After Buying Spree, McData McDrops

Although industry analysts say McData Corp.'s (Nasdaq: MCDTA) cash deals for Nishan Systems Inc. and Sanera Systems Inc. will give it the broadest storage networking lineup in the market, Wall Street was put off by McData's weaker-than-expected outlook and the dilutive effect of the deals (see McData Sweeps Up Nishan, Sanera).

McData's stock fell 17.9 percent today, closing at $10.40, amid a broader decline for technology issues.

The company reported $107 million in sales and net income of $9.1 million, or $0.08 per share, for the quarter ending July 31. It forecast revenue for the current quarter to be between $105 million and $110 million -- below the $113 million analyst consensus estimate -- with earnings of $0.05 to $0.07 per share, excluding the effect of the Nishan and Sanera acquisitions.

In sum, near-term competitive concerns trumped the anticipated long-term benefits of McData's acquisitions of Nishan and Sanera.

Analysts said Cisco Systems Inc. (Nasdaq: CSCO) in the most recent quarter appeared to be making inroads at the high end against McData (see Cisco Misses SAN Sales Target). In the fabric switch segment, meanwhile, McData's revenues were up 32 percent sequentially, indicating that it's continuing to gain share against Brocade Communications Systems Inc. (Nasdaq: BRCD), although analysts cautioned that competition was increasing for McData here, too."The acquisitions of Sanera and Nishan definitely remove [McData's] competitive disadvantage," says Kaushik Roy, an analyst with Susquehanna International Group. "But the guidance was flat... and director revenues were down 5 percent from the previous quarter. It seems like Cisco is showing up at the director level."

Others noted that McData won't see payback from the acquisitions right away. "We believe the acquisition of Nishan does offer the company the ability to drive some incremental opportunities into the SAN extension and iSCSI markets," writes RBC Capital Markets analyst Robert Montague in a note today. However, Sanera does not -- indeed, it has not landed any paying customers for its DS10000 switch.

Those factors led RBC to lower its fiscal 2003 EPS estimate to $0.23 on revenue of $431.7 million, down from EPS of $0.28 on revenue of $440.3 million. The firm lowered its fiscal 2004 EPS estimate to $0.22 on revenue of $493.4 million, down from EPS of $0.36 on revenue of $490.7 million.

All the same, analysts say McData managed to score some sweet deals for IP storage networking pioneer Nishan, which it picked up for $83 million, and high-scale SAN switch startup Sanera, which it bought for $102 million. "It's a great strategic move for McData," says Nancy Marrone of Enterprise Storage Group Inc. "They now have the broadest portfolio of storage networking switches on the market."

McData's payout for Nishan was around 15 percent less than the $100 million that had been poured into Nishan since it was founded in 1998, and it bought Sanera for $102 million, about as much as its VCs had invested in it. McData is paying cash for the startups, and even after the two acquisitions close -- expected in 30 to 45 days -- it will still have around $300 million in cash on hand.Peter Dougherty, McData's VP of business development and strategic alliances, says the acquisitions of Sanera, based in Sunnyvale, Calif., and Nishan, based in San Jose, will give the Broomfield, Colo.-based switch company a strong foothold in Silicon Valley, where its two primary competitors are based. "This gives McData a whole new set of DNA and growth sets," he says.

How was McData able to negotiate a price for Nishan that was less than the VCs put into it (or "below preference" in industry lingo)? "It's market pricing," says Dougherty. "The Nishan team was very, very excited at the opportunity to link up with McData... These guys have been slogging it out for four years... now they really have a chance to have an effect."

Maury Domengeaux, managing director of QTV Capital -- which was a Nishan investor -- says that overall, he's pleased with the McData deal. "Although everyone hoped for a greater return... liquidity is better than a loss, which is all too common these days," he says. "Second, it proves we picked a team that was able to produce value."

What's Next

McData said it plans to incorporate employees of Nishan and Sanera -- each of which has about 100 staffers -- into its San Jose, Calif., offices. McData's headcount is roughly 950, meaning the company will end up with around 1,150. McData officials declined to comment on how many Nishan or Sanera employees may be laid off, saying it was too early in the process to determine that."We are going to take a very Cisco-like approach here and do a very quick integration of these companies," Dougherty says. "We're convinced that these organizations can add value to McData almost immediately."

McData's plans for Nishan are to continue selling its FC-to-IP switch through OEMs, and eventually evolve the Nishan technology into an IP services blade for its director-class switches as well as drive it down into lower-end iSCSI devices. The main obstacle facing Nishan, which has had a quarterly run rate of $3 million to $5 million, was that many customers were unwilling to bet a key piece of their infrastructure on a startup, according to Dougherty.

"Customers don't want to buy an orphaned product from a startup company," he says. "You have a company such as Nishan with excellent technology, but if you're a Global 1000, you are going to be reluctant to buy product from them."

As for the Sanera switch, which provides up to 256 multiprotocol ports in a single chassis, McData expects to bring out a "McData-hardened" version in the second quarter of 2004, positioned above its existing Intrepid line, which tops out at 140 ports. McData expects to add such features as Ficon support, improved error reporting, and device discovery.

A third part of McData's next-generation product strategy involves licensing storage processor technology from startup Aarohi Communications Inc. McData plans to incorporate Aarohi's ASICs across its product families to provide intelligent storage services, mirroring the virtualization strategies of Brocade and Cisco. McData also said it has invested $6 million in Aarohi, giving McData approximately 15 percent ownership in the company."What it means to a customer is that they get end-to-end, seamless multiprotocol and intelligent fabrics," Dougherty says. "Our competitors have done a kludgy job here."

But competitors sniff that McData's move today was more or less pulling together a hodgepodge of disparate pieces, and they question whether the company will be able to effectively integrate them together. Brocade, for one, says its own acquisition of Rhapsody Networks provides the same kinds of intelligence and multiprotocol capabilities that McData hopes to obtain via Nishan and Sanera and its OEM deal with Aarohi (see Brocade Reupholsters Rhapsody and Brocade Scoops Up Rhapsody).

"There was not a panic attack in the building today," says Derek Granath, Brocade's director of product marketing.

McData, though, is convinced it has put together the best lineup of technologies for the next generation of its products. "It's taken a while, but I think we've pulled off a triple play," Dougherty says. "You can slight us for taking a while for rolling this out, but I think we have an extremely strong story."

Todd Spangler, US Editor, Byte and Switch