McData Maudlin Over Price Pressure

McData Corp.'s (Nasdaq: MCDTA) latest earnings report indicates there is probably one player too many in the Fibre Channel switch market.

The Broomfield, Colo., company lost $50 million in the third quarter despite increasing revenues by 17 percent from the previous year. That follows disappointing earnings results from its major rivals Brocade Communications Systems Inc. (Nasdaq: BRCD) and Cisco Systems Inc. (Nasdaq: CSCO) (see Did Brocade Blow an Opportunity? and Cisco Still a Kid in Storage).

Even factoring in one-time charges for acquisitions of Nishan Systems and Sanera Systems and an investment in Aarohi Communications (see McData Sweeps Up Nishan, Sanera), it's apparent that McData will still face problems in 2004.

McDatas stock price tobogganed today [Ed. note: wheeeeee!], down more than 12 percent to $9.29 by midafternoon.

McData's guidance for the next quarter and comments made by CEO John Kelley indicate the company is still feeling the pain from price concessions that caused it to lower its third-quarter guidance a month ago (see McData Lowers Q3 Guidance). Kelley frequently referred to pricing pressure and lengthening sales cycles during his conference call with analysts.That pressure came courtesy of Cisco’s entrance into the Fibre Channel switch scene last year. Although Cisco has taken little market share, it hurts McData and Brocade as the third competitor in what was a comfortable two-horse race.

"You certainly didn’t have pricing pressure when it was just McData and Brocade," says Steve Berg, analyst at Punk Ziegel & Co. "It started when a third player came in. And not just any third player – a large company that can endure a lot of pain."

Heavy Reading's Fall 2003 Storage Networking Market Perception Study found Cisco had the highest name recognition in the group among prospective buyers, and it tied overall category leader Brocade for highest perception rating for service and support.

Without mentioning Cisco by name, Kelley talked about a new competitor sending out demos and lengthening the sales cycle. Sources say Cisco is also pricing its switches aggressively.

"The market is very competitive right now," says Kelley. "We certainly have a formidable competitor -- pricing at the end-user level as well as with our storage partners has come under a lot of pressure."McData will probably find it impossible to reverse recent pricing declines. It made substantial concessions to EMC -- its biggest customer, and former owner -- of between 12 percent and 15 percent, according to ThinkEquity Partners. It will probably have to make similar concessions to its other main customers, IBM Corp. (NYSE: IBM) and Hitachi Data Systems (HDS). Kelley forecast gross margins in the low 50 percent range next quarter -- down from 58 percent in the third quarter.

"Pricing pressure is a forever fact of life now," Berg says, "unless somebody leaves the market."

McData was less reliant on sales to EMC last quarter. EMC accounted for 54 percent of McData’s sales, down from 62 percent in the previous quarter. Kelley said he expects sales to EMC to rise again next quarter as they improve their relationship. But the lower margin guidance suggests prices won’t rise.

"We've been working with EMC a long time, and they with us," Kelley said. "It was unfortunate that we got in the position that we did, and I’ll take ownership of a lot of the problem."

Kelley is also temporarily taking ownership of the company's top sales position, vacated last week by Alain Andreoli (see McData Sales Boss McExits). Kelley said Andreoli left for a better opportunity and expects him to become CEO of another company. Andreoli told Byte and Switch he expects to announce his new employer on Wednesday.— Dave Raffo, Senior Editor, Byte and Switch