Can McData Play With a Lead?

By all accounts, McData Corp. (Nasdaq: MCDT) is head and shoulders above its competitors in the market for enterprise-class storage area networking directors. But can the company keep its lead as competition increases and the sales environment gets tougher?

That question has Wall Street analysts standing on the sidelines, waiting to see if EMC Corp. (NYSE: EMC) spinoff McData can indeed play with a lead. Though most analysts covering the stock laud the company's technical and sales connections, their lukewarm Buy or Hold ratings indicate a lack of momentum for McData's business, which they say may not pick up anytime soon.

Andrea Grosz, vice president for equity research at First Union Securities, calls McData "the clear leader" in the market for high-end directors used in SAN implementations, and says the company's long-term outlook is good. But short-term market conditions, as well as expected increased competion from players like Brocade Communications Systems Inc. (Nasdaq: BRCD), has Grosz rating McData's stock as Market Perform, a call echoed by several of her Wall Street peers.

"Like all storage companies, McData's biggest challenge right now is the macro environment for IT spending," says Grosz. "They have a great market position and a great partner in EMC." McData also has OEM deals with IBM Corp. (NYSE: IBM) and Hewlett-Packard Co. (NYSE: HWP), and is expected to add Compaq Computer Corp. (NYSE: CPQ) to the list later this fall.

But the general slowdown in IT spending, along with some concerns about McData's internal margin performance has Grosz "cautious" about the stock's short-term prospects.Founded in 1982 as a provider of mainframe data networking products, the Broomfield, Colo.-based McData was purchased by EMC in 1995. Last August, EMC spun McData out in a successful IPO that skyrocketed to an all-time high of $141.38 per share by September. But McData's stock value declined along with the rest of the market and was last near $40 per share on May 28. Since sliding to near $20 in June, the stock has not moved much.

In its most recent quarterly report (July 18), McData missed analyst expectations by a penny, posting earnings of 4 cents per share on $81.3 million in revenue for the period ending June 30. The company also lowered its Q3 expected revenue target, to $82-$86 million for the period ending in September, a figure in line with most analysts' projections.

One of the burdens on earnings is McData's inability to keep internal costs in line. Almost every analyst covering the company has expressed dismay at McData's continued gross margin decline, which the company says is partly due to higher manufacturing costs, especially for its new 64-port director, the ED-6064, introduced this past spring.

"We've launched four new products in the last four quarters," says Brandon Hoff, senior marketing analyst for McData. While keeping the new products available has been a cost challenge, Hoff says McData expects to have its internal cost controls "fully in line" by the end of the year.

Most analysts praise McData's release of the ED-6064, a 64-port edge-to-enterprise Fiber Channel director -- i.e., a high-end, high-capacity Fibre Channel switch with RAS features -- which is the flagship of McData's new line, and which will eventually replace its successful ED-5000 series. In a written report, A.G. Edwards analyst Shebly Seyrafi says McData has also been successful penetrating the lower-end markets with its 8-, 16- and 32-port 3000 Series fabric switches.McData's Hoff says the 3000 Series products allow McData to present a full core-to-edge suite of products, a strategy switch powerhouse Brocade is pursuing, albeit from the opposite direction. Brocade has already announced a 64-port/128-port version of its Silkworm switch product, the 12000, which will pit it directly against McData's director products when it ships later this year or early in 2002 (see Morgan Stanley Ups Brocade).

"The question is: Who's better positioned to provide the whole core-to-edge package?" says Hoff, comparing McData's top-down approach to Brocade's department-up direction. "We'll let the market decide."

On the OEM front, analysts see both good and bad in McData's close relationship with its former parent, EMC. While it's never bad to be a strong partner with the storage market king, McData is also reliant on EMC for nearly 70 percent of its revenues, a factor that becomes a concern when EMC's business declines (see EMC Hammered).

"I'd like to see McData diversify, and add additional OEMs," says First Union's Grosz. Like other analysts, Grosz expects McData to name Compaq as an OEM sometime this fall.

- Paul Kapustka, Editor at Large, Light Reading
http://www.lightreading.com