The Cisco Guessing Game

There's nothing like silence to get tongues wagging. The refusal of Cisco Systems Inc. (Nasdaq: CSCO) to itemize storage in its latest earnings report has morphed into a major guessing game (see Cisco Call Puts SANs in Storage). Analysts have taken sides, and rival vendors are using Cisco's silence to buttress their own bad news.

This week, for instance, Greg Reyes of Brocade Communications Systems Inc. (Nasdaq: BRCD) and John Kelley of McData Corp. (Nasdaq: MCDTA) hinted that Cisco's storage reticence means it's not cutting the SAN switch mustard.

We can’t comment on the competitor who didn’t make an announcement,” said Kelley, who then commented anyway. “We have some idea about it, and our guess is that if they knocked the cover off the ball, we’d have heard about it. But we can’t make a comment.”

Reyes said, “Well, since Cisco to the best of my knowledge didn't publicly state how they did, it is hard for me to respond. I can give you my anecdotal opinion, which is Cisco has done a lot to validate the space, and I think that they have created an opportunity for us to go in and retell our story to many end users. And I can tell you sitting here today that we are very comfortable with our ability to compete and win against Cisco.”

In Kelley's view, even if Cisco's not outselling its rivals, it's making its presence felt in other ways – by lengthening sales cycles, for example.“When you go into the enterprise you get an IT view, and then you have another group called the network group who comes in and they have a view as well,” Kelley said, describing customer evaluations. “We found ourselves articulating our stories to the networking people, who have a company [Cisco] that they work with and like a lot. And we’ve been in there with our core IT people who have really liked us. This tends to elongate the evaluation cycle.”

McData can't blame all delays on Cisco, however. It was hurt by a longer qualification process than it expected with EMC Corp. (NYSE: EMC) for its Eclipse multiprotocol switch – and that had nothing to do with Cisco. McData had to wait for EMC to finish qualifying a new Brocade switch first. EMC finally qualified the Eclipse earlier this month (see EMC, McData Make a Connectrix).

So who's making excuses? Financial analysts who follow the industry are split on the issue. Some take Cisco’s refusal to disclose its storage numbers as a sign of weakness. Others say their checks indicate Cisco is indeed making progress and cutting into the business of both of its major SAN rivals (see Cisco Call Puts SANs in Storage).

Analysts Shaw Wu of American Technology Research and Kaushik Roy of Susquehanna Financial Group, for instance, say Cisco is gaining traction in the midrange, where Brocade is the market leader.

The camp that says Cisco is doing well received some support from a market research report that claims its SAN switch revenue increased 18 percent sequentially during the first calendar quarter of 2004 while the overall market declined (see Report: Cisco SANs Grew 18%). That report from the Dell'Oro Group doesn’t completely eliminate guessing, though. That 18 percent growth doesn’t directly correlate with Cisco’s fiscal quarter. Cisco’s quarter ran from February through April, while Dell’Oro tracked January through March. Dell’Oro Group founder Tam Dell’Oro says there are signs that Cisco had a strong January, which was part of the quarter Cisco announced in February.Some sources think it's possible that regardless of Cisco's performance, it may be time for a market consolidation – meaning that Brocade and McData could merge or be bought, perhaps by Cisco.

“It makes strategic sense for Cisco to acquire McData if Cisco is truly serious about storage,” Wu wrote in a research note this week. “McData gives Cisco a dominant position in high end SAN switches and allows Cisco to extract more of the storage profits pie from EMC.”

Nonsense, others attest. "Why would Cisco buy either of them?" says Roy. "They don't need the channels. They don't need the products. You can buy companies to put your competition out of business, but in this case it doesn't make sense."

At least one other analyst, who asked not to be named, thinks it's likely that if Cisco doesn't buy Brocade or McData, someone else will. "Usually, layoffs like Brocade's indicate a company's getting ready to put itself on the market."

This is nothing new. Persistent rumors have put Brocade and McData on the block for months.Whatever happens, the two are clearly using the industry's uncertainty to boost their stances. Reyes, for instance, had this to say about McData this week: “Our other competitor I think has some company-specific problems and I think is out of position in a couple of different market segments."

The record shows that both Brocade and McData face big challenges. McData’s revenue of $97.2 million was down nearly $17 million from the previous quarter, according to this week's earnings report (see McData Sees Another Quarter Pounding). Yet Brocade didn’t take much of that business (see Brocade Hits Estimates, Lays Off 110). Its revenue of $145.6 million was up less than $1 million sequentially, which means the two major switch vendors together had lower revenues than in the previous quarter.

Both Brocade and McData claim seasonality played a big role in their results, but their combined revenues from the same quarter from 2003 were up sequentially over the last quarter of 2002. So either the market has stopped growing, or somebody else is cutting into their share. And it ain’t Computer Network Technology Corp. (CNT) (Nasdaq: CMNT), which had its revenues fall $18 million sequentially.

So what's ahead, given the current state of the competition? McData forecast revenues of $92 million to $100 million for this quarter, which might turn out to be another sequential drop and a loss. Brocade also gave conservative guidance between $147 million and $152 million in revenues, which comes on top of news of its laying off 110 employees.

Cisco's given no guidance for its SAN switching business.Two key observations come out of all this. First, despite what Brocade and McData say, they're highly aware of Cisco, and they're hearing its footsteps through the market. In a way, Cisco wouldn't have to be doing much selling at all to disrupt prices, elongate sales cycles, and make life miserable, at least occasionally, for the other two big players in a fairly narrow market.

At the same time, the FC director market's been uneasily balanced among a trio of players for a long time. As the market returns and IT spending improves, it's unlikely things will continue as they are. Indeed, it's a given the teetering will increase. Today's mystery, namely Cisco's real status, is likely to give way to tomorrow's big surprise – and that's where the real guesswork comes in.

— Dave Raffo, Senior Editor, Byte and Switch