliant on EMC’s business. Today McData announced that NEC Corp.'s (Nasdaq: NIPNY) High Performance Computing division will resell its Intrepid 6000 series directors. McData also hopes its recent acquisition of IP storage switch vendor Nishan Systems will provide opportunities to expand its relationship with Dell Computer Corp. (Nasdaq: DELL).McData also recently acquired Sanera Systems and invested in Aarohi Communications

to increase its product portfolio and technology (see McData Completes Sanera Acquisition and McData Closes Nishan Acquisition).

RBC believes EMC also wanted concessions from McData on switch-based software, but expects McData to hold steady on software pricing. RBC also expects McData to broaden its software offerings through partnerships, acquisitions, and development.

McData, founded in 1982, was purchased by EMC in 1995. After putting McData through an IPO that raised $377 million in 2000, EMC spun it off in February 2001.

— Dave Raffo, Senior Editor, Byte and Switch